Tax Reform Series: Businesses
Permanent Reduction in Corporate Rate.
Although most changes affecting individual taxpayers will sunset, the top corporate tax rate was permanently lowered from 35% to 21%. This is the first time in generations where corporate income tax rates are lower than individual income tax rates, which begs the question: are U.S. corporations the next legal tax shelter for taxpayers' labor and investment income? The answer remains to be seen. Certainly, both practitioners and the IRS will start dusting off sections of the tax code and other rules designed to address and penalize any potential abuses (e.g. accumulated earnings and personal holding company taxes). Of course, there are genuine and appropriate reasons for retaining funds in a corporation too, and when they arise taxpayers must be ever more aware of the aforementioned and now reinvigorated anti-abuse rules.
Temporary Deduction for Pass-through Owners.
A complicated, if not the most complicated, part of the new tax law is a provision that provides favorable treatment of business income from pass-through entities. These include: sole proprietorships; partnerships, S corporations; and limited liability companies. Such entities pass business income directly through to their owners. That income avoids the corporate tax, but is then taxed at the individual's rate. There is a wide discrepancy between the new corporate rate (21%) and top individual rate (37%), and the 2017 Tax Act can provide a deduction equal to 20% of "qualified business income" from pass-through entities.
The details and specifics of each company's operations and income truly matter, because Congress has instituted a framework that both favors certain types of business income and outright denies the deduction for others. For instance, the deduction does not apply for specified service businesses (e.g. law firms, accounting firms, consultants)… unless it does. The Act will except some lower income taxpayers from the exception. For this reason, married individuals earning less than $315,000 (indexed) can take full advantage of the deduction and those earning less than $415,000 (indexed) may still receive a limited deduction.
The Act does not establish a one-size-fits-all approach to obtaining the deduction. Accordingly, every business owner will require an individual assessment to determine if they qualify for the deduction, or if not, what actions they can or should take to qualify. Given the moving parts, it remains to be seen whether practitioners and taxpayers alike can fully appreciate and understand implications of the new rules before the deduction sunsets in the end of 2025. Still, this one change can have huge implications and benefits to a pass-through business owner for the next 8 years. Therefore, it is absolutely essential to explore taking advantage of the deduction until sunset. Even those owning the disfavored and unwelcome specified service businesses may be able to take advantage of the full deduction. Creative estate and tax planning techniques (e.g. use of non-grantor trusts, increasing W-2 wages, segregating business lines) are available, but they must be balanced with whether actions taken to obtain the deduction are still desirable or will be costly to reverse after 2025.
The Answer is No Longer Simple.
Selecting the entity for a new business or restructuring was typically a simple decision process when the corporate tax rate was 35% and there was no 20% deduction for a pass-through owner's qualified business income. Generally speaking, the elimination of the corporate tax layer by selecting a pass-through entity was preferable for most business owners. The Act flips traditional considerations on their head at least through 2025 when the pass-through deduction sunsets. Business owners should now look at the C corporation structure with a renewed interest to decide whether the permanently lower corporate rate on current income is worth having to pay tax on subsequent dividends. By the same token, pass-through entities may ponder restructuring in a more tax efficient manner to segregate specified service lines in efforts to qualify to the deduction. The 2017 Tax Act does not succeed in simplifying tax laws, but it certainly creates planning opportunities for small and big businesses alike.
Just FYI Travis Scales is a tax attorney focused on efficient wealth accumulation and preservation strategies.