Change Your Tax Mindset - 3

Tax Reform Lessens Burdens to Converting Your C-Corporation

Converting a C-corporation into an S-corporation used to come with lengthy, expensive restrictions on asset sales but 2017's tax reform cut those penalties in half. (DTN file photo by Katie Dehlinger)

OMAHA (DTN) -- There was a time when C-corporations made a lot of sense for farmers, but as tax laws changed and the benefits eroded, farmers found changing their business structure could be cumbersome and expensive. Tax advisers say 2017's Tax Cuts and Jobs Act makes it easier than ever to make the switch.

"If you've been sitting on the sidelines waiting for a better time to get out of your C-corp, today is a good time," said Doug Claussen, certified public accountant with KCoe Isom in Goodland, Kansas.

Many farm corporations were formed in the 1970s because of lower corporate tax rates, ease of farm succession and deductible fringe benefits.

"C-corporations were the best thing for many years until the 1986 tax law," Claussen said. But for many, the tax consequences of converting were too steep to justify a change.

The new law lessens the penalties for converting from a C-corporation to an S-corporation, and tax experts say it's especially beneficial for farmers with an heir or heirs that aren't involved in business operations. C-corporations also aren't eligible for the new Section 199A deduction.

It's just one way changes to the tax code are forcing farmers to change their mindset. In this four-part series, DTN explains how to maximize deductions by avoiding losses, how changes to rules governing equipment trade-ins could complicate your state tax return, and why it might be a good time to change your farm's corporate structure to take advantage of lower tax rates and reconsider gifting strategies.

LOWER PENALTIES ON CONVERSIONS

Under the 1986 law, taking land out of a C-corporation triggered a taxable sale at the corporate tax rate, and then when the proceeds were distributed to the shareholders, they'd have to pay a tax on the cash dividend -- a double tax.

That meant the best way to transfer land out of C-corporation was to convert to an S-corporation, which means the tax liability is passed-though to an individual's tax return instead of the corporation's.

While converting corporate structure helped avoid the double tax, it required appreciated assets to be held in the S-corporation for a minimum of 10 years; otherwise, asset sales would be subject to a "built in gains" tax at the highest corporate income tax rate -- 35%.

The new tax law slashes that waiting period to five years and lowers the highest corporate income tax rate to a flat 21% for all C-corporate income.

"The waiting period is shorter and the 'hammer' is not as big," Claussen noted.

TAKING LAND OUT OF C-CORPORATION LOWERS TAX ON LAND SALES

Land is often one of the assets off-farm heirs like to inherit, because it generally appreciates in value and provides an annual return.

However, if the land is inside a farming corporation, the off-farm heirs only inherit corporate stock, Claussen said. That stock most likely doesn't pay an annual dividend, and the off-farm heir rarely sees the financial benefit from the increase in the value of the land, unless they sell their stock back to the on-farm heir.

Also, land inside a C-corporation does not receive a step-up in basis when a stockholder dies.

For example, a farmer bought 500 acres for $1,500 an acre. Now it's worth $8,000 per acre. If the land was not in a C-corporation when the owner died, the tax basis would step-up to the current market value of $8,000. The heirs could sell the land without paying any capital gains tax. That's $4 million tax-free.

If those 500 acres were in a C-corporation, and the farmer wanted to leave that tract to his off-farm heirs, it becomes more complicated, because the corporation lives on even after the farmer passes away. If the heirs wanted to sell that land, the corporation could sell the land for $8,000 per acre and pay tax on the gain ($8,000 - $1,500 = $6,500 per acre). At a 21% federal corporate tax rate on 500 acres, that tax bill would be $682,500.

In addition, the proceeds from the sale are treated as dividend payments. The cash dividend from the sale ($4 million - $682,500 tax = $3,317,500) would be subject to income tax at the shareholder level. That rate is usually 15%.

After taxes, heirs would receive $2,819,875 from the sale instead of the $4 million had the land not been inside of the corporation.

"The worse thing is owning land in a C-corp until you die if your heirs will likely sell the land after you have died," said Tad Goodenbour, a tax services partner with BKD CPAs and Advisors in Colorado Springs. "If I were 70 years old and had no on-farm heir, I would convert my C-corporation to an S-corporation and get the five-year clock running."

C-CORPORATIONS MISS OUT NEW DEDUCTIONS

C-Corporations are not eligible for the new Section 199A deduction, which is reserved for individuals and pass through-entities like S-corporations.

The new tax law cut the top corporate tax rate from 35% to 21%, while pass-through entities only saw their top rate decrease from 39.6% to 37%. The new Section 199a deduction of 20% for sole proprietors and pass-throughs was seen as a way to level the playing field with the new tax cut for C corporations.

"This is going to be big," said Rod Mauszycki, principal with CliftonLarsonAllen in Minneapolis and DTN/The Progressive Farmer's tax columnist. "Farmers who are now C corporations will be asking themselves should they switch to a partnership or an S corporation. I've seen several clients for whom it will be worth it to make changes. 199A could be a substantial deduction that would be missed in a C corp."

The deduction would help farmers better manage their tax liability and elevate the need for prepaying for input and making unnecessary asset purchases to avoid tax. Please see the first story in this series, "Paying a Little Tax Now Saves Taxes in the Long Run" for more details on why it's important for taxes to show an income each year: https://www.dtnpf.com/….

Essentially, qualified business income (taxable income) under one of the pass-through entities will get a 20% tax deduction that didn't exist previously. Passive investment such as capital gains, dividends and interest income does not qualify for the deduction. The deduction is phased out for income above $315,000 (for joint returns) and $157,500 for individuals.

The new law eliminated the 9% domestic production activities deduction (DPAD) deduction for farmers and farming entities. However, it has essentially been kept in place for cooperatives under 199A(g). If a farmer sells to a cooperative, the cooperative can pass through 199A(g) deductions to its patrons as it did with DPAD. If the farmer or farm entity also sells to a non-cooperative, he or she can also calculate an additional deduction under 199A.

The Internal Revenue Service is unlikely to finish writing the rules for Section 199A(g) before farmers need to file their taxes.

There are some drawback to converting a C-corporation to and S-corporation, Claussen said. If machinery or grain is owned by your C-corporation, there could be negative tax consequences to converting, but it will generally be offset by gains elsewhere.

And, for families who want to keep the farm corporation going forever, the C-corp structure works well.

Claussen recommends working closely with your tax adviser before making any changes to your corporate structure.

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Des Keller contributed to this report.

Editor's Note: If you're interested in learning more about changing your business structure and how it could affect your taxes, make sure to attend the "Use It. Lose It. Or Die With It." breakout session, hosted by KCoe Isom's Doug Claussen, at the DTN Ag Summit in Chicago. The DTN Ag Summit runs December 3-5. You can find all of the details at www.dtnagsummit.com.

(KD/BAS/CC/ES)