As published in Toledo Business Journal- February 1, 2018
Article information provided by David J. Baymiller, CPA, Gilmore Jasion Mahler, LTD.
On December 22, 2017, our President signed into law the Tax Cuts and Jobs Act, the largest major tax reform in over 30 years. Within this Act are major changes to the taxation of regular corporations (C corporations) and to non-corporate taxpayers, which include individuals, estates, and trusts who own interests in what are called pass-through entities such as sole proprietorships, partnerships, limited liability companies (LLCs), and S Corporations. These entities are for the most part not subject to entity level tax, but instead pass the income through to their owners who are then taxed on the income.
This article will focus only on the pass-through entity income tax changes that came about as a result of the tax rate benefit provided to C corporations limiting the tax rate to a flat 21%, a key component of tax reform.
Oh wait. Did I include the word “simple” in the title of this article? I guess I did. Using that word seems to get people to gravitate more toward reading a tax article. I thought that simplification was part of the original rhetoric and framework of tax reform. Well, as appears to always be the case with taxes, this change is not as simple and easy as was intended.
Before I get into the meat of the changes, let me just warn you that we will need a whole lot more guidance coming from the IRS and Treasury in order to understand how this all works.
Let’s start out with some basic rules.
Qualified Business Income (QBI): The net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer and it doesn’t matter if the taxpayer is “Active” or “Passive” in the business. This is determined for each qualified trade or business of the taxpayer.
Specified Service Trade or Business: Any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services; or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; or involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. Engineering and architectural services are excluded. This is a definition that needs a whole lot of clarity, which hopefully will be provided soon. For example, what are included in services in the fields of health? How do you determine what business has a principal asset being the reputation or skill of one or more of its employees or owners? Couldn’t this pull in a lot of companies that you wouldn’t normally think of as service businesses? And would this trump the exception for architectural and engineering services? Stay tuned.
Threshold amount: These are individual taxable income amounts that, if exceeded, cause the 20% deduction to be phased out. The starting threshold amounts are $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly. Once the taxable income exceeds $207,500 (or $415,000 for joint filers), you are fully phased in, and for owners of Specified Service Trade or Businesses, the deduction is $0. For other businesses that exceed the threshold amounts, the deduction is limited to what is called a “Wage (Capital) Limit” (Hmmm, sounding a bit complicated).
Wage (Capital) Limit: The greater of (a) 50% of your share of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of your share of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (basically, this is depreciable property cost). The (b) above was an additional provision added by Conference to allow for businesses with low or no wages to qualify, such as real estate businesses. (Uh-oh. Sounding more than a bit complicated here).
Qualified Trade or Business: Basically any trade or business other than a Specified Service Trade or Business and other than the trade or business of being an employee.
Some other important points:
Example (based on taxable income below the threshold amounts):
You are a single taxpayer with taxable income of $157,000. This is below the single threshold of $157,500 so all we care about is QBI. You have QBI from your 100% owned S Corporation of $100,000. Your deduction is 20% of $100,000 or $20,000. It doesn’t matter whether you are a Specified Service Trade or Business or not. Any Specified Service Business or Qualified Trade or Business qualifies for this.
Simple and easy stops right here.
Now, we move to taxpayers with taxable income in excess of the above Threshold Amounts ($157,500 or $315,000), where the deduction is subject to phase-in rules. So, now we need to take into consideration the Specified Service Trade or Business as well as the Wage (Capital) Limit.
Unfortunately for us, the limitation on the 20% deduction is computed differently for businesses that are Specified Service Trade or Business and all other Qualified Businesses.
Let’s examine Specified Service Trade or Businesses. In computing the qualified business income, the taxpayer takes into account only the applicable percentage of qualified income, gain, deduction, or loss, and of allocable W-2 wages. The applicable percentage with respect to any taxable year is 100%, reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amounting to $50,000 ($100,000 with a joint return). What the heck does that all mean?
Let’s look at an example to make this clearer, but I am only going to use the 50% Wage Limit and not the 25% wage plus 2.5% of capital to try to simplify it.
A single taxpayer owns 100% of an S Corporation and has taxable income of $182,500 — of which $150,000 of this is QBI due to providing services in the field of health after paying wages of $100,000 to employees and herself. She has an “applicable percentage” of 1 - ($182,500-$157,500) / $50,000, which is equal to 50%.
Then, 50% is applied to the QBI of $150,000, or $75,000. Then, we have to determine the includible wages, which is 50% of $100,000, or $50,000. The deduction is then the lesser of 20% of $75,000 ($15,000) or 20% of $50,000 ($10,000), which leaves the deduction for the single taxpayer who is over the threshold amount at $10,000.
What if the taxable income is $207,500? With the same factors above, the deduction would be “applicable percentage” of 1 - ($207,500-157,500) / $50,000, which equals 0, which means that there is $0 deduction. For Specified Service Trade or Business income, the deduction can be totally eliminated.
This total elimination, however, does not apply to Other Qualified Businesses. For other qualified businesses, the formula is more complicated and I strongly urge you to seek advisement from a tax professional.
There are a number of other issues related to this whole pass-through business benefit. We shall see what comes out of the additional guidance by the IRS and the Treasury, which will allow us to really explore the opportunities and plan accordingly.
One question that has surfaced is whether a pass-through business should just convert to a C Corporation and get the benefit of the 21% tax bracket on all of the C Corporation taxable income.
I will tell you right now that there is no one size that fits all, and care should be taken and due diligence done to understand all of the issues associated with being a C Corporation as it relates directly to the business activity as well as to the owners instead of just blindly converting.
This is all going to be such fun, don’t you think?