Could Affect Government Revenue : Some Firms Reorganizing to Avoid Higher Tax Rate

When Congress passed the sweeping new tax-revision bill, it chose to tax individuals less and corporations more. Corporations naturally did not like that. And now some of them, both large and small, are figuring out ways to duck the higher taxes.

Some have simply decided they just will not be corporations anymore. They are planning to unincorporate. Others will resort to a different form of business organization that will not be subject to corporate taxation.

The result could be less revenue for the federal government, which has been counting on $120 billion in extra corporate taxes over the next five years to cover the tax rate cuts for individuals.

The incentives for corporations to avoid the new higher taxes are great. For the first time since the federal income tax was born in 1913, maximum tax rates for individuals will be below the rates for corporations. Under current law, corporations are taxed a maximum 46% and individuals are taxed a maximum 50%.

But under tax revision, the top corporate tax rate in 1988 of 39% will compare to a top individual tax rate of 33%--and corporations will be losing a host of cherished and lucrative deductions.

“In view of the changing tax rules, a lot of corporations are taking a hard look at whether their present form of operation is desirable,” said Sidney Kess, director of tax policy and planning for KMG Main Hurdman, an accounting firm.

And some experts say there could be a year-end surge in such conversions because of other provisions in the tax law that make such steps more costly next year.

Corporations considering changing their tax status generally are looking at one of two methods: restructuring into a limited partnership, or into a type of business organization known as an S corporation.

Both of these business organizations allow the entities some of the privileges of corporations. But taxes are no longer assessed against the business entity and instead are charged only against the shareholders in the case of S corporations, or against those who own units of limited partnerships.

“I’ve not yet seen a situation where (converting to S status) didn’t make sense,” Alex B. Hossack, a partner in the Los Angeles office of the accounting firm of Seidman & Seidman/BDO, said of his business clients. He said clients considering a switch include a local publishing company, advertising agency, small manufacturers, retailers and import-export firms. These companies generally are owned by only a few individuals.

Professionals Are Candidates

Doctors, lawyers, actors and other high-income professionals who incorporated themselves for previous tax benefits also are prime candidates for switching to S-corporation status, experts said.

As firms are reincarnated as S corporations or limited partnerships, shareholders will be paid a higher portion of profits.

Community Psychiatric Centers, a Santa Ana-based health-care concern that plans to convert to a limited partnership by year-end, said investors will receive $2.40 a share in profit distributions next year, compared to only 32 cents this year in dividends.

Shareholders of Alexander’s, a New York-based retailer that also plans to convert to a limited partnership, could get as much as 72% of the firm’s profits in 1988 compared to only 27% this year, according to some estimates.

Such steps are not going unnoticed by federal authorities and congressional tax writers. But they say it is not clear yet how many companies might make switches and whether it will reduce tax revenues significantly.

IRS Concerned

“This is something we are concerned about,” Internal Revenue Service spokesman Steven Pyrek said of corporate conversions to limited partnerships. But he added that the IRS has not published a position on the matter yet.

The congressional Joint Committee on Taxation, which wrote the tax bill, anticipated that corporations might change their status to cut taxes, said one committee official who asked not to be identified. But the committee did not think the effect would be major, so it did not calculate how much the federal government would lose in tax revenue.

Analysts said the threat that Congress could close the loophole is discouraging some companies from changing their corporate status.

Congress is likely to address the issue, possibly when it considers technical corrections to the tax bill next year, “if enough companies start doing it,” said Ira H. Shapiro, director of tax policy for the accounting firm of Coopers & Lybrand. “They don’t operate in a vacuum.”

Even before the tax bill, both limited partnerships and S corporations had significant tax advantages.

Taxed Only Once

Under conventional corporate status, profits are taxed first at the corporate level and again when distributed to individual shareholders as dividends. However, profits in partnerships and S corporations are taxed only once, after they are distributed to individual shareholders or partnership members.

Realizing this benefit, some companies--mostly with real estate or oil and gas holdings--have already transferred some or all of their assets into limited partnerships even before tax revision seemed certain of passage. The ownership units of about 25 of these limited partnerships (sometimes called master limited partnerships because their shares are traded on stock exchanges) are traded on the New York Stock Exchange, formed by such companies as Burger King, Mesa Petroleum, Newhall Land & Farming, Freeport-McMoRan and Diamond Shamrock.

Tax revision, by setting a top individual rate of 33% versus a top corporate rate of 39%, thus only provides further incentive “to do what some people have been contemplating for years,” said Arnold G. Rudoff, national director of partnership analysis for the accounting firm of Price Waterhouse.

Tax revision also is providing another demand for conversion to limited partnerships. Under the new tax law, losses from so-called “passive” investments such as tax shelters, where investors have no management control, can only be deducted against income from other passive investments. Thus, many taxpayers with tax shelters will not be able to use write-offs from those shelters unless they can offset them against income from other profit-making limited partnerships.

However, converting to limited partnerships or S corporations is not easy and has its drawbacks, experts say.

S Corporation Rules

For example, to form an S corporation, a concern cannot have more than 35 shareholders. It also cannot have a non-resident alien or another corporation as a shareholder. Also, certain types of retirement and fringe benefits are not deductible expenses to S corporations.

In addition, California is one of 14 states that do not recognize S corporations and tax them instead as regular corporations. So S corporations in California must settle only for lower federal taxes.

Limited partnerships also have their drawbacks. Limited partners are taxed on their share of all the profits of a partnership, regardless of whether those profits are actually paid to them. Thus, limited partnerships generally pay most or all of their profits to the shareholders and are discouraged from plowing back those profits into buying new plant and equipment for expansion.

Also, to convert to a limited partnership, a company must “sell” its assets to the newly formed limited partnership. That process of liquidation could subject shareholders to capital gains taxes. Also, the company could be subject to so-called “recapture” taxes if the assets are valued in the partnership higher than they were valued on the books of the corporation.

However, companies planning such liquidations anyway are trying to complete them before year-end because capital gains taxes will rise next year under tax revision. Also, tax revision repeals the so-called General Utilities Doctrine, which exempted firms from paying capital gains taxes after complete liquidations. Thus, if it liquidates next year, both a firm and its shareholders could be subject to capital gains taxes.