Tax Reform and Pass-Through Entities
On December 22, 2017, our President signed into law the Tax Cuts and Jobs Act, the largest major tax reform in over 30 years. Within this Act are major changes to the taxation of regular corporations (C corporations) and to non-corporate taxpayers, which include individuals, estates, and trusts who own interests in what are called pass-through entities such as sole proprietorships, partnerships, limited liability companies (LLCs), and S Corporations. These entities are for the most part not subject to entity level tax, but instead pass the income through to their owners who are then taxed on the income.
This article will focus only on the pass-through entity income tax changes that came about as a result of the tax rate benefit provided to C corporations limiting the tax rate to a flat 21%, a key component of tax reform. Before I get into the meat of the changes, let me just warn you that we will need a whole lot more guidance coming from the IRS and Treasury in order to understand how this all works.
Let's start out with some basics:
- The new rules are effective for tax years beginning after December 31, 2017 and expire after December 31, 2025
- There is a deduction for individuals, estates, and trusts equal to 20% of domestic "Qualified Business Income" (QBI), which is defined below, from a pass-through entity
- Since the maximum individual income tax rate is now 37%, the 20% deduction provides an effective top marginal tax rate of 29.6%
- QBI would include Specified Service Trade or Business, which is defined below
Definitions in Basic Terms
Qualified Business Income (QBI): The net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer and it doesn't matter if the taxpayer is "Active" or "Passive" in the business. This is determined for each qualified trade or business of the taxpayer.
Specified Service Trade or Business:
Any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services; or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; or involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. Engineering and architectural services are excluded. This is a definition that needs a whole lot of clarity, which hopefully will be provided soon. For example, what are included in services in the fields of health? How do you determine what business has a principal asset being the reputation or skill of one or more of its employees or owners? Couldn't this pull in a lot of companies that you wouldn't normally think of as service businesses? And would this trump the exception for architectural and engineering services? Stay tuned.
These are individual taxable income amounts that, if exceeded, cause the 20% deduction to be phased out. The starting threshold amounts are $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly. Once the taxable income exceeds $207,500 (or $415,000 for joint filers), you are fully phased in, and for owners of Specified Service Trade or Businesses, the deduction is $0. For other businesses that exceed the threshold amounts, the deduction is limited to what is called a "Wage (Capital) Limit" (Hmmm, sounding a bit complicated).
Wage (Capital) Limit:
The greater of:
(a) 50% of your share of the W-2 wages paid with respect to the qualified trade or business or
(b) The sum of 25% of your share of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (basically, this is depreciable property cost).
The (b) above was an additional provision added to allow for businesses with low or no wages to qualify, such as real estate businesses. (Uh-oh. Sounding more than a bit complicated here).
Qualified Trade or Business:
Basically any trade or business other than a Specified Service Trade or Business and other than the trade or business of being an employee.
Some other important points:
• The 20% deduction is a deduction against taxable income and not adjusted gross income (AGI)
• The 20% deduction cannot exceed your taxable income reduced by net capital gain for the year
• If your individual taxable income (AGI at the bottom of page one of your Form 1040, less itemized deductions) is less than the threshold amounts, you do not need to worry about the definition bullet point for Specified Service Trade or Business or Wage (Capital) Limit
Example: Easy one first, which is based on taxable income below the threshold amounts.
You are a single taxpayer with taxable income of $157,000. This is below the single threshold of $157,500 so all we care about is QBI. You have QBI from your 100% owned S Corporation of $100,000. Your deduction is 20% of $100,000 or $20,000. It doesn't matter whether you are a Specified Service Trade or Business or not. Any Specified Service Business or Qualified Trade or Business qualifies for this.
Dealing with Threshold Limitations and Exceptions
Now, we move to taxpayers with taxable income in excess of the above Threshold Amounts ($157,500 or $315,000), where the deduction is subject to phase-in rules. So, now we need to take into consideration the Specified Service Trade or Business as well as the Wage (Capital) Limit.
Unfortunately, the limitation on the 20% deduction is computed differently for businesses that are Specified Service Trade or Business and all other Qualified Businesses.
I am going to begin with Specified Service Trade or Businesses. In computing the qualified business income, the taxpayer takes into account only the applicable percentage of qualified income, gain, deduction, or loss, and of allocable W-2 wages. The applicable percentage with respect to any taxable year is 100%, reduced by the percentage equal to the ratio of: (the excess of the taxable income of the taxpayer over the threshold amount) to $50,000 ($100,000 with a joint return). What the heck does that all mean?
Let's look at an example to make this clearer, but I am only going to use the 50% Wage Limit and not the 25% wage plus 2.5% of capital to try to simplify it.
Example: Specified Service Trade or Business
A single taxpayer owns 100% of an S Corporation and has taxable income of $182,500 — of which $150,000 of this is QBI due to providing services in the field of health after paying wages of $100,000 to employees and herself. She has an "applicable percentage" of 1 - ($182,500-$157,500) / $50,000, which is equal to 50%.
Then, 50% is applied to the QBI of $150,000, or $75,000. Then, we have to determine the includible wages, which is 50% of $100,000, or $50,000. The deduction is then the lesser of 20% of $75,000 ($15,000) or 20% of $50,000 ($10,000), which leaves the deduction for the single taxpayer who is over the threshold amount at $10,000.
What if the taxable income is $207,500? With the same factors above, the deduction would be "applicable percentage" of 1 - ($207,500-157,500) / $50,000, which equals 0, which means that there is $0 deduction. For Specified Service Trade or Business income, the deduction can be totally eliminated.
This total elimination, however, does not apply to Other Qualified Businesses.
Let's move to Other Qualified Businesses. If the taxable income exceeds the threshold amount, the Wage (Capital) limitation applies. If the maximum threshold is met, the Wage (Capital) limit applies fully.
The tentative deductible amount for these other businesses is equal to the lesser of 20% of the qualified business income with respect to such trade or business or the greater of (a) 50% of the W-2 wages with respect to that business, or (b) 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property (the Wage (Capital) Limit). The one big difference with this computation is that there is not a "1 minus a percentage" as in the computation for Specified Service Businesses.
Again, what does this mean?
Another example, and again I am only going to use the 50% Wage Limit and not the 25% wage plus 2.5% of capital to try to simplify it. This example is complicated.
Example: Other Qualified Business
Same facts as above, except I am changing wages to $50,000 to show the full effect of the wage limitation. The Qualified Business manufactures widgets.
(a) is 20% of QBI of $150,000, or $30,000.
(b) Is 50% of W-2 wages of $50,000, or $25,000.
Since (b) is less than (a), the application of the wage limit applies.
The wage limit computation is as follows: ($182,500-$157,500) / over $50,000, which equals 50%.
(a) Above of $30,000 is reduced 50% of the difference between (a) and (b) = $30,000-$25,000 x 50%, which equals $2,500.
Therefore, the taxpayer's deductible amount is $30,000-$2,500 = $27,500.
What if the taxable income is $207,500? With the same factors above, the wage limit computation is as follows: ($207,500-$157,500) / $50,000 equals 100%.
(a) Above of $30,000 is reduced by 100% of the difference between (a) and (b), which equals 5,000 x 100%, or $5,000.
Therefore, the taxpayer’s deductible amount is $30,000-$5,000 = $25,000, which is equal to the 50% of wages limitation.
If all of those figures and equations have your head swimming, don’t panic. That’s what your tax professional is for; to help walk you through all of this. If you haven’t already reached out to him or her for a conversation on the impact of tax reform on your business, I suggest you do so right away.
Also keep in mind there are a number of other issues related to this whole pass-through business benefit. We shall see what comes out of the additional guidance by the IRS and the Treasury, which will allow us to really explore the opportunities and plan accordingly.
One question that has surfaced is whether a pass-through business should just convert to a C Corporation and get the benefit of the 21% tax bracket on all of the C Corporation taxable income.
I will tell you right now that there is no one size that fits all, and care should be taken and due diligence done to understand all of the issues associated with being a C Corporation as it relates directly to the business activity as well as to the owners instead of just blindly converting.
This is all going to be such fun, don't you think?
David Baymiller, CPA contributed this blog. A partner in GJM’s Tax Department, Dave has over 35 years of public accounting experience with an emphasis on tax planning and consulting. Dave recently joined other GJM experts to present an education session on the Tax Cuts and Jobs Act. The event offered information on key changes for individuals and businesses as a result of the new law.
Established in 1996, Gilmore Jasion Mahler, LTD (GJM) is the largest public accounting firm in Northwest Ohio, with offices in Maumee and Findlay. Locally owned, GJM offers cloud-based accounting services and provides comprehensive services including assurance, business advisory, tax, risk advisory and healthcare management. The Firm’s professionals specialize in industries including construction & real estate, healthcare, manufacturing & distribution and utilities.