The new tax law signed into effect at the end of December 2017 has created a scramble among business owners and professionals as they try to figure out how to take advantage of lower corporate tax rates and favorable deductions for pass-through entities. If you’re thinking about restructuring your business, here’s some basics that you need to take into consideration.
Becoming a C Corporation
One of the biggest aspects of the tax bill was the reduction of corporate tax rate for 35% to 21%, one of the aspects of the bill that is permanent rather than set to expire in the future. In addition, corporations with foreign operations may now benefit from a hybrid participation exemption system that reduces tax on overseas profits.
If you’re thinking about becoming a C-corp to benefit from the lower tax rate, keep in mind that there are several advantages and disadvantages to this legal structure. C-corps have far more complicated paperwork and regulations to follow, and profits are subject to double taxation—first the corporation is taxed on profits, then any dividends paid out to shareholders are also subject to tax after they are paid out.
However, companies that are looking to reinvest their profits in the business instead of paying dividends could see a significant benefit from the new tax bill (at the federal level, ignoring for the moment state tax implications). Startups or businesses in high-growth or expansion mode that have not yet switched to C-corp may want to discuss with a tax lawyer whether this may be a good option for the company. Just keep in mind that any transformation to a C-corp business should remain flexible; although the tax rate is technically permanent, succeeding governments may decide to raise the federal rates in the long term.
Understanding the pass-through deduction for LLCs and S Corporations
One of the murkiest aspects of the tax bill is the so-called pass-through deduction, which allows for non-corporate owners (read: individual people) of pass-through entities (such as S-corps, LLCs, LPs, or a Schedule C business) to deduct 20% of their qualified business income from their tax return. But this isn’t just a simple across-the-board deduction; the law comes with a number of caveats.
Taxpayers that earn less than $157,000 for an individual or $315,000 for a married couple in 1099 or non W-2 income can deduct 20% of the income they receive through a pass-through business from their overall taxable income. Single freelancers or participants in the “gig economy” that have incomes below the thresholds (after business expense deductions) can benefit from this new change and should consider setting up LLCs or S-corp entities if they haven’t already.
For individuals or couples that exceed these taxable income thresholds, a number of caveats apply. First, the pass-through deduction is capped the greater of either a) 50% of the individuals share of the W-2 wages paid by business to employees, and b) 25% of such W-2 wages plus 2.5% of the unadjusted cost basis of the business’s “qualified property” (generally depreciable assets used in the business, such as machinery).
The second, more vague caveat is whether or not the business is a specified “service business.” These entities do not qualify for the 20% deduction at all. Currently these include such businesses in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, or any trade or business where the “principal asset” is the “reputation or skill” of its employees or owners.
Tax strategies for service businesses
The ambiguities of the tax bill wording poses some issues with classification of service businesses. For example, although architecture firms could theoretically be exempt from falling into this service business category, a famous architect whose reputation is a crucial selling point to the firm may fall under the principal asset clause.
The vagueness of the law however does create opportunities to work around the “service business” classifications and re-cast companies. Some business advisories have proposed a strategy of combining or splitting business entities to ensure that the business falls outside of the excluded categories.
For example, if you are a financial advisor also invests in real estate, managing hotels and large properties, it may make sense to combine both jobs into one entity that you can classify as a real estate company, instead of having a separate financial services entity. The opposite could also work: if you have a dentistry practice that also performs back office duties or debt collection, the divisions could be spun off into a separate management company.
Another potential option for service businesses, particularly firms with many consultants or advisories working within them, is starting an employee leasing entity. The leasing entity would employ the firm’s current employees and lease them to the firm at a markup of the current salary. Others may choose to get creative with leasing options on the buildings where they perform their services.
Proceed with caution and with an eye on the future
It’s important to remember that the more creative a business tries to get with its tax strategies, the more scrutiny it will likely draw from the IRS. The penalties for misstating or misclassifying your business or income are likely to be greater and more stringent for these new rules. And with the law being fresh on the books, expect to see clarifications of intent from the IRS in the coming years that may close certain loopholes.
Businesses will also need to consider whether their tax strategies would benefit them long term. The pass-through deduction is poised to expire in 2025, and although the corporate tax rate is written as a permanent one, any significant changes in government could potentially change that in the coming years. If the law changes in the future, you don’t want to be stuck in an inefficient form of business that’s only causing more headaches than it is bringing benefits.
Always work with a financial advisor and tax lawyer for the best advice, and be sure to consider both short-term and long-term benefits and drawbacks in any tax strategy decision that you make.
The information contained in this article is for informational purposes only and does not constitute legal or professional advice. For additional information on tax strategy planning for your business, please contact your financial advisor or the partners at Thompson Bukher LLP.