Thursday, January 4, 2018

Tax Reform and Sole Proprietorships, Partnerships and S Corporations

Much attention has been paid to the doubling of the standard deduction as well as the lowering of the corporate tax rates contained in the Tax Cuts and Jobs Act of 2017 (the “Act”).  The corporate federal rate will now be 21 percent and there is a maximum dividend rate of 23.8 percent (combined would be 39.8 percent (79 percent times 23.8 percent plus 21 percent)) and the top individual tax rate is 37 percent, which is the rate generally applied to the income of pass-through businesses (sole proprietorships, partnerships, and S corporations).  As such, in order to keep some of the advantages of a lower rate of pass-through businesses, complex changes  are contained within the Act.  Careful attention will need to be made to see whether particular pass-through businesses can benefit from the Act and thus reduce their taxes by several percentage points.  Contained herein is a brief overview which can serve as a high-level guide.  However, please note that some of the information contained herein may change based upon future IRS guidance, and the exact effects on certain transactions and entities, such as like-kind exchanges, tiered entities, and trusts and estates, are not currently known (although the Act directs the IRS to develop guidance for these areas).  As you will see, these changes are surprisingly complex even without any of the regulations, and careful attention will need to be paid to the various calculations contained therein.  Moreover, not all pass-through businesses will be able to benefit, but some may be able to see at least some modest reductions.

At the outset it should be noted that an actual entity formed under state law, e.g., a limited liability company or a limited partnership, is not required to take advantage of the Act’s provisions.  So sole proprietorship and common law partnerships would be able to take advantage of the additional deductions, provided that they otherwise meet all of the requirements contained under the Act.  Limited liability companies that have a single member can elect corporate taxation or can keep the default classification of being treated as disregarded, and thus as a sole proprietorship.  Multiple member limited liability companies can elect corporate taxation, or they can keep their default classification as a partnership.  Obviously, any limited liability company that elects corporate taxation but does not elect to be an S corporation will not be a pass-through entity and as such the provisions discussed herein would not apply.

Under the tax law for tax year 2017, individuals who receive pass-through entity income are taxed on that income at their individual rates.  Partners and S corporation shareholders are taxed on their share of the income regardless of whether or not the income is distributed to them and sole proprietorships are not treated as separate from their owner and are taxed accordingly.

The Act adds a new code section, 199A, that allows a deduction by individuals of up to 20 percent for certain domestic qualified business income from pass-through businesses.  Therefore, for those businesses that fully qualify, their rates would be reduced from 37 percent to 29.6 percent.  199A applies to tax years after December 31, 2017 and before January 1, 2026.  The deduction is available to individuals who itemize as well as individuals who claim the standard deduction, but is subject to phase in or elimination if taxable income exceeds certain thresholds or for certain service trades or businesses.  Performing services as an employee does not count as a qualified trade or business.  Exactly what types of business qualify as a trade or business will need to be better specified with regulations, particularly with rental properties.

The deduction amount is calculated as follows, and is the lesser of:
  1. The combined qualified business income amount (income, gain, deduction, and loss effectively connected to a trade or business within the United States and included for determining taxable income are qualified), or
  2. Twenty percent of the excess of the individuals taxable income over the sum of (i) that individual’s net capital gain under IRC 1(h) and (ii) that individual’s aggregate cooperative dividends.
The lesser of:
  1. Twenty percent of the individual’s aggregate qualified cooperative dividends, or
  2. The individual’s taxable income minus that individuals net capital gain.
The deduction cannot be more than the individual’s taxable income, reduced by net capital gain, for the tax year.  For purposes herein taxable income is determined without regard to the 199A deduction.  Note that cooperative dividends cover a variety of different business cooperatives, such as cooperative telephone companies, and as such there are special rules under 199A for claiming these deductions.

The combined qualified business income amount for a tax year equals:
  1. The sum of deductible amounts for each qualified trade or business of the individual, plus
  2. Twenty percent of the individual’s aggregate qualified REIT dividends and qualified publically traded partnership income.
This deduction is limited to the greater of:
  1. Fifty percent of W-2 wages (wages that qualified trade or business paid to its employees and include certain deferrals) paid by the business; or
  2. The sum of 25 percent of the W-2 wages plus 2.5 percent of unadjusted basis of certain property that the business uses to produce the qualified business income.
However, this limitation does not apply if the individual’s taxable income for the tax year is equal or less than $157,000.00 or $315,000 for a joint return.  For single filers who make more than $157,500 and less than $207,500, there is a phase in of the limitation, and for joint filers who make more than $315,000 but less than $415,000 there is also a phase in.  The purpose of this limitation is to try to prevent abuse.  As an example, it prevents employees quitting their jobs, setting up S corporations that contract with their old employer, and then not pay themselves a salary, and thereby convert their salary into Qualified Business Income and obtain the lower rate.  In this case, since the S corporation would have no W2 wages and no applicable property, then the limitation would be zero, and as such no deduction allowed.  The 25 percent and 2.5 percent of unadjusted basis of certain property was added late into the bill to allow certain rental property owners to still claim a deduction if they could not otherwise qualify under the 50 percent limitation.  However, it is not completely clear which rental activities rise to the level of a trade or business.

Certain specified service trades or businesses cannot claim the 199A deduction, and those businesses are in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, performing arts; investing and investment management, trading, dealing in securities or dealing in partnership interests or commodities.  In addition, those businesses whose principal asset is the reputation or skill of one or more of its employees or owners also cannot claim the 199A deduction.  However, a modified qualified business deduction may be claimed even for a specified service trade or business if the taxable income for the tax year is less than $415,000 for taxpayers filing a joint return or $207,500 for all other taxpayers.

Code Section 199A regarding pass-through businesses contains new provisions that will have to be carefully analyzed, particularly all the various calculations for both deduction amounts as well as for the limitations, phase-ins and modifications.  One takeaway from this article is that the choice of business entity has now become more complex, and that pass-through entities might not always be the best answer if the business owner(s) cannot qualify for the lower pass-through rate.  In the coming months it can be expected that many new rules and regulations will be issued to better define the new concepts under 199A that will hopefully allow for more precise calculations and planning.