Several months into the 2018 tax year, many business owners remain unclear about exactly how recent tax reform legislation will impact their bottom line. That’s especially true for pass-through firms that are unsure if they qualify for a significant deduction the law provides.
The new deduction was effective January 1, 2018, as part of the Tax Cut and Jobs Act. It provides a deduction of 20% on “qualified business income” earned from pass-through entities, codified as Internal Revenue Code Section 199A.
Certain companies are excluded, specifically “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, 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.”
However, the exact classification of what work any particular firm performs is open to interpretation, and the “reputation or skill” asset test is nebulous. So, while we wait for detailed guidance, many entrepreneurs are left wondering what their effective tax rate will be and how to handle their estimated quarterly payments in the interim.
Nonetheless, there are several steps pass-through entities can take right now to head off possible unpleasant surprises later.
Separate various business units: Any company performing more than one function that fears its main business will be excluded could separate any aspects of the firm that might qualify for the deduction into separate units.
For example, a law firm will not qualify for the deduction, but if the firm owns property, such as an office building, those assets could be held by a related entity. That real estate income could then qualify for the 20% deduction, lowering the overall effective tax rate.
The Treasury Department has indicated that it may try to stop businesses from separating in this manner to increase its 20% deduction, but it may still be worth the attempt.
Look at W-2 wages: When taxable income is above $315,000 for people filing as married and up to $157,500 for single filers, the deduction is limited to the greater of 50% of the firm’s W-2 wages, or 25% of the firm’s wages plus 2.5% of the firm’s unadjusted basis of all depreciable property.
Many firms pay all W-2 wages at the holding company or management company level, not bothering to allocate workers to various divisions within the company. This may even be the case for brother-sister businesses as well.
However, undertaking a bookkeeping exercise of correctly allocating W-2 wages to each appropriate business unit can lower the overall tax burden.
In addition, firms that have significant outlays for 1099 contractors may find that it makes sense to convert some (or all) of those workers to full-time, W-2 status in order to take advantage of the deduction.
Alternatively, a business paying its owners substantial compensation may consider reducing that compensation, because income pulled out of the business as compensation does not qualify for the deduction.
Restructure triple-net leases: The deduction is not expected to apply to so-called triple-net lease properties, where the tenant pays real estate taxes, insurance, and maintenance costs associated with a leased property in addition to rent. That’s particularly common in related-party leases.
However, rental income qualifies as trade or business income and therefore qualifies for the deduction. So, if the landlord restructures the lease so that the tenant no longer pays real estate taxes, insurance, and maintenance costs, real estate income will qualify for the deduction.
Restructuring triple-net leases has an additional tax benefit: Losses on a triple-net lease property may be considered a capital loss, which can only be applied against capital gains and written off at $3,000 annually until exhausted. By comparison, business income is considered an ordinary loss, allowing for the write-off of at least $500,000 in the year of the loss.
Separate international income: The law only permits the deduction on domestic income, so firms should prepare to pay the higher tax rate on any international profits.
Firms should plan accordingly, ensuring that they understand what transactions are generating the foreign income and identifying ways to minimize that income. This may include separating foreign business activities into separate business units from domestic operations.
Decide how to handle estimated quarterly taxes: Whether a firm qualifies will make a significant difference to estimated taxes. A firm that does not qualify will pay a maximum tax rate of 37%, compared to a 29.6% effective rate for a firm granted the deduction.
So, firms that are unsure if they will qualify must decide whether to pay estimated quarterly taxes at the higher or lower rate. Those taking an aggressive tax stance may choose to pay the lower rate now and pay any additional tax obligation in the firm’s annual return if it fails to qualify.
Firms that take a conservative stance or that might be concerned about fines and penalties can pay the higher rate now while making the case for the deduction in their annual filing.
As businesses await detailed guidance on Section 199A, it’s important to get a sense of how things could play out in order to know which planning ideas are most impactful.
That’s not something that should be left until next April. Owners should consult with their tax advisers and separate issues into three categories: things that should be done as soon as possible; items that can be placed on hold pending IRS guidance, and longer-term considerations, such as the tax implications of changing from renting to owning property.
Kurt Piwko is a partner in the national tax office of accounting and consulting firm Plante Moran.