Family business succession planning after the 2017 Tax Act

The Tax Cut and Jobs Act of 2017 (the 2017 Act) introduced a number of changes that open planning opportunities for family businesses. The reduced corporate tax rate and the introduction of the "qualified business income" (QBI) deduction merit review of choice of business entity, while the 2017 Act's doubling of the federal gift, estate and generation tax exemption opens planning opportunities for family business transfers.

Choice of business entity. The 2017 Act reduced the top federal income tax rate for corporate taxpayers from 35 percent to 21 percent.

The 2017 Act also introduced a 20 percent deduction for QBI (generally income from a domestic Subchapter "S" corporation, limited liability company or other entity that allocates income and associated tax liability to the owner).

Unlike other provisions of the 2017 Act, this corporate rate cut does not "sunset" on December 31, 2025. The rate cut has prompted many business owners to consider whether they should change the tax status of their business entity. Those family businesses that are taxed as Subchapter "S" corporations or partnerships may consider whether it would be more tax efficient to change the tax status of the business to a Subchapter "C" corporation. The business owner should assess a number of factors before changing tax status, including:

• Is a sale imminent?

If the business owner plans on selling the business in the near future, converting the tax status of the entity to a Subchapter "C" corporation may increase the tax liability on any sale proceeds the owner receives. This is because a traditional "C" corporation is a separate taxpayer.

If the corporation sells its assets, which is often the buyer's preference, then there will be two levels of tax: first, to the corporation on the sale of its assets; second, to the corporate shareholder following distribution of the sale proceeds from the corporation.

• Do you need distributions?

The lowered corporate rate will benefit corporations that can retain their earnings and reinvest them in the business rather than distributing them to shareholders.

However, business owners must be aware of the accumulated earnings tax (AET). The AET is a separate 20 percent tax that is assessed upon earnings and profits of a corporation that exceed the reasonable needs of the business.

• About the QBI deduction

The QBI deduction introduces additional complexity to the choice of entity decision.

Theoretically, the QBI deduction was included in the 2017 Act to achieve a level of parity with the corporate rate cut so that owners of businesses would be taxed at a lower rate on business income allocated to them, so that if the QBI deduction applied, the top marginal tax rate on the QBI would be 29.6 percent.

However, there are a number of issues to consider in determining whether a business owner will benefit from the QBI deduction, including:

• Is the income QBI?

• Is the income from a "specified service business?"

• Is the QBI deduction phased out/reduced because of level of taxable income of the business owner?

The legal and accounting community is still awaiting guidance from the IRS on the QBI deduction, including the scope of what constitutes a specified trade or business.

• Estate, gift tax changes

The 2017 Act doubled the federal estate, gift and generation skipping exemption to $11.18 million per person, or $22.36 million for a married couple.

This enhanced exemption enables family business owners to transfer family business interests now or in the future, with reduced or no concern about the prospect of estate tax liability after their death.

The IRS also withdrew the controversial Chapter 14 proposed regulations on October 20, 2017.

The proposed regulations would have affected the valuation of family business entities and reduced the effectiveness of a number of traditional planning techniques. The increased exemption offers an opportunity to business owners. Like the choice of entity decision, there are a number of factors that should be considered, including:

• Income needs

Can the business owner afford to gift the business interest outright, or would another technique make more sense, including a sale of part or all of the business interest to family?

• Exemption worries

Absent other changes in the law, the enhanced exemptions "sunset" on Dec. 31, 2025 and revert to the 2017 level. Although many advisers view any "clawback" of the increased exemption as unlikely, the potential exists, creating planning uncertainty.

• Business interest and death

If the business owner retains the business interest until death, the tax basis of the business interest is "stepped up" to equal fair market value on date of death.

This step up may represent a significant income tax savings.

• Tax, succession planning

The increased exemptions, while attractive, should not conflict with other businesses succession planning, particularly if one family member is active in the business and will succeed to management of the business after the business owner exits. Transferring family business interests to those that will not be active in the business should not jeopardize management of the business.

The 2017 Act was favorable for family business owners. These changes affecting the corporate tax rate and the new QBI deduction require a review of choice of business entity to assess the most desirable structure. In addition, the estate tax changes offer opportunities for family business succession planning.

• Ken Clingen is managing member at the law firm of Clingen, Callow & McLean in Wheaton.