The focus of this article is to highlight how the owners of pass-through entities are impacted under the new tax rules. Though the intent of the law is to simplify your tax reporting requirement, this has not yet been achieved for businesses with pass-through entity income. Before we get into the details, this year planning is of utmost importance for all pass-through entities.
The most notable change for these entities is the IRC § 199A’s new 20% deduction. The new Qualified Business Income Deduction (QBID) provides an additional 20% deduction off the Qualifying Business Income (QBI). The deduction has a lifespan of eight years (2018 – 2025), and is subject to limitations and adjustments. One such limitation is on a Specified Service Business (SSB), “where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” In simple terms, if most of the income in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, etc. is generated based on the skill set of the owners and employees, the business may be an SSB.
Before we continue, it may be worth your while to review the last business article from April 2018. It contains a vast amount of information on how your 2018 tax reporting will be impacted by the new tax law.
As we proceed, when a new tax rule (statute) is enacted, in theory it may be understandable, but from a practical standpoint, it may be more difficult to fathom on paper. The IRS will be meeting at the end of July to provide further direction on certain areas of the law; in the meantime, there is still a lot we know that will allow us to start planning now.
Where is the pass-through business income coming from?
- K–1 operating income from partnerships (including multi-member LLCs) and S Corporation shareholders.
- Net Income from sole proprietorships (Schedule Cs include single member LLCs, Schedule E and Schedule F filers who are individuals, estates, or trusts).
Schedule E activity must be a trade or business (including property rentals). It should be noted that some states treat certain rental income as non-business income, in which case some may not qualify for a QBID.
A word of caution to S-Corp owners.
As a reminder, S-Corp owners are required to take a salary (reasonable compensation) from the company. The principle behind this is that most other entries with pass-through income are subject to the 15.3% Self Employment tax (SE), which creates an unfair advantage. The IRS requires that the owners/officers of the S-Corp take a reasonable salary from the profit of the business before distributing it to the shareholders. The wages an S-Corp owner takes do not qualify for the QBID, only what remains. (The word among tax professionals is that reasonable compensation may be an area of increased audits from the IRS.)
An article written by Toni Nitti a few years ago (yet still relevant) depicts this well. Read it here.
Another concern is that a large number of S-Corp’s are not making much profit.
How will this new deduction affect my overall tax reporting?
Here is a list of some of the areas to which QBID does not apply:
- QBID does not reduce the 15.3% Self Employment Income tax liability.
- QBID does not reduce Net Investment Income Tax (NIIT) is investment income tax on capital gains, non-business interest, dividends, etc.
- QBID does not increase your business Net Operating Loss (NOL).
- QBID does not reduce your Adjusted Gross Income (AGI).
What are some of the limitations of the QBID?
- The income threshold for SSB(s) is simpler:
Most pass-through entity income is coming from an SSB and an income threshold limitation applies. If you file a joint return, your spouse’s income could limit or eliminate the 20% business deduction.
Additionally, your other income (such as investment income) could also affect your ability to take advantage of the QBID. As noted in the last article, personal taxable income exceeding $315,000 married/ $157,500 single may limit your ability to take the deduction. If your taxable income is $415,000 married/$207,500 single, you could basically lose the deduction altogether.
- The more complex restrictions and adjustments are to the non-SSB(s):
These are other caps that could affect those businesses that are non-SSB. These caps revolve around wages and depreciable business properties. Those will not be discussed in this article due to the complexity and its uniqueness from business to business.
Long before the law was enacted, the questions were coming in; here are three (3) of the most frequently asked questions we have received from our clients and others.
- What business is best for me? Do I give up my S-Corp status and go back to a C-Corp?
While this question is best answered on a per taxpayer basis, here’s what I want you to understand: C-Corporation income that is distributed to the owner is double taxed. (To read full answer, click here.)
- I am an independent contractor; do I form an LLC or S-Corp?
My response would be yes since I am looking beyond a tax viewpoint, however, let’s first make a correction. S-Corp is not a legal entity; it’s simply a tax election that the company makes. Before making a decision to form a company, consider the cost to form or organize a legal entity, to maintain and don’t forget the NYC publishing requirement, that is an added cost.
Please keep in mind that proper books and record should be maintained for the company. You should consider using the service of an accountant to track the financial stability of the company.
If you are interested in forming a legal entity, we can help you to form one that is right
for you and assist you with your accounting needs, so please contact us. (To read full answer, click here.)
- I get a W-2 from my employer, however my role is one like that of an independent contractor, I pay my own health insurance and take care of my own job expenses.
The response to this question is not clear-cut. Some industries require that you are classified as an employee. I would first ask that you evaluate your role with your employer and if you strongly believe you are an independent contractor, consider forming a legal entity. (To read full answer, click here.)
Here is our two cents about each tax status!
C-Corps are great if they are profitable and you are an employee of the corporation. The company can pay for your health insurance, retirement matching, profit-sharing, reimburse you for tuition, and a plethora of other benefits, if they can afford it. There is also a great death benefit. Consider the long-term impact, and if you plan to take the company public in the future, then C-Corp is the choice to make.
S-Corp election is a great way to capitalize on your expenses; however, keep in mind that your financial health is beyond tax reporting. As mentioned in the previous article, if your intent is to rent or buy a home in the future, underwriters and landlords look unkindly on low income. It may be seen as a sign of poor cash flow, thus the question is raised about your “ability to pay.” Also poor cash flow is not attractive to other types of lenders and investors.
S-Corp also has another layer of reporting, that is payroll reporting. Last, but not least, not everyone can qualify for S-Corp status.
LLC & Partnerships: Single member LLCs are viewed as sole proprietorships and are reported as a part of your personal tax returns, unless you elect S-Corp status. All your expenses are exposed and in plain view to the IRS, so proper record keeping is imperative. It is also one of the most scrutinized areas by the IRS. Don’t let this deter you, it still remains one of the more easy to “manage” legal entities; and more flexible than S-Corp.
What’s next? Planning!!
There are no two ways about it — all pass through-entities should consider a tax planning consultation. This will allow you to get a better sense of your 2018 tax liability and plan in advance, to reduce the possible negative effect of the new tax laws.
And, if your total income exceeds $315,000 married/ $157,500 single, you may need a comprehensive tax planning analysis.
Don’t Wait! It is URGENT that every client with a pass through entity or total income in excess of $315,000 married/$157,500 single, contact us by July 31, 2018 to set up a time to meet so we can create a tax plan that will allow you to mitigate any possible adverse effects from the new tax law.