There are winners and losers under the new tax reform law, the Tax Cuts and Jobs Act (TCJA). Pass-Through Entities; S corporations, partnerships, LLCs, and sole proprietorships (collectively, PTEs) can count themselves among the winners. The TCJA is primarily designed to provide tax cuts for businesses of all types. It also adds complexity, and in some circumstances, the potential tax savings for C corporations may outpace the savings available to PTEs. It is important to note that regulations and other guidance have yet to be promulgated that are needed to clarify several matters in the TCJA.
Qualified Business Income Deduction
The TCJA reduces the corporate tax rate to 21 percent, but this only applies to C corporations. The TCJA also provides eligible PTE owners a reduced effective tax rate thanks to the new 20 percent deduction against Qualified Business Income (QBI).
As a result, business owners taxed at the 37 percent maximum individual tax rate would pay an effective rate of 29.6 percent on QBI. If the net investment income tax also applies, the effective rate would increase to 33.4 percent. This disparity, as compared to the 21 percent corporate tax, may raise eyebrows. However, the corporate tax involves double taxation when profits are paid out to shareholders as dividends; whereas, the distributions from PTEs are generally received tax-free.
The QBI deduction is available without regard to the level of owner participation in the business, so passive investors are eligible to claim the deduction. The TCJA makes no attempt to redefine the nature of a trade or business for tax purposes, so existing nuances and ambiguities regarding the determination of an activity’s status as a trade or business remain.
The deduction is claimed at the taxpayer level (e.g. on their individual or trust return) and the amount is limited. The deduction is equal to the lesser of (a) 20 percent of QBI, or (b) the amount that is the greater of (i) 50 percent of W-2 wages paid by the qualified business or (ii) 25 percent of W-2 wages paid plus 2.5 percent of the unadjusted basis of qualified depreciable property. A common form of compensating partners or LLC members, guaranteed payments, does not qualify as W-2 wages for this purpose. Certain individuals and trusts are not subject to these limitations. Specifically, the limitation does not apply if the taxpayer’s taxable income does not exceed $157,500 ($315,000 for married taxpayers filing a joint return (MFJ)). The W-2 wages or qualified depreciable property limitations are then phased in, and only apply fully when a taxpayer’s taxable income exceeds $207,500 ($415,000 for MFJ).
C Corporation Conversion Opportunities
A conversion from a PTE to a C corporation may actually be advantageous under the new tax law. PTEs should weigh the other benefits of the pass-through structure against the lower 21 percent corporate tax rate, particularly if dividends or distributions are limited and the business is not planning an exit from the business in the near future. The new $10,000 individual limitation on the deduction of state income taxes will weigh heavily on this analysis in Minnesota, because an individual’s state income taxes arise from QBI whereas C corporations can deduct state income taxes without limitation.
PTEs should forecast the tax impact resulting from the new QBI deduction, along with other tax changes, to reassess the amount of ongoing estimated tax payments and its impact on cash flow. For more information about how the new tax law affects your business, please contact Brian Barsi at 612-376-1237 or firstname.lastname@example.org.