Just passing through
Tax reform has reduced the tax burden for many pass-through businesses, but accountants need more guidance from the Internal Revenue Service.
From the pages of In Business magazine.
The Tax Cut and Jobs Act is still trying to gain some traction in the court of public opinion, but there is little doubt among accountants that it brings tax benefits — significant benefits in many cases — to pass-through businesses. The degree of those benefits is subject to opinion because even though small business confidence has reached record highs, the law’s critics charge that “pass-throughs” do not benefit as much as businesses organized as C corporations.
With a so-called “pass-through” business — such entities comprise the majority of small businesses — corporate profits are taxed according to the owner’s personal tax rate, not the new and much lower 21% corporate rate. Since most small businesses are organized to have income passed through to an owner who then reports it as personal income, we asked local accountants to assess how they make out.
With related rules having been proposed and the period for public comment having passed, it’s now up to the Internal Revenue Service to issue the final rules at some point in the near future. Accounting professionals interviewed for this article cited vague areas of the proposed rules they would like to see clarified in the final regulations, but overall they believe most “pass-throughs” will benefit from the law — with a few notable exceptions.
The best news, according to our tax experts, is that effective this year, owners of pass-through entities will be able to shave 20% off their earnings before paying taxes on it. The TCJA’s 20% deduction is on qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. QBI basically means the net amount of income, gain, deduction, and loss with respect to the trade or business, but does not include certain types of investment such as capital gains or losses, dividends, and interest income unless the interest can be properly allocated to the business.
If your taxable income is more than $157,500 for individual filers or $315,000 for married couples filing jointly, the deduction is subject to limitations. This gets into the weeds just a bit, but the deduction is limited to the greater of 50% of W-2 wages paid with respect to the business or 25% of W-2 wages paid plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property.
Second, the deduction isn’t allowed for specified service trade or businesses once the owner’s income exceeds certain threshold amounts, which are indexed for inflation.
“For taxpayers who are under those limits, applying the new rules will not be nearly as complex, but if you’re over those limits, it may be complicated,” says Dennis Kleinheinz, a partner with Meicher CPAs. “There are more hoops to jump through if you are over those income limits, particularly if you’re a specified service trade or business. Then, you might not qualify at all for the 20% deduction.”
Service businesses are one limitation, but the primary limitation is that 50% of the wages paid by the business to employees, including the owners themselves, must exceed the 199A deduction. Gordon Meicher, managing partner of Meicher CPAs, provided an example. “Let’s say you’re a proprietor, a simple LLC with no employees listed on your return, and you sell widgets. We have a guy that sells six products and makes $500,000. He has no wages, so he won’t get a deduction because he’s over the $315,000 threshold. The $500,000 times 20% is $100,000, so he needs at least $200,000 in wages in order to take the new Section 199A deduction. He doesn’t have any employees, so he has no wages and that hurts him.
“We take the same business and we say, ‘You’re an S corp, so pay yourself $200,000 in wages.’ It worked out to be $160,000. The S corp then paid about $160,000 in wages, and 50% of that is $80,000.
“Under his corporate structure as an S corp, this individual therefore has $80,000 a year tax-free that otherwise he was paying taxes on.”
That’s exactly the kind of thing that happens, and such changes in the tax law are why it’s more important than ever for small businesses to have someone who understands the new rules and can help determine what levels of wages need to be paid and how to stay under the income limits.
Ironically, most of the people who report pass-through income are not in fact small-business owners in the conventional sense but are professionals like lawyers, doctors, and accountants, or simply wealthy investors. Yet many of these very pass-through owners — particularly service providers such as accountants, doctors, and attorneys — don’t qualify for the pass-through deduction. Examples of the specified service businesses are those in the fields of health, law, accounting, actuarial science, performance arts, investment or investment management, trading or dealing in securities, partnership interests or commodities, consulting, athletics, financial services, brokerage services, or where the principal asset is the reputation or skill of one or more of its employees or owners.
Note that engineers are not listed among these specified service businesses, and Meicher provided an example of how bad accounting advice can impact business people. “Just yesterday, I had an engineer come in and he says, “Aw, it’s so bad, this new tax law. I’m not going to get any benefit. I’m going to lose my state tax deduction. I’m going to lose my mortgage deduction. It’s terrible.’ I told him that engineers are exempt from the specified service trade or business rules. His accountant didn’t even know that,” Meicher states.
Moreover, qualified business income is domestic trade or business income within U.S. and Puerto Rico other than investment income (except income from publicly traded partnerships that’s eligible for inclusion), investment interest income (other than qualified real estate investment trust and corporate dividends), net capital gains, and foreign currency gains.
“You have to have qualified business income to be eligible for the 20% deduction of domestic qualified business income (QBI),” notes Jason Grosh, director-tax for BKD CPAs and Advisors, who referred to it as the “20% deduction” and notes that it’s set to expire after Dec. 31, 2025. “That means you must have income from a qualified domestic trade or business.”
Moreover, if taxable income is above the specified income thresholds, the 20% deduction starts to get phased out if you’re in a specified service trade or business. If you’re in one of these “SSTBs” and your taxable income is over the full phase outs of $207,500 for single and $415,000 for married and filing jointly, you’re not eligible for the 20% deduction for that SSTB, although non-SSTB income would still potentially qualify for the 20% deduction. The floor and ceiling of the phase out will be indexed for inflation.
This gets even further into the accounting weeds, but for taxpayers who are not in an SSTB, if their taxable income is greater than the full phase outs, the deduction will be limited to the lesser of 20% of QBI or the greater of 50% of W-2 wages paid with respect to that business, or 25% of W-2 wages paid plus 2.5% of unadjusted basis immediately after acquisition of qualified property.
In plain English, these can be significant limitations if you’re over the thresholds. If you’re a higher income individual and you want to get this deduction, it’s something to be cognizant of. “Given these limitations and taxable income thresholds, it becomes even more important for taxpayers to engage in year-end tax planning to manage their taxable income and ensure they receive the permanent tax benefit related to the 20% deduction,” Grosh advises.
To make it even more complicated, the proposed regulations provide an opportunity to aggregate certain trades or businesses together for purposes of Sec 199A. The benefits of making the election will need to be evaluated by taxpayers on a case-by-case basis.
In general, C corps love the Tax Cuts and Jobs Act, especially if they don’t pay out dividends and face double taxation, but how do pass-throughs make out? Like everything else with the tax code, that depends. Generally, the results are pretty good, but if you’re an upper income individual, you might not fare as well depending on what state you’re in and how much of a federal tax benefit you received for paying state and local taxes pre- and post-TCJA. Under the law, state and local tax deduction limitations are capped at $10,000 and lawmakers eliminated or reduced the benefit of some individual itemized deductions.
“Without doing an analysis based on an individual’s specific facts, you can’t say [who benefits] with any certainty,” Grosh states. “However, the change in the law is most likely to be less beneficial for taxpayers in higher tax states than it is for people in the lower income tax states.”
Many taxpayers who had been itemizing in the past won’t be itemizing in the future because the standard deduction — now $24,000 — is so high that it will create a higher deduction than their itemized deductions. Business people in high tax states, for example, might be able to claim a $10,000 deduction on state and local taxes, but that doesn’t take them very far. “Not really because he doesn’t have a mortgage on his house, and his standard deduction is going to be $24,000,” Meicher explains. “He has $40,000 in state taxes, and his property taxes are $10,000, so he won’t get anything for his state taxes. Instead of claiming a $10,000 itemized deduction for taxes, he will claim the $24,000 standard deduction.”
That will definitely change people’s tax planning, Kleinheinz adds, because while Wisconsin is not in the same high-tax category as California or New York state, it does have a high state income tax, high property taxes, and a medium level sales tax. “We used to do a lot of planning with older taxpayers and real estate taxes. They would double up on itemized deductions in one year and then take the standard deduction the following year,” he explains. “We’re going to see a different group of taxpayers doing that in the future.”
The TCJA lowered the top individual income tax rate from 39.6% to 37%. Under the pre-TCJA tax regime, some pass-throughs were eligible for what’s called the Domestic Production Activities Deduction (DPAD), which was a 9% deduction. Under TCJA, more taxpayers will be eligible to utilize the 20% deduction than were able to utilize the 9% DPAD deduction, Grosh explains. So taxpayers in the highest income tax brackets who were effectively paying U.S. income tax at a 36% rate (91% times 39.6%) would now effectively be paying tax at a 29.6% rate (80% times 37%).
“This is a more than 6% reduction in effective tax rate,” Grosh adds. “Again, a more detailed analysis would need to be done to account for how much impact the reduced deduction for state and local taxes under TCJA has on the change in a specific taxpayer’s federal income tax.”
According to Kleinheinz, the new tax law basically levels the playing field between S corps and C corps. “With an S corp, your highest individual marginal tax rate is going to be 37%. With a C corp, you’re now going to be taxed at the corporate level at 21% and then you’re going to have an additional 15% individual tax on any dividends that the corporation pays out,” he explains. “So the combination of S corp income taxed at 37% with a 20% deduction on business income, versus a C corp at 21% corporate tax and then another 15% tax on dividends levels the playing field a little bit between S corps and C corps.”
Tax tipping the scales
Based on the proposed pass-through rules, which are subject to change, our accounting experts offered three tax tips:
1. Aggregate operations. In the back of the Section 199A proposed regulations, there are aggregation provisions that allow a business owner to aggregate their “operating” business with their rental business, if they have this combination. In other words, if you have one business entity that operates a business and then another entity which owns the real estate used to operate the business, you can combine those two entities and you’ll get the 20% deduction on your combined income from both entities. “You don’t have to [do this], but generally you should,” Meicher says. “You’re allowed to aggregate businesses and real estate as long as there is common ownership and the real estate is used by the operating business. The point is this: Even if you’re an operating business and you’re doing a triple-net lease, if you aggregate your business, you can still qualify that 199A deduction, the 20%.”
Jason Kadow, managing partner of KMA Bodilly CPAs & Consultants, would like clearer IRS guidance on the ordering of the 199A deduction for these activities. Among the unanswered questions from his perspective are: What entity gets counted first? What happens if you have a service business? Does the service business go first and is the other business pushed out because of the income limitation? “It really doesn’t matter if they both qualify, so if I’m an accountant and I rent my own building, if I have a lot of income and can get a deduction here, what happens to my income on the other side?” Kadow asks. “There are still some questions because the ordering has not been explained yet.”
2. Donate generously. Another tax-savings strategy for pass-through businesses involves donor-advised funds. These funds are where you contribute all your money to a trust for charities in one year, something Meicher has done himself in the past year, before the new tax law was enacted. Part of the strategy is donating stock gains to charity and avoiding capital gains taxes. Now, because of the new standard deduction of $24,000 for a married couple, if you put several years of charitable contributions into a donor-advised fund in one year, you can get an above-the-standard deduction amount.
“You just put four or five years worth of charitable contributions into the fund in one year,” Meicher explains. “When you do it with appreciated stock of a publicly traded company, you don’t pay tax on the stock gains and you get a charitable deduction.
“That is going to be so important for many wealthy Madisonians.”
3. Don’t hesitate. Kadow advises business owners not to wait when it comes to taking advantage of the new tax law. Based on early tax projection work, he believes it brings significant savings to a lot of businesses, especially if they are proactive. For the quarterly estimate due in January, they should be doing their planning in October; otherwise, they are going to have to wait a longer period of time to get a refund.
“We’re already having them reduce their estimates, so that’s money they can use now,” Kadow explains. “Instead of waiting until April or May of 2019 to get their money, we’re telling them based on what we now know about your income, you’re going to save x-number of dollars, and more than 50% of them are cutting down their quarterly tax estimates and are going to put that money back into their business.
“That’s going to grow the economy, and it’s going to help hire somebody if they can find employees,” Kadow adds. “By being proactive, business owners can get their money now.”
Okay to reorganize?
In certain cases, some believe it might be financially advantageous to reorganize as a C corp. This is not universally accepted accounting advice because a lot depends on how much the conversion process costs and how streamlined applicable state laws are, but some accountants believe it’s worth considering.
One snag is the fact that C corps can be double taxed, once on the 21% preferential rate, and again when the owners pay out dividends. For those who do not pay out dividends, opting instead to reinvest profits in the business, the conversion is more beneficial. In some cases, especially if a C corp plows its cash back into the business, Grosh believes that reorganization makes sense. “Again, with taxes, it’s very fact specific,” he says.
If the business wants to retain cash and is not planning to distribute the cash or sell the business in the near future, it could make sense to convert from an S corp to a C corp. “If the business owner wants to take all the cash out of the business and doesn’t want to accumulate cash, it’s generally going to be better off as an S corporation,” Grosh states.
Meicher contends that for the overwhelming majority of small businesses, S corps are still a better way to go because the income that’s left in the business increases one’s basis in the corporation.
“You are allowed to take this money out without tax,” Meicher notes. “Also, if you sell the business, you get credit for prior earnings left in the business, whereas retained earnings in a C corp provide no benefit in those circumstances.”
Ideally, regulations should clarify issues pertaining to the law, but sometimes they raise more questions than they resolve. The Internal Revenue Service has issued proposed guidance on Section 199A of the Tax Cut and Jobs Act, which pertains to the treatment of pass-through businesses. The public has had a chance to weigh in, and a public hearing is set for Oct. 16.
Who knows how long it will be before the IRS publishes the final regulations? The saving grace is that proposed regulations might be relied upon until final “regs” are issued, but accountants worry that final rules will not come until the end of 2018 or worse, during the peak of the 2019 tax season.
One thing local accountants would like more clearly spelled out is how the law treats rental income. The proposed regulations do not specifically define whether rental income is eligible for the 20% deduction. “If a triple net lease is not involved, there is generally favorable case law providing for taxpayers to treat rental income as trade or business income in certain situations, but it’s still an unresolved issue in the new law,” says Jason Grosh, director-tax for BKD CPAs & Advisors. “Yes, that’s one of the areas where we need more guidance.”
Dennis Kleinheinz, a partner with Meicher CPAs, has actually contacted the IRS for answers, but wants more clarity about whether rental income qualifies for the deduction. “The IRS person who wrote the proposed regs would like the Section 199A deduction to apply to all leases except triple net leases,” he says. “So if you have a triple net lease where you are collecting the rent from the tenant, and the tenant is expected to operate the property, I don’t think that’s going to qualify for this 20% deduction. However, if you are managing the property, you’re paying the real estate tax, the insurance, and repairs and maintenance, I’m hopeful that will qualify for the deduction.”
Jason Kadow, managing partner for KMA Bodilly CPAs & Consultants, has some questions about how businesses are classified. “In the past, a lot of accountants, when they’ve put in the SIC code for the businesses — people just throw it in,” he notes. “They really didn’t look at it, but now they are really going to want to look at what SIC code they put in because the IRS is going to look at that and say, ‘You know, when the final regs come out, we’re going to refine who qualifies as a service business.’ So they are going to look at that SIC code and say, ‘Is that a service-related business? Is that something that’s qualifies for the full 199A, or are there going to be limits based on those service businesses?’”
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