The Tax Cuts and Jobs Act (“TCJA”) brought a substantial tax rate reduction for C corporations to 21 percent, down from the previous maximum rate of 35 percent.
As a result of the significant rate reduction for corporations, Congress felt that some benefit was necessary for the owners of pass-through entities and provided a new pass-through deduction designed to reduce the tax liabilities of the owners. The new Section 199A permits a deduction of up to 20 percent of qualified business income (“QBI”) from a domestic pass-through business, plus 20 percent of qualified real estate investment trust (“REIT”) dividends and 20 percent of qualified publicly traded partnership (“PTP”) income, if applicable, and is available for tax years beginning after December 31, 2017, and before January 1, 2026.
On August 8, 2018, the Treasury Department and the Internal Revenue Service issued proposed regulations on the Section 199A pass-through deduction. The robust proposed regulations define and provide guidance on a number of items identified within Section 199A; however, additional guidance and clarification on additional issues is still being requested by taxpayers and service providers. Until the final regulations are published, you will have to rely on the proposed regulations.
What are some potential actions taxpayers should take before the end of the 2018 tax year?
1.Plan for the Threshold Amount: Individuals below their applicable threshold amount –$157,500 of taxable income for all filers except joint filers, and $315,000 for those filing jointly[1] – are able to recognize a QBI deduction for the lesser of 20 percent of their qualified business income or 20 percent of their taxable income. The rules regarding specified service trade or businesses (“SSTBs”) do not apply, nor is there a need to analyze W-2 wages paid by the business or qualified property owned by the business when below the threshold. Once a business owner’s taxable income exceeds the upper range of the phase-out of the threshold ($207,500 for individuals, and $415,000 for married filing jointly), the owner cannot claim a QBI deduction for income generated from an SSTB. Additionally, if the business is not an SSTB, the QBI deduction is subject to the limitations based on wages and qualified property. Plan now to reduce income and increase deductions. Consider bundling charitable contributions; implement or increase contributions to retirement plans; increase bonus payments; or defer income when possible.
2. Evaluate Married Filing Separately: In addition, married couples should determine if filing separately would yield more favorable treatment for the QBI deduction. When one spouse receives a high source of income and the other spouse has SSTB income, once the married couple exceeds $415,000 of taxable income, none of the SSTB income will qualify for the 20-percent deduction. For example, suppose husband is a sole-proprietor lawyer whose law business, an SSTB, is estimated to generate a net profit of $150,000, and wife is a W-2 employee earning a $500,000 salary as a corporate executive. Together, husband and wife’s taxable income is well over the $415,000 upper limit of the phase-out for the QBI deduction for joint filing. If filing jointly, husband and wife would not be able to claim any amount of QBI deduction. However, if husband and wife would file separately, wife as an employee would not be able to claim a QBI deduction on her return but husband would be able to reap a QBI deduction after accounting for self-employment tax and his own standard deduction on his return. It also may be more beneficial for married couples to file separately when each spouse has qualifying income; however, due to being over the threshold amount, the phase-out based upon wages or qualifying property may lead to a substantially reduced QBI deduction for one or both spouses.
3. Reconsider Entity Selection: Business owners may want to reconsider entity selection. The TCJA’s new rates result in an effective federal tax rate of 39.8 percent for a C corporation that pays out all of its earnings to shareholders (assuming highest applicable federal tax rates and qualified dividends) and a range of 29.6 percent up to 40.8 percent (depending on the availability of Section 199A, the applicability of the net investment income tax, and assuming highest applicable federal rates) for an owner of a pass-through entity. While the effective federal tax rate is only one of the tax considerations for making a choice-of-entity determination, there are several additional points to consider, including state tax differences, international tax differences, estate and gift tax planning, and ultimately the exit strategy or potential sale of a business. Type of entity may fluctuate or even eliminate the Section 199A deduction – sole proprietors do not pay themselves a W-2 wage so when below threshold, will have higher QBI as a result of not paying owner compensation but if above threshold, will have no deduction since there will be no W-2 wages if owner is sole employee; S corporations are required to pay reasonable compensation which reduces QBI but increases the W-2 threshold. In addition to the tax costs, taxpayers should contemplate non-tax costs. For example, attorney’s fees to amend or review agreements, transaction costs, state registration fees, additional tax compliance fees, etc., should also be determined when modeling entity types. Taxpayers should assess any potential future costs, keeping in mind that the Section 199A statute is set to expire at the end of 2025. The cost to unwind an entity conversion due to changing tax laws could prove to be costly and inefficient.
Entity Choice: Comparison of highest 2017 and 2018 tax rates
| Entity Type | 2017 | 2018 | Change |
| Pass-Through Entity (“PTE”) active no 199A | 39.6% | 37.0% | -2.6% |
| PTE passive no 199A* | 43.4% | 40.8% | -2.6% |
| PTE active full 199A | 39.6% | 29.6% | -10.0% |
| PTE passive full 199A* | 43.4% | 33.4% | -10.0% |
| C Corporation (assuming no dividend tax) | 35.0% | 21.0% | -14.0% |
*includes 3.8% net investment tax on passive income
Aside from mathematical modeling, the new laws passed in the TCJA have served as a catalyst for business owners to also reconsider qualitative factors about the structure, strategy, and future of their businesses. Do the business owners desire access to cash? The answer to this one question could be the determining factor for many on whether to convert to a C corporation or stay as a pass-through entity. But there could be other deciding factors, such as what is the business growth strategy; is an exit from the business in the foreseeable future; will the next generation assume responsibility? You should analyze the big picture.
Your business will need guidance and a practical approach to navigate these newly proposed regulations. Our dedicated team at Cherry Bekaert can explain the details of these changes specific to your situation and help you determine which actions are best for your business.
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[1] For taxable years beginning in 2019, the threshold amount under IRC § 199A(e)(2) is $321,400 for married filing joint returns, $160,725 for married filing separate returns, and $160,700 for single and head of household returns. Rev. Proc. 2018-57, November 15, 2018.
