The recently enacted Tax Cuts and Jobs Act (TCJA) has broad implications regarding the federal taxation of businesses and their owners. Depending on a variety of factors, the owners of a business may achieve significant tax savings by restructuring their business. A business entity is either taxed as a C corporation or as a pass-through entity or structure (i.e., a S corporation, partnership, disregarded entity, or sole proprietorship, among others). It is important to note that multimember LLCs are often taxed as partnerships, or in the alternative, may elect to be taxed as either S corporations or C corporations. Single member LLCs may either be disregarded for tax purposes or may also elect to be taxed either as S corporations or as C corporations.
The TCJA introduced the following changes that will affect which entity type provides a business owner with the greatest tax advantage: (i) reduction of the highest C corporate tax rate from 35% to 21%; (ii) introduction of a deduction of up to 20% on “qualified business income” for individuals and trusts; and (iii) reduction of the highest individual income tax rate for ordinary income from 39.6% to 37% (although the highest capital gains rate remains unchanged at 20%). Absent new legislation, the reduction of the C corporate tax rate is permanent while the other changes introduced by the TCJA and discussed in this article are in effect only for tax years beginning after December 31, 2017 but prior to January 1, 2026.
Business owners must determine which of the following is more advantageous from a tax perspective: (i) a reduced C corporate tax rate, plus a second level of taxes upon the payment of dividends (at capital gain rates if the dividends are “qualified dividends”); or (ii) a single level of tax at their respective individual tax rates on their respective shares of income earned through a pass-through entity after receiving a deduction of up to 20% on “qualified business income”. Owners of pass-through entities (taxed as either S corporations or partnerships) who would otherwise be taxed at the highest rate of 37% on income earned from a pass-through entity will instead be taxed on “qualified business income” at an effective rate of 29.6% if they receive the maximum 20% deduction. Owners may also be subject to an additional 3.8% Medicare tax on earnings from either C corporations or pass-through entities.
“Qualified business income” consists of either profits from an active trade or business or from rental income (including REIT dividends and qualified cooperative dividends), each when earned by a pass-through entity. Excluded from “qualified business income” are foreign-earned income, certain investment-related income, all reasonable compensation paid to shareholders of S corporations, and all guaranteed payments paid to business owners of partnerships (or members of LLCs taxed as partnerships).
However, a business owner of a pass-through entity may not receive the maximum 20% deduction (or may be completely ineligible for the deduction), depending on whether one of three limitations described below applies.
First, the deduction of up to 20% may either phase out or be eliminated depending on the business owner’s income, from all sources, and depending on whether the business is a “specified service trade or business” (SSTB). The trade or business is a SSTB if it (i) involves the performance of services in any of the following fields: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services; or (ii) has the principal asset comprising either the reputation or skill of one or more of its employees (excluding engineering and architecture firms). If the business is a SSTB, then the deduction begins to phase out if a business owner’s total income from all sources in 2018 exceeds a certain amount ($157,500, if single, or $315,000 if married and filing jointly) and is eliminated if the business owner’s income in 2018 exceeds a certain amount ($207,500, if single, or $415,000 if married and filing jointly).
Second, if a business owner’s total income from all sources in 2018 exceeds a certain amount ($157,500, if single, or $315,000 if married and filing jointly), and the business is not a SSBT, then the business owner’s deduction is limited to an amount equal to the lesser of: (i) 20% of his “qualified business income” with respect to the qualified trade or business; or (ii) the greater of (A) 50% of the business owner’s wages (timely reported to the Social Security Administration) with respect to the qualified trade or business, or (B) the sum of (1) 25% of the business owner’s wages with respect to the qualified trade or business, and (2) 2.5% of the original cost of “qualified property” used that business (i.e. depreciable property).
Third, if a business owner’s total income from all sources in 2018 does not exceed a certain amount ($157,500, if single, or $315,000 if married and filing jointly), then, regardless of whether the business is a SSBT, the business owner may deduct the lesser of: (i) 20% of his “qualified business income”; or (ii) the difference of his taxable income and his net capital gains.
Of course, there are additional tax factors outside the scope of this article (i.e. employment taxes, potential sale of the business, tax planning opportunities related to the death of an owner, etc.), that should also be considered when determining the most advantageous structure of a business. Business owners should consult with both their accountant and attorney to discuss the tax, asset protection, and business management ramifications of organizing or restructuring their business.
For further guidance or additional information regarding the impact of the Tax Cuts and Jobs Act, or for general counsel concerning the business entity form most appropriate for your business, please contact Brian C. Marsiglia of MB Law by phone at 303-376-6008 or by email at firstname.lastname@example.org.