Sweeping changes to the tax laws enacted last year continue to have many business owners and managers scratching their heads.
The headlines of the 2017 Tax Cuts and Jobs Act were all about lower tax rates for businesses, specifically the cut of the graduated tax rate on C corporations from a high of 35% to a flat 21%, along with a 20% deduction available to qualified pass-through businesses, including S corporations, limited liability corporations, partnerships and sole proprietorships.
In some cases, the changes in tax rules may be significant enough for some owners to consider reorganizing their business structures from a pass-through entity to a C corporation, or vice versa, depending on the specific strategy, future, operations, market, cash flow, and capital needs of each business.
While much remains to be seen as the IRS formulates rules and guidance, several important clarifications are being issued, giving businesses an opportunity to figure out just where they fit into the new tax regime.
Changes for pass-through entities
Sole proprietorships, S corporations, limited liability companies (LLCs) and partnerships are categorized as pass-through entities because, as the name suggests, profits generated by these entities are allocated directly to the businesses owners, whereupon those profits are taxed as part of the owners’ income tax returns.
Pass-through entities have become increasingly popular because, among other things, the pass-through structure avoids the double taxation that occurs in C corporations, in which the corporation pays taxes directly on its income, and then shareholders pay tax again on distributions or gains from sales of stock in the corporation.
One downside of a pass-through structure is that pass-through owners must pay tax on all business earnings every year, irrespective of whether they receive the corresponding cash from the business, while C corporation owners are not subject to a shareholder-level tax if the corporation retains the earnings. This makes staying abreast of year-to-year changes in tax laws essential for owners of pass-through businesses.
Two major changes pertaining to owners of pass-through entities as dictated by the new tax laws are:
- A reduction in personal income tax rates. Specifically, the top marginal rate dropped from 39.6% to 37%, along with corresponding reductions in all but the 35% bracket. In addition, the income limits on many brackets were increased, which also will reduce tax bills for many filers.
- The newly-enacted 20 percent deduction. This deduction on pass-through income has the potential to reduce the top marginal rate from 37% to 29.6%. However, as with any tax break, this new deduction is subject to a long list of limitations.
For those pass-through owners with taxable income of less than $315,000 for joint filers ($157,500 for single filers), the only restriction is that the income must be considered bona fide “trade or business income,” and that it not be an attempt to mischaracterize wages.
Accordingly, those below this income threshold that meet the bona fide trade or business income requirement will generally be afforded the full 20% deduction on qualified income. Businesses and workers will continue to face the same IRS rules regarding employee vs. independent contractor classification. In addition, tax law revisions do not change the requirement that S corporations pay “reasonable compensation” to owners who perform substantial services, which may restrict the ability of personal service businesses organized as S corporations to claim the full benefit.
The unrestricted benefit of the 20% deduction phases out — or, more accurately, the various limitations associated with the deduction begin to phase in — as joint taxable income increases from $315,000 to $415,000 (from $157,500 to $207,500 for single filers), with taxpayers above the $415,000 and $207,500 thresholds subject to the full effect of a series of limitations.
Specifically, the 20% deduction generally may not exceed 50% of the owner’s allocable share of the business’s W-2 wages, or 25% of the owner’s allocable share of the business’s W-2 wages plus 2.5% of the owner’s allocable share of the acquisition cost of tangible depreciable property.
For example, two equal partners in a business generating $1,000,000 of qualified income, paying $300,000 in W-2 wages, and owning no tangible depreciable property, would generally each have a deduction – prior to any limitations – of $100,000 (i.e. 20% x $1,000,000 = $200,000, split equally by the two owners). However, in this case, the wage limitation would apply and each partner’s deduction would be limited to 50% of his allocable share of the W-2 wages, or $75,000 each.
Sole proprietorships, S corporations, limited liability companies (LLCs) and partnerships are categorized as pass-through entities because, as the name suggests, profits generated by these entities are allocated directly to the businesses owners.
Tax reform for specified service trades or businesses
In addition to the wage and property limitations, income from "specified service trades or businesses" (SSTBs), will not be eligible for the deduction (assuming the taxpayer is over the income threshold discussed previously).
What is an SSTB?
The statute defines an SSTB to include
“any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” In addition, an SSTB includes any trade or business involving “the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”
The proposed regulations clarify that performance of services in the field of health generally applies to professionals who directly care for patients or other clients, but that it does not apply to related medical services and suppliers, such as running a health club or spa, providing payment processing services for health professionals, or the research, testing, manufacture or sales of pharmaceuticals or medical devices. The proposed regulations apply a similar rationale to the services performed in the field of law, in that such services generally include direct provision of legal advice to clients, but not ancillary services, like legal printing, stenography or process serving.
Under the proposed regulations, services performed in the fields of performing arts and athletics follow that same line of reasoning, applying to actors and directors but not to motion picture equipment or facilities, and applying to athletes, coaches and team managers but not to the provision of services that are not “unique to athletic competition,” such as videotaping team practices or maintaining athletic facilities or equipment.
The exclusion of services performed in the field of consulting applies to the “provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” In addition, the proposed regulations clarify that services performed in the field of consulting also include those generally associated with lobbying – providing advice and counsel regarding advocacy in an attempt to influence decisions made by a government, governmental agency or legislators. However, under the proposed regulations, consulting specifically does not include training or educational work, or consulting that is included with or embedded in the sales of goods or services that are part of a business not otherwise excluded under these rules, as long as the consulting services are not separately billed.
Investment and securities trading activities are also not eligible for the 20% deduction. This includes activities such as “investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)) partnership interests, or commodities (as defined in section 475(e)(2)).” However, the definition of financial services in the proposed regulations does not include banks, which means shareholders of S corporation banks may be able to take the deduction.
Perhaps the most discussed, and possibly the most ambiguous, limitation in the statute is the exclusion of any trade or business where the principal asset is the reputation or skill of the owner(s) or employees. However, despite initial uncertainty, the proposed regulations have defined this very narrowly. Specifically, the proposed regulations state that this test will only apply to businesses or individuals who are paid for the use of an individual's image, likeness, name, signature, voice, trademark or other associated aspects of the individual’s identity, who collect appearance fees, income or who earn money from endorsing products or services.
While the general rule excludes any income from the performance of services in the one of the listed, or otherwise excluded, fields, the proposed regulations do provide a de minimis rule for trades or business deriving income from both excluded SSTB operations and qualifying operations. Specifically, the proposed regulations provide that a trade or business generating otherwise qualified income will not be an SSTB if less than 5% of its gross receipts are from SSTB-type activities, or less than 10% of its gross receipts if it has gross receipts of $25 million or less for the taxable year.
Active vs. passive investors
The new rules are the same for active and passive investors and do not change how net investment income taxes or self-employment taxes are calculated.
Sole proprietors and members of partnerships will continue to pay the combined 15.3% self-employment tax on their net business income up to $128,400, except for income from rental real estate, which is exempt.
S corporation owners will pay FICA taxes on their wages. While passive investors do not face self-employment tax, they will continue to pay the 3.8% net investment income tax (NIIT) that was enacted as part of the Affordable Care Act, which applies to certain types of taxpayer income with modified adjusted gross income of more than $200,000 for single filers or $250,000 for joint filers.
Obviously, S corporation owners will want to classify themselves as active in order minimize investment income taxes. LLC members will want to adjust their holdings between manager and investor class shares, in order to accomplish a similar result.
In addition to the reduced individual rates and new deduction for pass-through income, pass-through owners will now face a new limitation on allowable business losses. Moving forward, a business owner will be limited to a $500,000 trade or business loss ($250,000 for individual filers) in any year. Losses in excess of those amounts will be treated as a net operating loss (NOL), carried forward to the next tax year and subject to the applicable NOL limitations.
Business owners should be sure to consult their tax advisers on these and other details of the new tax act. Questions include:
- Will my business qualify for the 20% deduction?
- How do these changes impact my allowable deductions?
- Do I need to change my business structure?
- How might these changes affect a sale of the business?
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