The Tax Cuts and Jobs Act (the “Act”) that President Trump has now signed into law alters the federal income tax regime applicable to business operations conducted on and after Jan. 1, 2018. In doing so, it creates new issues and opportunities to consider for structuring business operations in the most optimal manner from an income tax perspective.
Reduced Corporate Rate
The Act reduces the corporate income tax rate to a flat rate of 21% and eliminates the corporate alternative minimum income tax. The reduced flat corporate rate applies equally to personal service corporations. As a result of these changes, in certain circumstances, such as in the case of business operations that generate substantial taxable income and most of the income is reinvested each year back into business operations, taxpayers may find an advantage to adopting a corporate tax structure. If it is determined that a corporate income tax structure is preferable, the change should obviously be made as soon as possible. Note, with appropriate planning, the decision can be made retroactive for up to 75 days.
Pass-Through Business Income Deduction
The Act provides for a preferential tax rate for income arising from pass-through entities and proprietorships through a 20% deduction on the income business owners earn, which is then taxed at the individual rate. This 20% deduction means that certain pass-through income will be subject to a maximum 29.6% tax rate after accounting for the deduction, instead of the maximum individual tax rate of 37%. Accordingly, when the benefit of the 20% deduction on pass-through income is fully available, the highest effective income tax rate on pass-through income will be 29.6% compared to the highest effective income tax rate on C corporation income that is distributed out to shareholders of 36.8% (ignoring the Medicare surtax and state and local taxes).
The “qualified business income” (generally, ordinary income arising from a trade or business) that is eligible for the 20% deduction is limited for taxpayers whose taxable income is above the threshold amount of $157,500 ($315,000 in the case of a joint return). The limitation is based on: (i) 50% of the business’s W-2 wages, or, if greater, (ii) the amount that is the sum of 25% of the business’s W-2 wages plus 2.5% of the acquisition cost of tangible depreciable property used in the business operations. The latter threshold alternative based partly on the value of property used in the business was a late addition to the Act that makes the deduction more broadly available to capital intensive businesses (such as real estate and automated manufacturing).
In the case of many professional service businesses, other than engineering and architectural services, the deduction is phased out for taxpayers with taxable income over $157,500 who file individually and $315,000 who file jointly, such that the benefit is entirely eliminated for such professionals filing individually with taxable income at or above $207,500 and taxpayers filing jointly with taxable income at or above $415,000.
Many Factors to Consider Before Making Any Changes
The combination of the lower corporate rate and the new deduction on pass-through and proprietorship business income will place a premium on the manner in which business operations are structured in one or more entities. When comparing the corporate tax structure to a pass-through structure, factors that will need to be considered include: (i) the likelihood of retaining the new corporate and pass-through tax structure by future legislative and executive branches, (ii) the intended uses of business profits by the owners of the business, and (iii) the preferential exit strategies for future sales of the business. The correct structure for any particular business will depend on the circumstances of that particular business and its owners, with no single strategy necessarily being the right fit for any one particular business.
Members of Taft’s Tax practice are available to assist you in making appropriate decisions to optimize the tax efficiency of your business structures.