On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) became law. Perhaps the biggest headline item was the reduction of the corporate tax rate from 35%, one of the highest in the world, to 21%. This change should be carefully considered by parties to a financial restructuring, because the reduced corporate tax rate could make the corporate entity the most ideal entity to choose for resolving a debtor’s restructuring.
Prior to the TCJA, it was almost always the case that a debtor would be desperate to avoid corporate status, because operating in the corporate form meant “two levels of tax,” the first level applied to the corporation, at a rate of 35% and then the second level applied to the shareholder, generally at a rate of 23.8% (the capital gains and dividends rate (20%), plus, the net investment income tax rate (3.8%)). As a result, corporate income of $100 would be taxed down to $49.53, for an effective tax rate of 50.47%, which ignores state and local taxes.
Even after TCJA there are still two levels of tax, however, now that the corporate rate is 21%, the of effective tax in the simple example above would be approximately 40%, and the after tax return would be $60 (again ignoring state and local taxes). One might say that because the highest individual tax rate has been reduced to 37% (on ordinary income and 23.8% on most long-term capital gains) that it is still better to avoid the two levels of tax, however, now, perhaps more than ever, careful consideration must be made regarding the nature of the assets and operations of the restructuring entity, because now the benefit of corporate deferral and the business reasons for wanting to operate as a corporation could result in the corporate form of business being superior to that of a liquidating trust, disputed ownership fund, qualified settlement fund, limited liability company, limited partnership or other form of passthrough vehicle.
As in most areas of law, the facts are critical. Choosing the right vehicle in restructurings requires careful analysis of the facts. Regretfully, over the years, because the difference in after-tax returns was so dramatically worse when using a corporate vehicle under prior law, little consideration was given to the benefits of a corporation, because it was so rarely beneficial. This led to bad results, albeit infrequently. One example, under prior law, for when a corporate entity might be superior to a non-corporate form, would be if distributions of income could not be made, yet claimants to those assets were too numerous to avoid “publicly traded partnership” status (essentially a rule that treats a partnership as a corporation) and the claimant class was not finally defined (i.e., it consisted of disputed claimants). The parties may have defaulted into thinking that “qualified settlement fund” (“QSF”) was the best choice, and when the highest individual rate was 35% (prior to 2013), this may have been a choice that was not costly. However, when the highest individual rate increased to 39.6% (in 2013), this meant that undistributed income of the QSF was taxed at a higher rate than if the income was earned by a corporation. Moreover, if the claimants held corporate stock, instead of QSF interests, transferability may have been allowed (subject to S.E.C. rules), and the claimant could have sold its shares and been taxed only on gain (at 20%), and foreign claimants could have sold shares tax free. Now imagine that same scenario, but the corporate rate is not 35%, it is 21%, and the individual rate is not 39.6% but 37%. The delta has gone from 4.6% to 16%, and the points on stock sales remain the same (with a slightly higher rate now of 23.8% for U.S. shareholders).
This is a very particular example, and as mentioned, really one of the rare cases under prior law when a corporate entity would likely have been a better choice. The point of the example is to emphasize that now, more than ever, advisors to debtors should carefully consider the facts before dismissing the corporate form.
Benefits of the Corporate Form
Over the past several decades the main reason not to use a corporate form has been taxes. Now that the corporate rate has been dramatically reduced, to a level not seen since the 1930’s, coupled with the benefits of deferral on shareholder taxation of corporate earned income, those traditional reasons for avoiding corporate form are gone, or greatly at least greatly diminished.
Therefore, it is appropriate to consider the benefits of operating as a corporation. A significant benefit is limited liability. Although now all states have limited liability company statutes, it is worth considering whether the protection against personal liability provided by a particular state corporate statute is more favorable. Another benefit is that unlike with many trusts, a corporation has broad management powers and further can invest in various assets in order to attempt to maximize the return on its corpus of property contributed to it by the restructuring entity. Corporations are also eligible for (and subject to) the full panoply of corporate provisions of the Internal Revenue Code, including Sections 368 (relating to tax free reorganizations), 381 (transfer of tax attributes) and 351 (contributions of property to a corporation).
Here it is worth noting that one critical consideration regarding choice of entity relates to the formation of the entity. It is frequently the case that the debtor and claimants will desire that the formation of the entity be taxable so that they have the ability to recognize their loss. Taxation to the debtor on formation of a corporation should result because Section 351(e) turns off the regular tax-free provision. This section provides that assets transferred to a corporation in exchange for stock to be used to satisfy indebtedness of the debtor is not eligible for the general tax-free rule under Section 351. Further, when the stock is transferred to the creditors that should be a taxable exchange as well, however, both the consequences to the creditors and debtor are subject to the rules governing tax free reorganizations (Section 368), which could apply in some cases.
The only limitations to the transferability of stock in the corporation would apply under Securities and Exchange rules, not tax rules. Also, another benefit to corporate status is tax compliance. Filing tax returns and overall administration would likely be more straightforward for a corporation. The corporate entity would file a Form 1120 and would not generally be required to report detailed information to its shareholders, other than standard Form 1099 reporting. In contrast, passthroughs will need to file Form 1065 or 1041 and include Schedule K-1 or a substitute K-1 to the owners of the passthrough.
Even after TCJA, there are many reasons why a non-corporate vehicle should be considered. For example, if the assets are not expected to generate income on a regular basis, but rather in a one-time event. This is often the case when the asset is a cause of action. A litigation trust would likely be the best choice in this scenario, especially if it is expected that the beneficiaries of the trust will be identified prior to resolution of the cause of action. As shown above, if the claimants are still in dispute, not distributing any litigation proceeds could result in taxation at the highest individual rate, at the trust level, in certain cases. This is why it is important to consider the nature of both the claimants and the assets in order to choose the most tax-efficient restructuring vehicle.
This article is not meant to be an exhaustive comparison of all the different restructuring vehicles, but rather a recommendation to all advisors to carefully consider the potential benefits of using the corporate form.