If there are winners and losers under the new tax reform law, pass-through entities—S corporations, partnerships, LLCs, and sole proprietorships (collectively, PTEs)—can count themselves among the winners. The tax reform law introduced as the Tax Cuts and Jobs Act (TCJA) is primarily designed to provide tax cuts for businesses of all types, and it delivers on that goal. It also adds complexity, and in some circumstances, the potential tax savings for C corporations may outpace the savings afforded to PTEs. This formerly unorthodox scenario and many other new provisions for PTEs require careful study to ascertain the full impact of TCJA on such businesses.
Qualified Business Income Deduction
Businesses other than C corporations cannot take advantage of the profound reduction in the corporate tax rate to 21 percent, but eligible PTE owners will see a reduced effective tax rate thanks to the new 20 percent deduction against qualified business income (QBI).
Business owners taxed at the 37 percent maximum individual tax rate would pay an effective rate of 29.6 percent on income subject to the 20 percent deduction. If the net investment income tax also applies to such income, the effective rate would increase to 33.4 percent. This disparity, as compared to the 21 percent corporate tax, may initially raise eyebrows; however the corporate tax involves double taxation when profits are paid out in dividends. This will be discussed below, but let’s analyze the QBI deduction, also referred to as the pass-through deduction.
The QBI deduction is available without regard to the level of owner participation in the business, so passive investors are eligible to claim the deduction. The new law makes no attempt to redefine the nature of a trade or business for tax purposes, so existing nuances and ambiguities regarding the determination of an activity’s status as a trade or business will remain. Taxpayers must study every activity under the light of existing case law to determine whether such activities rise to the level of a trade or business. For example, courts have found that a triple net lease of one rental property did not constitute a trade or business. Other factors may also lead to similar determinations.
A qualified business is any trade or business other than (a) one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment management services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners; or (b) one involving the performance of services as an employee.
The deduction is available to both individual owners and trusts, and is claimed at the individual or trust level. The amount of the deduction is limited, however. It is equal to the lesserof (a) 20 percent of QBI, or (b) the amount that is the greater of (i) 50 percent of W-2 wages paid by the qualified business or (ii) 25 percent of W-2 wages paid plus 2.5 percent of the unadjusted basis of qualified depreciable property used in the qualified business.
QBI essentially is the ordinary income, less ordinary deductions, of a qualified business. Gain from the sale of a business is not considered QBI and is therefore ineligible for the 20 percent deduction. Trust dividends are treated as QBI, whereas interest, dividends, capital gains, and several other items are not.
W-2 wages for purposes of the limitation against the 20 percent deduction generally is the amount reported as such for employment tax purposes. Hence, a common form of compensating partners or LLC members—guaranteed payments—does not qualify as W-2 wages for this purpose. Compensation for shareholders also appears to be excluded from W-2 wages on the basis that is not properly allocable to QBI. Commentators on the tax reform law are divided over this observation, and it may require clarification in a technical corrections bill or new regulations to remedy the uncertainty. The qualified depreciable property provision will have an impact on the real estate sector, where business owners may use property management companies in lieu of paying wages to employees. Such businesses are therefore afforded an alternative to remain eligible for the 20 percent deduction.
Certain individuals and trusts are not subject to the W-2 wages or qualified depreciable property limitations. Specifically, the limitation does not apply if the taxpayer’s taxable income does not exceed $157,500 ($315,000 for married taxpayers filing a joint return). The W-2 wages or qualified depreciable property limitations are then phased in, and only apply fully when a taxpayer’s taxable income exceeds $207,500 ($415,000 for married taxpayers filing a joint return).
Regulations have yet to be promulgated that are needed to clarify several matters; however, the new deduction will be made available in arrangements involving tiered ownership of a qualified business.
C Corporation Conversion Opportunities
Depending on the situation, a conversion from a PTE to a C corporation may actually be advantageous under the new tax law. PTEs should weigh the other benefits of the pass-through structure against the lower 21 percent corporate tax rate, particularly if dividends or distributions from the pass-through business are limited, and the business is not planning an exit from the business in the near future. In these situations (and assuming in all examples that the individual is in the maximum 37 percent rate), the 36.8 percent effective tax rate for individual shareholders of C corporations after dividends would not apply (39.8 percent with the net investment income tax), because only the 21 percent corporate tax rate applies. Compared to the 29.6 percent effective tax rate for QBI (33.4 percent with the net investment income tax) that applies regardless of distributions, the decision to maintain pass-through status is no longer so clear-cut.
The new $10,000 individual limitation on the deduction of state and local income and property taxes will weigh heavily on this analysis as well, because an individual’s state income taxes often arise from QBI, whereas C corporations can deduct state income taxes without limitation. And these nuances become even more pronounced when the QBI deduction does not apply, such as with ineligible business activities or as a result of the W-2 wage limitation. Further confounding this analysis is that the individual tax rate reduction to 37 percent is not permanent (scheduled to expire after 2025), whereas the corporate tax rate reduction to 21 percent is permanent.
Depreciation
Shifting gears to a broader focus, there are many other TCJA provisions that impact PTEs. Qualifying property acquired and placed in service after Sept. 27, 2017 is eligible for 100 percent bonus depreciation in the year it is placed in service. The 100 percent rate drops by 20 percent per year beginning in 2023, until it is eliminated in 2027.
And for the first time, the 100 percent expensing is available for both new and used property. Eligible assets are those with a depreciable life of 20 years or less and are expected to include the expanded definition of qualified improvement property. A significant drafting error, however, failed to grant qualified improvement property the reduced 15-year class life (from the 39-year class life it had under the prior law) and therefore, it will also not qualify for 100 percent expensing without correction. This is expected to be addressed in a future technical corrections bill, although that is not certain.
An additional depreciation benefit for commercial property is available under Section 179, which permits expensing of assets that otherwise would need to be capitalized and depreciated. TCJA expands the annual Section 179 limitation for qualifying assets from $500,000 to $1 million, with a phase out beginning at $2.5 million. Section 179 is available for qualifying improvement property, property that is required to be depreciated under the Alternative Depreciation System (ADS), and property that includes roofs, HVACs, fire protection and alarm systems, and security systems. Cost segregation studies will be more valuable than ever as a result of these changes to 100 percent bonus depreciation and Section 179.
Business Interest Limitation
The TCJA imposes a new limitation on the interest expense deduction for any business, equal to its interest income plus 30 percent of its adjusted taxable income (essentially EBITDA). Businesses whose average annual gross receipts for the prior three years are less than $25 million are exempt from this new limitation. Real property trade or businesses also have the option to elect out of the limitation altogether, but as a trade-off, must depreciate property using ADS rules. Excess unused business interest can be carried forward indefinitely.
Excess Business Losses
The TCJA added a new loss limitation rule applicable to non-corporate taxpayers, whose trade or business losses are now limited to $500,000 annually for joint returns ($250,000 single). Because this new limitation applies to a non-corporate taxpayer’s business losses, aggregated net losses passed through from various partnership and S corporation holdings are included. Any excess loss is carried forward as a net operating loss. This means, for example, if interest expense, 100 percent bonus depreciation or enhanced Section 179 deductions have helped generate an overall pass-through loss of $1 million, an individual can only use $500,000 of it to shelter other income (e.g., wages, interest, dividends, or capital gains) in that year. Remember, the passive loss limitation rules still apply (and will apply before the excess business loss limitation does), and the limitation applies to the aggregate of all personal and pass-through losses for the year. Any unused excess business loss that is carried forward as a net operating loss is governed by the general rules for net operating losses in the carryforward years.
Net Operating Losses
Net operating losses can no longer be carried back two years, and instead will now be carried forward indefinitely. The deduction is limited, however, to 80 percent of taxable income (determined without regard to the NOL deduction) for losses arising in taxable years beginning after Dec. 31, 2017. As a result, net operating losses no longer can completely eliminate taxable income, a concept borrowed from alternative minimum tax calculations.
Carried Interests
Politicians engaged in a great deal of discussion over the past few years about preventing the holders of carried interests from enjoying capital gains tax treatment for profits interests in partnerships granted without corresponding capital contributions. Ultimately, the TCJA made a fairly modest change in this area by increasing the holding period to qualify for the long term capital gains tax rate from the normal one year to three years.
Cash Method of Accounting
The cash method of accounting will be available for more taxpayers under the TCJA. Taxpayers now are eligible for the cash method for accounting so long as the average gross receipts for the three prior tax years do not exceed $25 million. Furthermore, the cash method is available regardless of whether such taxpayers maintain inventories as an income-producing factor, and such taxpayers are also exempt from the requirement to capitalize indirect costs to inventories under uniform capitalization rules.
Estate and Gift Planning
The TCJA doubled the lifetime death, gift and GST exemptions to $11.2 million per person (this is an estimated amount – the final amount that is indexed for inflation has not yet been released). Discounts for lack of marketability and control were not affected by TCJA.
Action Items
PTEs may want to forecast the tax impact resulting from the new QBI deduction to reassess the amount of ongoing estimated tax payments and to plan for other implications of the new deduction. PTEs must also begin to account for the new incentives available with respect to cost recovery, and whether such provisions may interact with excess business loss and net operating loss limitations.
For more information about how the new tax law affects your business, please contact your local tax provider.
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