In December 2017, the most sweeping tax reform since 1986 was passed into law. While we believe this reform is a win for most business owners, taxpayers should be mindful about the impacts these reforms can have on their businesses, as taxes represent a large % of expenditure. As savvy business owners know, proper tax planning translates into additional operating capital to support operations and growth.
Ultimately, one of the main goals of tax reform was a much-needed reduction in corporate tax rates (C-Corporations), which previously topped out at 35%, in addition to the tax shareholders pay on dividends received from these entities. Under tax reform, the top corporate rate was lowered to 21%, making the corporate tax structure more competitive and therefore corporations could have additional capital for investment. Most small businesses however aren’t structured as C-Corporations because of the historic double tax burden of paying 35% corporate tax plus a tax on dividends received. Instead, most small businesses are structured as “pass-through” entities (Partnerships, S-Corporations, and Sole Proprietorships), meaning the entity doesn’t pay tax, but rather passes through the income to the owner(s) of the entity, where the tax is paid. Assuming for a moment that most pass-through entities are owned by individuals (not always the case), this creates a potential disparity if not addressed. Under tax reform, the top individual tax rates only went down to 37% from a top rate of 39.6%, potentially creating an unintended disadvantage for pass-through entities if not addressed. Because Congress knew this to be an issue, for tax years beginning after December 31, 2017, taxpayers are allowed a deduction of up to 20% of their “Qualified Business Income” (“QBI”) they receive from domestic pass-through entities under a new code section known as Section 199A, or affectionately referred to as the “20 Percent Deduction”.
In this article, we will briefly focus on this new provision, as it has garnered much attention and discussion in the tax planning community, due to it’s complexity and ambiguity, especially given the amount of taxpayers it will impact.
To begin with, taxpayers must determine the amount of QBI they have. Under the statutory language, QBI is the net amount of income, gain, deduction, and loss received from any qualified trade or business of a taxpayer, excluding investment income, or items such as capital gains, interest, dividends, etc. It also does not include guaranteed payments or reasonable compensation you’ve received in your capacity as a partner or shareholder, as applicable.
Once you’ve determined that you have QBI, the first step is to determine the amount of QBI for each business activity you have. Next, you compute the initial 20% deduction for each qualified activity. Third, you need to address the income limitations. If your income is above $415,000 (married filing joint), the deduction is limited the lesser of 20% of QBI or the greater of (a) 50% of W2 wages or (b) 25% of W2 Wages plus 2.5% of your Fixed Assets (gross or original cost before depreciation).
Sounds fairly simple, correct? As with anything in tax, nothing is quite so simple. For starters, if your business fits within the meaning of “specified service trade or business”, the deduction is not available unless you fall within or below the above mentioned threshold ($415k married filing joint). A specified service business is one which involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The last sentence is quite ambiguous, but so are the definitions of several specified fields (ex. consulting is a broad term).
Other nuances in the tax reform bill have created more questions than answers, prompting organizations such as the American Institute of CPAs, American Bar Association, and other professional organizations and trade groups to write letters to the Treasury Department for needed clarification. Areas of concern are questions such as:
- What is an activity? Is it the income of each business entity, or is drilled down further into income derived from various activities within each business entity? For example, what if you have one business entity that offers several different types of services or products for sale? Do you aggregate these for purposes of the deduction, or are you are required to separate them?
- If you have multiple related but separate entities, how do you treat wages of each entity in a situation where one entity pays all wages out of administrative convenience and is reimbursed by the related company? For example, say you own 2 companies, both of which generate an income that put you well above the income thresholds noted above. For simplicity, assume neither company has depreciable assets so you’d use the 50% of wages test mentioned above. In Company A, you pay all employee wages for both companies (similar to a common paymaster setup), and Company B reimburses Company A for its share of the wages. Because of this arrangement (which is common in practice), Company B does not technically have any W-2 wages since Company A reports those for payroll reporting purposes. Because in our example we assumed Company A & Company B each have income over the thresholds, and because these could be deemed as separate activities, QBI must be determined separately. As such, the deduction on Company B will be the lesser of 20% of business income or the 50% of Wages (defined in the statute as W2 wages), which in this case would technically be $0 for Company B, even though it reimbursed for its share of the wages in reality. In this scenario, Company B could be prevented from any deduction simply because of its payroll arrangements. We simply aren’t sure how the Treasury Department will interpret this, but be advised this could be problematic.
- While the statute states that QBI does not include reasonable comp or guaranteed payments of shareholders/partners, does this simply mean these wages as reported from these entities are not to be included in determining the deduction, or does this mean these wages (particularly S Corp partner wages reported on a W2) are to be excluded from the 50%/25% wage limitations for taxpayers over the $415k income threshold?
- For specified service trades or businesses, what does the principal asset being the skill or reputation of one or more of its employees or owners mean? This question has made many industry groups nervous, as it could be interpreted broadly to be too inclusive (contractors for example) that were likely not meant to be included.
- Will rental or triple net lease properties be treated as a qualified business income? Some consideration should be given to real estate partnerships and their current capital structures, particularly as it relates to their debt terms given most real estate partnerships will likely be taking advantage of the 25% of wages plus 2.5% of capital asset when taking into consideration the limitations. They should also be aware of how the new interest expense limitations under reform apply to their situation and whether the entity qualifies as a real estate business.
There are numerous other questions and uncertainties that remain unclear at this time, but the Treasury Department has stated it plans to release guidance later this year, possibly as early as June. For now our best guess will be based on our interpretation of the committee reports from which the legislation was ultimately drafted, mining of old statutes and regulations to gain clarity on how certain items might be interpreted, and finally staying in touch with peer groups and trusted organizations. Armed with these insights, tax planners must be proactive and prepare our clients for various outcomes so that we can be strategically positioned for optimal results.
If you would like to explore how this new provision might impact your business, please reach out to me at firstname.lastname@example.org or give me a call at 972-437-5201 to discuss.