It was a long time coming but the Republican House was able to pass the largest tax overhaul this Country has seen since the Regan Era tax code changes of 1986. With these changes come more questions than answers on how the law will affect business of all types. A particular area of concern relates to the types of businesses known as pass-through entities. Most of us run our businesses as one of these types of entities. I am referring to S-Corporations, partnerships, and even those who report their business as a sole proprietorship. Let’s start by briefly discussing the non-pass through entity know as a C-Corporation. Between the higher tax rate and double taxation possibilities, hordes of business owners jumped to convert their C-Corporations to S-Corporations back in 1986. Most entities formed since than have been S-Corporations–until the simplicity of the Limited Liability Company craze began.
I am currently fielding questions from business owners thinking about switching to the C-Corporation tax structure. They have read that C-Corporation tax rates were dropping from the highest rate of 35% all the way down to 21%. However, the point they’re missing is that the C-Corporation still suffers from the cost of double taxation. After profits have been taxed at the corporate level any monies withdrawn by the shareholder will then be taxed as a dividend at a top rate of 23.8%. This combines to an effective rate of 39.8%.
Pass-through entities are usually considered “small businesses,” even though we know that is not very often true. With that reasoning, Congress was determined that the small business owners obtain the tax breaks that they deserved as well. That is why Code Section 199A was created. The main purpose of this code section is to provide a 20% deduction of qualified business income from a pass-through entity to its owners. A 20% deduction on qualified business income (QBI) sounds like a great idea and straightforward but keep in mind, if it is part of a tax code, it is going to be complicated.
The first thing to know is the definition of QBI. QBI is the net amount of income, gain, deduction and loss with respect to a trade or business. QBI does not include investment-related income or loss, such as capital gains or losses, dividend income or interest income. QBI can include income from real estate holdings. QBI does not include any wages you earn as an employee. This is definitely an area that will be scrutinized for those looking to maximize the deduction. Those that are professionals, own service businesses or are in what is termed as a “specified trade or business,” there is a phase out of the deduction for income over $157,500 for single taxpayers and $315,500 for married taxpayers.
The overall intent of the Qualified Business Income Deduction is to have owners of pass-through entities be subject to tax rates that are lower than those of the C-Corporations.
I have barely touched upon what is now a very complicated portion of the new Tax Cuts and Jobs Act. There are many aspects to consider before changing your entity’s tax structure. There will definitely be some technical corrections and pronouncements by the IRS on this Code Section so you should be sure to get strong, well thought out tax advice before committing to any major changes in your current tax structure.
Please feel free to call any of the Partners at GKG if you would like any additional information on this subject or to discuss your specific situation.
Wayne L. Martin, CPA, CGMA