Recently, the Federal Register published the IRS’s draft regulations to clarify the new law that provides a 20% deduction on pass-through business income. Under the Tax Cuts and Jobs Act passed in December 2017, this law will be in effect for tax years 2018 through 2025.
The draft regulations clarify who, exactly, is eligible for the new 20% deduction and who is not. In the rush to pass the tax bill, this provision wasn’t written clearly enough. The IRS is trying to fix that problem now. Assuming the final regulations are very similar to the draft regulations, the following information is provided to help you decide whether it might make sense to restructure your business.
- Companies that are established under one organizational form may find it beneficial to restructure as the business evolves over time.
- Certain types of restructuring can result in more favorable tax treatment for the business and its owners.
- Recent regulations mean that certain loopholes have been closed, so make sure that you understand all the implications and requirements of a restructuring before undertaking it.
Qualified Businesses and Qualified Business Income
To be eligible to claim a tax deduction for 20% of qualified business income (QBI), your business must be a pass-through entity. Pass-through entities are so named because the business’s income “passes through” to the owner. It isn’t taxed at the business level, but instead at the individual level. Owners of pass-through businesses pay tax on their business income at individual tax rates. Pass-through businesses include sole proprietorships, partnerships, S corporations, trusts and estates. By contrast, C corporation income is subject to corporate tax rates.
So what is “qualified business income”? The IRS defines it as net business income, not including capital gains and losses, certain dividends or interest income. The 20% deduction reduces federal and state income taxes but not Social Security or Medicare taxes, which means it also doesn’t reduce self-employment taxes, a term that refers to the employer-plus-employee portions of these taxes that people pay when they run their own businesses. (See 10 Tax Benefits for the Self-Employed and 5 Biggest Challenges Facing Your Small Business.)
The 20% QBI deduction, also called the Section 199A deduction after the part of the tax code that defines it, is calculated as the lesser of (1) 20% of the taxpayer’s qualified business income, plus (if applicable) 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income, or 20% of the taxpayer’s taxable income minus net capital gains. The calculations are pretty complicated, so in this article we’re going to keep things simple by not talking about real estate investment trust dividends or qualified publicly traded partnership income.
Section 199A Deduction Phaseout Levels
With taxable income of $315,000 or less if you’re married filing jointly – and $157,500 or less for any other filing status – you can claim the full 20% deduction. However, according to a Tax Foundation report, many pass-through businesses are large companies, and “the majority of pass-through business income is taxed at top individual tax rates.” Certain hedge funds, investment firms, manufacturers and real estate companies, for example, are often structured as pass-through entities. Thus, the limits stand to affect a great many taxpayers.
If you’re one of the taxpayers who owns a pass-through business and you have taxable income above these limits, figuring out what deduction, if any, you qualify for under the new tax law is tricky.
The first thing you need to determine is whether you own what the IRS calls a specified service trade or business (SSTB). These are businesses in the fields of “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.” The IRS has clarified that the vague last clause (“...where the principal asset is the reputation or skill...”) is meant to apply to celebrity income, such as a famous chef being paid to allow a cookware line to use their name or a famous television personality getting paid to make an appearance.
Financial advisors, wealth managers, stockbrokers, accountants, doctors, lawyers and other businesses in the named fields are considered SSTBs. All others are not. Some of the interesting exceptions include architects, engineers and insurance agents.
Under the new tax code, it’s generally better not to own an SSTB. Owners of SSTBs are subject to a phaseout and a cap on their deduction. The phaseout in 2018 applies in the $315,000 to $415,000 range for married taxpayers and in the $157,500 to $207,500 range for all other taxpayers. These figures will be adjusted for inflation each year. Within these ranges, the deduction is limited. Above these ranges, there is no deduction.
What happens if you’re the owner of a non-SSTB pass-through entity? Let’s say you’re single and your taxable income is about $207,500. You are allowed to take the deduction if you have qualified business income. However, your QBI deduction may be limited by the amount of W-2 wages your business has paid its employees and by the unadjusted basis immediately after acquisition (UBIA) of the qualified property your business holds. The deduction is limited to the higher of 50% of total W-2 wages paid or 25% of total wages paid plus 2.5% of the UBIA of all qualified property.
Changing Your Business Structure or Reclassifying Your Business
If you think you might pay lower taxes as a non-SSTB pass-through entity, you might be wondering whether you should change your business structure in an attempt to lower your taxes – especially if, say, your high-revenue business both sells insurance and provides financial advice, meaning you have both SSTB and non-SSTB income.
Financial professionals should not try to classify themselves as something other than a financial advisor, retirement planner or actuary to avoid being considered an SSTB, said Scott A. Bishop, MBA, CPA/PFS, CFP®, partner and executive vice president of financial planning at STA Wealth Management, LLC, in Houston, Texas. “They are specifically excluded from benefiting from this deduction,” he said.
Other workarounds that businesses are trying to use “will not work in almost all cases as they are already being looked at by the IRS,” Bishop added.
These workarounds are referred to as “crack and pack,” or splitting up one business into two or more different businesses with the same owner to separate out SSTB income and non-SSTB income and avoid missing out on part or all of the QBI deduction.
The 80/50 rule says that “if a ‘non-SSTB’ has 50% or more common ownership with an SSTB, and the ‘non-SSTB’ provides 80% or more of its property or services to the SSTB, the ‘non-SSTB’ will, by regulation, be treated as part of the SSTB,” explains CPA Jeffrey Levine, CEO and director of financial planning for Garden City, New York's BluePrint Wealth Alliance, in a blog post at Kitces.com. Some businesses may be able to get around the 80/50 rule by reducing the common ownership of the SSTB and non-SSTB businesses below 50%.
What about changing your pass-through business to a C corporation to take advantage of the 21% flat corporate tax rate, another change that is new for 2018 under the 2017 Tax Cuts and Jobs Act?
Bishop said that converting from a pass-through entity to a C corporation for the lower 21% tax bracket usually is not a good idea due to the double taxation of dividends when taking distributions. A simplified example shows why. If you have a C-corporation and have $1 million in C-corp income, you will owe $210,000 at the 21% tax bracket on the corporate tax return, form 1120. Then, when the corporation pays a dividend, you will pay tax again on that distribution on your personal return (form 1040).
How then can high-income pass-through business owners best reduce their tax liability under the new rules? There are several steps they can take to reduce taxable income below the phaseout thresholds, says Brion Collins, CFP®, ChFC, CLU, managing director and principal at Bronfman Rothschild in Delafield, Wis. “These include implementing larger retirement-plan contributions such as profit sharing or defined-benefit plans, lumping charitable contributions through thoughtful use of donor advised funds, being intentional about realized capital gains and losses and delaying other sources of income such as pension payments, Social Security or RMDs in the first year.” For taxpayers who are 72 or older, delaying the first year of required minimum distributions from a retirement account and taking two the following year would make sense if it lowered taxable income enough to get the taxpayer below the threshold for the tax break in 2018.
Business owners who are limited by the 20%-of-taxable-income calculation “might wish to increase taxable income through Roth conversions or changing retirement plan deferrals from pre-tax to Roth,” Collins elaborated. Since the qualified business income deduction is limited to the lesser of 20% of QBI or 20% of taxable income, in addition to the asset and wage tests, taxpayers might not have enough taxable income to get the full benefit of the QBI deduction.
Suppose a taxpayer who is married filing jointly has $100,000 of pass-through income and no other income, Collins explained. That individual would be eligible to deduct 20% of the total, or $20,000. But after taking the standard deduction of $24,000, his or her taxable income would be $76,000. Since 20% of taxable income is $15,200 and that’s lower than 20% of QBI ($20,000), the taxpayer can only deduct $15,200, not $20,000. However, if that person did a Roth IRA conversion of $24,000, taxable income would then be $100,000 and the taxpayer would be able to take the full $20,000 QBI deduction.
This is a greatly oversimplified example, Collins explained, but it shows how the new tax rules work.
“Others who have not recently reviewed salary-versus-dividend distributions and rental payments on properties they use for their businesses may find it a good time to complete such reviews to ensure they are reasonable,” he said.
Collins noted that while business owners should regularly review salary and bonus arrangements for themselves and all employees, many get too busy and neglect this task. The reason it’s especially important to complete this review now, in conjunction with tax counsel, is that having too much W-2 income could reduce eligibility for the qualified business income deduction – while if a business owner has too little W-2 income, it could lead to tax penalties. Collins added that the QBI considerations also make reviewing rent and lease payments especially important right now.
The Bottom Line
Before the draft regulations become final, the government is accepting public comments on them until October 1. A public hearing will then be held on October 16. Once the IRS finalizes the regulations based on the input it receives, affected business owners will finally be able to confidently make changes that will minimize their tax liability.
As this article has shown, the rules are not easy to understand. High-income owners of pass-through entities, especially those classified as SSTBs, should consult with a tax professional to formulate planning strategies that will increase the likelihood of their being able to get the most benefit from the qualified business income deduction.