As we prepare for perhaps another round of major tax law changes, you might want to consider the status of your clients’ legal postures. Making a client’s business structure more nimble or setting the stage to obtain outside or inside basis step-up could offer some solutions.
Partnership income taxation provides much more flexibility:
- Partnerships can be divided on a tax-free basis. Corporate divisions require long holding periods, active businesses, and a number of other factors before they can be tax-free.
- Partners in a service partnership can come and go with minimal tax consequences. They can even avoid capital gain tax on a seller-financed sale.
- When a partnership interest is sold, the buyer can get an inside basis step-up.
- When an owner dies, the entity’s inside basis attributable to the deceased owner will obtain a new basis if the entity has a Section 754 election in place. The election’s deadline is the partnership income tax return that includes the date of death, and extensions may be available. Even if one misses the deadline, the election might be made when funding bequests of the partnership interest.
Additionally, when starting a business, consider that owners can write off debt-financed losses more easily through a partnership than any other entity.
Consider migrating an existing corporation toward a partnership structure:
- Any real estate should be bought outside of the corporation and leased to it. Entering into a long-term lease and bequeathing the real estate to children not involved in the business can give them a nice income stream. Equipment leasing can also work well if one can zero out its taxable income or take appropriate steps to avoid self-employment tax and the 3.8% net investment income tax. Equipment leasing can be especially attractive if the owner has a very limited life expectancy – write-off the equipment one day, and get the basis restored soon after. If the equipment purchase is debt-financed, the basis step-up generates no estate tax.
- Any new business ventures can be started in a new entity. The new business venture might be another product line or service or a geographical expansion of the existing business. The existing business can loan money to the new business on favorable terms to help get it going.
- If the founder has not signed a non-compete agreement, part or all of the business’ goodwill might belong to the founder personally. The founder can contribute his or her goodwill to a new entity taxed as a partnership, and the corporation can contribute its other assets to the new entity.
Whereas a new business might be started in a simple limited liability company (LLC), a business generating significant profits could be run by one or more LLCs held by a parent limited partnership. Limited partners do not pay self-employment tax on their shares of the entity’s income (although they do pay SE tax on compensation for services they perform). The general partner could be an S corporation, which receives a management fee and pays the owners reasonable compensation.