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Flow-Through Taxation Continues to Stir Debate Among Lower-Middle-Market Firms

As business leader sentiment toward the new tax reforms continues to wane, David A. VanEgmond of PwC’s Private Company Services practice recently answered a few of our questions concerning the rising banter around corporate tax rates.

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MME: For many lower-middle-market firms, we hear that the effective tax rate is now higher — and partnerships and LLCs are finding themselves at a real disadvantage …

VanEgmond: Well, a lot of these businesses operate as flow-through entities with regard to how they pay taxes, and for a lot of closely held companies, the disparity has just become so great with the rest of corporate America. It’s not just that we need corporate reform. It’s that with corporate reform, we can’t lose sight of the fact that the number of companies that now operate in this flow-through form of taxation is quite substantial.

There are something like 4.3 million pass-through employers — and 54 percent of all the private sector jobs are through employers who use a pass-through method. The business administration reported that C-corps on average pay an 18 percent rate, and partnerships and S-corps are at a 26 to 27 percent rate. That was before the tax increases, so the disparity is even bigger now.

The big benefit on the flow-through is that they don’t get double taxed. When you take your money out of a corporation, you then pay a dividend on it, whereas if you’re a flow-through, you don’t. And while there’s clearly a difference, the sense is that there needs to be greater parity.

MME: When it comes to wealth transfer in family-owned companies, are the corporate tax issues changing there as well?

VanEgmond: Well, there were some estate tax rules that looked like they were going to sunset, and then there were some rules that were put in as part of the tax reform at the end of 2012. These were policies that allowed people to still make gifts under the exemption amount, so a lot of people do lots of different things from a planning point of view. These could be using tools such as grantor-retained annuities, where they put stock into an annuity trust and take back the fair value and appropriate return and try to shift appreciation to the beneficiary of those trusts. They can consider making outright gifts and looking at the appropriate discounts that they can take on minority shares, noncontrolling shares, and voting vs. nonvoting stocks, and move that from generation to generation. Then there’s a philosophy that says you are paying a gift and paying a gift tax, so to move not only the value of what you’re transferring but also the gift tax out of your estate is all good planning, and that planning is still appropriate when moving family businesses from one generation to the next. There’s a lot of other planning that needs to go along with succession planning.

MME: When lower-middle-market firms decide to begin doing business overseas, what tax issues will they want to be out in front of?

VanEgmond: It begins with assessing how they are going to do business. Are they just going to conduct business from a U.S. location and sell goods into a country? Some countries require that you have operations within the country if you want to conduct business, so a U.S.-based company may be required to open a branch. So you have to understand the local rules, and you may in fact make money in a given country, but it can be very difficult to get money out of the country. It may take a good deal more time than you would expect, and there may be some hidden tax or toll changes such as withholding that you may not have expected. There could be taxes with which smaller middle-market companies are not as familiar. The U.S. doesn’t have a VAT, but throughout most of the world, there are VAT systems. You have to understand the impact of VAT on the movement of your goods in different territories and jurisdictions, and getting the alignment right can potentially create a very tax-efficient situation for the company.

I’ve seen companies that have a transfer pricing policy for goods or services, and they might incur certain start-up expenses in foreign locations that are very reasonable. But then again, a jurisdiction may say, “Hey, you’re doing business here, and we don’t see how you’re not making a profit,” and a company could end up with an outcome that they did not expect. The process of getting countries to okay moving cash back to the U.S. depends on the country. You may have to go to a government bureau or department and seek out what’s required.

MME: What do middle-market business owners want most from corporate tax reform?

VanEgmond: We have the highest corporate statutory rate and the second highest corporate effective rate, so corporate reform, tax reform, and deficit reduction have to go hand-in-hand. I think there is a perception in the business community that whereas government can kick the can down the road, business owners cannot. They face issues and they have to make decisions, and they’re looking for something more out of the government from a directional point of view. What exactly is the policy? For a number of years, we heard the word “certainty” being echoed, and people wanted more certainty. I don’t think that this is necessarily front-and-center anymore, but I don’t think it went away either. People would like more clarity, and they would like to have the issues dealt with and stop seeing the can kicked down the road yet again.

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