On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act of 2017, which significantly changed tax planning for all businesses. Current business owners should consider whether changes to their existing form of business would be beneficial under the new law; and those contemplating establishing a new business should rethink traditional maxims that have guided most business formations since the 1986 Tax Act.
Businesses may be operated in a number of different legal structures: corporations, partnerships, limited liability companies, and sole proprietorships. There are also subcategories: for example, corporations may be either traditional “C” corporations, which pay a separate corporate tax, or if they qualify, may elect to be treated as “S” corporations, which generally do not pay a separate corporate tax. Similarly, partnerships may be general partnerships, in which all partners are liable for the obligations of the partnership, or limited partnerships, in which only the general partner is liable for partnership obligations; and the limited partners are shielded from such liability. Each business form has its own legal and tax characteristics, and the choice of which one to use for a particular business is generally determined by weighing the relative importance of those different factors.
For many business owners, a primary goal is to protect their personal assets from claims against their business, and corporations traditionally fulfilled this objective best. On the other hand, U.S. tax law generally favored operating many businesses as “pass-through” entities, such as partnerships, to avoid the double-tax dilemma faced by traditional corporations in which earnings were first taxed at corporate rates and the remainder was subject to tax again at individual rates when those earnings were distributed to the owners through dividends. This tension between tax and nontax objectives led to the development of certain “hybrid” types of entities, such as S corporations, limited partnerships, and limited liability companies, which sought to combine the advantages of personal liability protection with a single layer of tax. Many businesses have been formed or restructured as these hybrid entities.
A New Playing Field
The new Tax Act creates a whole new playing field for the choice of entity analysis. While the basic tax difference between traditional corporations (subjecting earnings to two levels of tax) and pass-through entities (subjecting earnings to only one level of tax) remains, the changes that have been enacted will require a much closer analysis of the impact of that basic difference on any specific business. While there are many changes under the new Tax Act that may impact a particular business, two of the fundamental ones that will affect this analysis for almost all businesses are the dramatic reduction in the corporate tax rate and the addition of a new and quite complex deduction for pass-through tax entities. Adding to the complexity of the analysis is the fact that the change in the corporate tax rate is “permanent” (which for tax purposes, simply means there is no automatic sunset for this provision), whereas the new deduction for pass-through entities is scheduled to disappear in 2026.
Under prior law, corporations (other than personal service corporations) were taxed at a graduated rate which reached a maximum of 35%. The actual marginal rates varied in a somewhat convoluted manner between 15% and 39% through rate brackets intended to allow corporations to pay lower rates at smaller earnings levels and then take back those benefits as earnings reached greater amounts. Individuals were also taxed at graduated rates, with the top rate reaching 39.6% (with an additional taxes for certain high-earning individuals, such as the 3.8% net investment income tax and the 0.9% additional Medicare tax). Investment income, such as long-term capital gains and most dividends from U.S. corporations, were taxed at separate rates, with the top rate being 20% (plus an additional 3.8% net investment income tax for those in the higher rate brackets). It is important to note that these rates are imposed on taxable income, which is reached only after working through the various exemptions, deductions, and phase-outs that applied, as well as taking into account the impact of the alternative minimum tax.
Despite the complexity of the calculation for any particular business and business owner, it was apparent in most situations that avoiding the corporate tax and structuring the business as a pass-through entity would usually result in a lower overall tax. Looking just at the marginal rates, the effect of the double tax would be an effective rate of 50.47% (35% corporate tax on 100% of income, plus 23.8% tax on dividend of remaining 65% of income), as opposed to the 39.6% rate if a pass-through entity were used.
The new Tax Act replaces the graduated corporate tax rates with a flat rate of 21% and slightly reduces the individual tax rates so that the top marginal rate is now 37%. It keeps the same rates for investment income such as dividends, as well as the additional 3.8% for net investment income of certain higher-earning individuals. Based just on this change, the effective rate for passing income through a traditional corporation and on to its owner as a dividend would drop to 39.8% (21% corporate tax on 100% of income, plus 23.8% tax on dividend of remaining 79% of income). Even with the top individual marginal rate reduction to 37%, this change would make the choice between a traditional corporation and a pass-through entity much closer, especially given some of the other changes under the new Tax Act, such as the elimination of the exemptions and most itemized deductions for individuals and the effective elimination of those deductions that remain for many because of the increased standard deduction. If the income earned is also subject to the additional 3.8% net investment income tax, which does not apply to corporations, taxpayers will often come out better holding passive investments in a taxable corporation, even assuming double tax at the highest marginal rate. In addition, the ability to defer the second layer of tax by delaying dividends could allow business owners using traditional corporations more flexibility in timing the second layer of tax on their income, which may easily offset any small rate advantage of using a pass-through entity for an active business.
Congress realized that the dramatic reduction in corporate tax rates could have an adverse impact on businesses which operate as pass-through entities and so added a special deduction for the owners of those types of businesses, which was designed to maintain a larger rate differential in the overall tax paid by these different entity types. This deduction for “qualified business income” is both deceptively simple and extraordinarily complex. The simple part is that it is designed to be a deduction of 20% of the income earned by the owners of pass-through entities, so their effective tax rate would drop from 37% to 29.6% and thereby maintain approximately the same rate differential between traditional corporations and pass-through entities as under prior law. The complexity lies in the many details of how this deduction is calculated, including phase-outs of the deduction and safe harbors from those phase-outs, and what types of businesses do and do not qualify for it; and it is well beyond the scope of this alert to try to get into the many details that will be important in the analysis of a particular situation.
This example will demonstrate the value of careful planning in this area. Under the new Tax Act, the 20% deduction phases out for business owners over certain income levels (between $157,500 and $207,500 of taxable income for single taxpayers, and between $315,000 and $415,000 for married taxpayers filing jointly). However, certain types of businesses may qualify for one of two safe harbors that could still permit all or part of the deduction if the business pays sufficient wages to employees or has significant capital investments. Suppose a married business owner is earning $500,000 net of all available deductions from his or her business. They have been operating the business as an LLC, taxable as a partnership; and the owner has been flowing through the earnings of the business as a distribution from that LLC. Under the new Tax Act, that owner would receive no benefit from the 20% deduction even though his or her income was “qualified business income,” because his or her taxable income exceeded the maximum allowed for the deduction.
However, if that same owner changed the form of the business entity from an LLC, taxed as a partnership, to an S corporation (which often can be accomplished by a simple filing with the IRS) and paid a portion of the earnings to himself or herself as wages, instead of simply passing the entire amount through as a distribution from the LLC; the owner could come within one of the safe harbors and qualify at least a portion of the earnings for the extra 20% deduction, providing an immediate and significant tax savings. The applicable safe harbor allows a deduction equal to the lesser of the deduction that would otherwise be allowed (20% of the qualified business income) or the owner’s share of 50% of the wages paid by the business. If that owner paid himself or herself $143,000 as a salary from the S corporation, he or she would then obtain an immediate deduction of $71,400 on the remaining income received after payment of that salary ($500,000 total income less salary paid of $143,000 leaves $357,000 of qualified business income, allowing a deduction of the lesser of 20% of that amount or 50% of the salary paid, which would be $71,400). That deduction is simply created by restructuring the form of the business and carefully determining the proper split between salary and dividend distributions. As with most brand-new tax provisions, there is very little guidance at this point for applying some of these rules, leaving wide open various planning possibilities depending on a particular business owner’s situation.
What to Do Now?
The new Tax Act is a game changer for business entity planning, and every owner of a business or person considering starting a business should work closely through the alternatives to determine a strategy that will maximize their benefits under the new rules. It also impacts the analysis concerning the most effective structure for a number of passive investments, such as securities or real estate. In some cases, that may mean changing from one type of entity to another. In other situations, it may simply mean changing the manner in which the owner operates within the existing business structure. In still others, it may mean separating out certain parts of an existing business into separate entities. We are available to assist in this analysis and to come up with a plan that works for your particular business and your own individual situation.