The Tax Cuts and Jobs Act of 2017 is the most comprehensive tax reform within the last 30 years. While the primary focus of the changes has been geared towards individuals and large corporations, the opportunities and added complexities for small-business owners are significant and should be explored. Whether your company is incorporated or held closely, you must recognize how the recent adjustments to the Internal Revenue Code can potentially affect you and your workers.
How have things changed for C Corporations?
The top corporate tax rate has fallen. C corps now pay a flat 21 percent tax. For most C corps, this is a big win; for the smallest C corps, it may be a loss.
If your C corp or LLC brings in $50,000 or less in 2018, you will receive no tax relief — your firm will pay a 21 percent corporate income tax as opposed to the 15 percent corporate income tax it would have in 2017. Under the old law, the corporate income tax rate was just 15 percent for the first $50,000 of taxable income.
In addition, the 20 percent corporate Alternative Minimum Tax (AMT) is no more. The tax reforms permanently abolished it. Not only does this repeal simplify tax reporting for businesses, it also now permits businesses to take advantage of certain tax incentives that were previously lost under the old AMT regime.
What changed for S corps, LLCs, partnerships and sole proprietorships?
Previously, the tax rate on income from pass-through businesses to the owners could be as high as 39.6 percent. The TCJA has created the Qualified Business Income (QBI) deduction also known as the Section 199A deduction. This deduction allows many owners/shareholders to reduce the net income received from the business by 20 percent.
Many LLCs report as partnerships and are therefore pass-through entities which are not subject to the corporate tax rate; only LLCs subject to the corporate tax will be affected by the new law.
There are, of course, certain limitations based on the type of business, capital gains, and wages. Specific service businesses (such as law, accounting, health, consulting, financial services) also have personal taxable income thresholds — at which point the deduction is phased out. The phase-out begins at $315,000 for a married couple filing jointly and $157,500 for an individual. After $415,000 for a married couple and $207,500 for an individual, the QBI deduction is not permitted. This deduction applies through at least 2025.
How might these changes affect how business owners keep track of their expenses?
• Increased options for accounting methods — Businesses with revenue not exceeding $25 million may now take advantage of the more straight-forward cash method of accounting, as opposed to the accrual method. This allows businesses to recognize income and expenses in the year in which they are actually paid.
• Elimination of certain deductions — Meals, entertainment and membership dues for social or business clubs and many transportation costs are no longer deductible.
• et operating loss carryforward —The new law limits the net business losses for both C Corporations and the owners of pass-through entities. The losses for the owners of pass-through entities are limited to $500,000 for married filing jointly and $250,000 for all others. The new law for C Corporations provides for an indefinite carryforward period (as opposed to the prior 20-year limitation) and limits the net operating loss (NOL) for those losses incurred after Dec. 31, 2017, to 80 percent of the corporation’s taxable income within a given year. This change will require corporations to separately track NOLs for periods on or before Dec. 31, 2017, and those after Dec. 31, 2017.
Who might consider restructuring their business organization in light of these changes?
This decision is highly dependent on the specific circumstances surrounding the business and its owners.
Each pass-through entity has its own method of reporting and paying out or distributing income. Considering the complexities of the QBI deduction, especially as it relates to different levels and types of income and deductions, owners may want to take a look at whether it makes sense to restructure as a different type of pass-through entity to realize a tax savings.
Is it advantageous to convert from a pass-through entity to a C Corporation?
If you determine that the effective rate of the entity’s taxable income with the QBI deduction (or if your business is unable to take advantage of the QBI deduction) significantly exceeds the corporate flat tax rate of 21 percent, it may be advantageous to convert to a C Corporation. Another consideration is that Section 199A establishing the 20 percent QBI deduction is set to expire at the end of 2025, while the 21 percent corporate rate is currently not set to expire. As we approach 2025, many business owners will likely keep a close eye on whether the 20 percent QBI deduction is made permanent or extended.
Prior to making such a conversion, the business owner will want to think through increased costs involved in converting to a C Corporation. There are additional filing fees and expenses, plus additional compliance costs and double taxation on dividends issued from corporate income. Lastly, as we know, a future president and Congress can change this 21 percent tax rate. If that occurs, converting a C Corporation back to a pass-through entity can be an involved process.
Is there any scenario in which ownership of a company might be changed in order to relieve a new tax burden as a result of this bill?
There are a number of potential scenarios in which a company can be changed or restructured to achieve tax savings:
• The high-earning business owner may want to consider moving real estate or assets owned by the business to a newly created entity. The original business pays rent or leases the property from the newly created entity which decreases the original entity’s profits by shifting them to the new business. This shift may result in a qualification of at least a partial QBI deduction.
• Another idea for the high-earning business owner is the creation of non-grantor trusts for their spouse, children, and even grandchildren. This may be particularly useful for a specific service business whose profits exceed the phase-out threshold for the QBI deduction. The creation and administration of these trusts require careful planning. Also, an important point to keep in mind is that the transfers of the business interest to these trusts are irrevocable gifts.
It’s difficult to distill this sweeping tax reform into a single-most important item. Overall, the Tax Cuts and Jobs Act is generally viewed as a win for businesses. This presents business owners with unique planning opportunities for significant tax savings. As with any new tax law, there are provisions within the law that are highly complicated and will require additional guidance from the IRS.
Tami S. Amici, CTFA, is the VP and trust tax & estate officer for Tompkins Financial Advisors. Contact her at firstname.lastname@example.org
Author’s note: For informational purposes only. Please consult your tax advisor for specific advice pertaining to your individual situation.