Christmas Came Early In 2018: The New Tax Legislation

Business Edition

By Greg Freyman, CPA, CGMA

“Thankfulness is the beginning of gratitude. Gratitude is the completion of thankfulness. Thankfulness may consist merely of words. Gratitude is shown in acts.” —Henri Frederic Amiel

If you have a topic of interest you would like to see us cover, feel free to reach out and let us know; we are always happy to hear your thoughts, ideas, and feedback.

Before we put you all to sleep with a lot of boring tax talk, let’s simply say that great things are about to come that will surely stimulate the economy in more ways than meets the eye at first glance.

When the individual sitting across my desk gives me that blank stare, and exhales, and states in a whining tone, “but……I don’t want to pay taxes”, I say wait, taxes are a necessary evil that keeps all of us going as a nation.

Whether or not we want to pay our fair share of taxes is irrelevant, and one needs to understand that the Tax Code has many incentives to encourage certain desirable activities, such as expanding a business or obtaining additional education and training. The four major functions of the income tax system are revenue-producing, economic, social, and regulatory.

The tax law changes we are about to encounter in 2018 exemplify how crucial taxation is to our everyday lives, and are a perfect example of how reducing tax rates and offering new tax breaks is clearly an economic function. With lower tax rates the consumer will have more disposable income which will translate that cash into increased spending, savings, and investment.

To get the most meaning from this blog, please read the following basic definitions:

  1. Flow-through/pass-through entity – is an entity that does not pay any federal income taxes and passes the activity to the owners so that the owners can pay income taxes on the activity produced by the entity. This is typical of an S-corporation or a limited liability company (LLC).
  2. Subchapter C-corporations – are often called “C corps” or simply “corporations.” According to the U.S. Small Business Administration, regular corporations are sometimes referred to as C corporations because Subchapter C of Chapter 1 of the Internal Revenue Code lays out the general rules that govern corporations and their shareholders.
  3. Subchapter S-corporations – for United States federal income tax purposes, are closely held corporations (or, in some cases, LLC’s or a partnerships) that make valid elections to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.

In our tax system, to form a legal entity for business purposes, and enjoy the protection of limited liability, there are three basic selections to choose from.

  1. Sole-proprietorship/LLC /Partnership – taxes were traditionally paid at lower individual income tax rates
    1. Pass through taxation, all income is taxed at the member level
    2. Can be a disregarded entity when there is a single member, which means there is no distinction between the owner and the LLC for tax purposes, and all the reporting takes place on the individual tax return of the single member/owner of the entity
    3. Two members of an LLC, or two partners (with certain exceptions) will be required to file a partnership tax return
    4. Conversions to “S” or “C” status corporation is available upon election
  2. “C” Type Corporation – taxes were traditionally paid at highest corporate income tax rates
    1. All corporations are born as Subchapter C corporations by default
    2. Income is taxed at the corporate level and again taxed at the shareholder level with qualified dividend distributions taxable at capital gains rates (a double tax)
    3. Conversion to “S” status corporation is available upon election
    4. Conversions to “S” type corporation can trigger built-in-gains
  3. “S” Type Corporation – taxes were traditionally paid at lower individual income tax rates
    1. Limitations exist, not every situation is suited for this type of entity
    2. S election must be made within certain time limits
    3. Pass through taxation, all income is taxed at the shareholder level
    4. Bypasses the possibility of double taxation, however exceptions exist
    5. S-corporation that were former C-corporations have special concerns
    6. Revocation of election is available

The Main Updates

Without further ado…………let’s dive in to the nitty gritty

  1. “C” type corporate income tax rate reduction to 21% flat rate
  2. The new Section 199A Deduction for pass-through entities of 20% of Domestic Qualified Business Income (QBI) – but will not reduce your taxable income below $0
  3. Accelerated cost recovery systems
  4. New interest paid deduction limitations
  5. Loss deduction limitations under certain situations

For brevity, we will be discussing in detail only the first two main updates.

New 21% Flat Rate for C-corporations – Walk Through

The lower flat tax rate is actually not so free and clear, as there are surely some winners and some losers, as with everything.

The Winners

The great big news is for anyone now currently organized as a C-corporation, and has taxable income greater than $81,000, they will now wake up to less taxes as of January 1,2018.

The Losers

If your C-corporation’s taxable income is at or below $81,000, you will have an increase in taxes. That is right, you heard me, an increase in taxes! Also, important to note, that most small businesses, are at or around this level of taxable income, and our industry is mainly composed of small business, not huge conglomerates like Coca-Cola or General Motors.

This is where our insight is most helpful by the way, merely stating the changes would not add much value to our loyal readers, now would it? We would simply be reiterating what hundreds of others have already reported to the public.

Let’s take an example to reflect exactly how this will translate into an increase in taxes for the average small business owner.

Our current C-corporation taxes are calculated with a marginal bracket system. What does that mean? It means that the taxable income is progressively taxed at higher and higher rates as the income subject to taxation increases.

Our current marginal tax brackets look like this:

Federal Corporate Tax Rate

As you can see, the first $50,000 of taxable income is taxed at 15% (which is $7,500 in federal taxes), and the next $25,000 is to be taxed at 25% ($6,250 in federal taxes), and so on.

What would be the total federal corporate tax if the corporation’s taxable income was exactly $75,000? The answer is $13,750, as we would add the two layers of tax at the respective progressive rates, or $7,500 + $6,250.

The problem here is that you may think that your corporation is paying 25% percent in taxes, but, in effect, it is not, it is paying in taxes at 18.33%. You can prove that to yourself by simply adding up the taxes imposed under the marginal bracket system and dividing the result by the taxable income ($7,500 + $6,250)/$75,000 = 18.33% effective tax.

Federal Corporate Tax Rates

So, anyone paying attention to this point is clearly asking themselves, well how is this a tax break for those that are in the 25% marginal bracket? And you are a hundred percent correct, it is not – it is all smoke and mirrors, as most small businesses will land at around this level of taxable income, and currently, are paying less in taxes than they will be under the new law.

Don’t say we didn’t warn you.

Under the new law, a business that earns exactly $75,000 of taxable income will be paying in at a new flat rate of 21%, or $15,750 ($75,000 * 21%), as opposed to $13,750, which is an increase in taxes of exactly $2,000 per year.

New Flat Rate

New Business Pass-Through Deduction (Section 199A)

The Winners

Note: although we say business up above, this new deduction will also affect trusts and estates, also pass-through entities.

The new section 199A deduction will equal 20% of domestic QBI.

Why is this new deduction so exciting? Well, as with anything, a new deduction where there was none before, proves to have some great incentives for those operating as a pass-through entity.

As previously mentioned, pass-through entities do not pay any income taxes on a federal level, and pass-through the net income (or loss) to the individual owners. If the entity passes through a net income, the owners will pay taxes on that income based on their respective individual income tax rates. This would mean that if you, as an individual owner, would be in the top marginal bracket of 39.60% (for 2017), you would be paying taxes on any additional income at this respective rate.

For those in the new top marginal federal tax bracket of 37% (taxable incomes greater than $600,000) and receiving the 20% deduction from their pass-through entities, in effect the additional income will now be taxed at 29.60% (37% * 80%) as opposed to the new individual top marginal rate of 37%.

The Limitations for “The Winners”

You may be asking yourself, so, what is the catch? There is always a catch, isn’t there? Ok, here you go……

The first limitation, which applies to everyone, will test the deduction to the lesser of:

  1. The QBI deduction amount
  2. 20% * (total individual taxable income – capital gain)

For Example

A married couple has profit of $100,000 from self-employment (a sole-proprietorship) from their pizza shop. They also have $34,000 of other income. They will take a new standard deduction of $24,000 in 2018.

Based on the assumed circumstances up above, this is how we would arrive at the QBI utilized.

QBI Deduction

* QBI Deduction = lesser of:

  1. QBI Deduction amount
    • net business income $100,000 * 20% = $20,000
  2. 20% of taxable income
    • taxable income $110,000 * 20% = $22,000

For those with taxable income greater than $415,000 (married filing jointly (MFJ)), there will be an additional limitation to calculate the deduction

The deduction will be limited to the lesser of:

  1. 20% of the Qualified Business Income, OR
  2. greater of the two:
    • 50% of W-2 wages
    • 25% of W-2 wages plus 2.5% of unadjusted capital investment in the business

Thanks, can you throw an example our way, professor? Sure thing!

For Example

A married couple has profit of $70,000 from their LLC (a partnership) from their investment in real estate. There are no employees, and hence, no W-2 wages, but, there are assets/capital invested in the property.

Their taxable income is $600,000 or greater, placing them in the 37% federal tax bracket.

QBI Example

The Losers

Sigh, unfortunately, there are always losers in every game.

For those in a specific industry, there will be no section 199A deduction allowed once income is greater than $415,000 (MFJ). Limitations start to kick in once taxable income starts to go over $315,000 (MFJ) or $157,500 for single filers.

Which industries in particular? It would include professional service firms. Professional services firms exist in many different industries. More specifically, professional service firms can include, according to Wikipedia, lawyers, doctors, advertising professionals, architects, accountants, financial advisers, engineers, and consultants, among others. Basically, they can be any organization or profession that offers customized, knowledge-based services to clients.

Note: The new limitation on the new section 199A deduction will exclude architects and engineers, as they do not fall under the specific sections of the tax code.

HUH? This is all great accounting talk Greg, but can you simplify things for me, that is what I pay you for, right?

Glad you asked my friend, I have just the summary chart for you.
If you would like to see exactly how you will be affected for your situation, please do not hesitate to contact our office so that we may calculate the deduction you can expect to receive.

Flow Chart

Bonus Insights

Things to be wary of before deciding to jump back from the S-corporation setting to a C-corporation form of taxation (revoking the S election)

  1. Potential exposure to the Personal Holding Company (PHC) tax or the Accumulated Earnings Tax (AET) at a 20% rate
  2. Tax rules may change in the future, and the tax rates may revert to where they were for each entity type, and you may be stuck by that point
  3. Distributing assets from a converted S-corporation will trigger potentially more taxes for the shareholders, and any tax savings may be lost

Things to consider for C-corporations

  1. May offer lower levels of taxation with the new flat rate and offer certain other lower tax levels under section 1202 given the right circumstances
  2. Not every situation is suitable for S-corporations, and a C-corporation would be the obvious choice, some of these reasons may include legal reasons and business reasons, not only tax reasons
  3. Pass-through entities can have their losses suspended if they are deemed to be hobby losses by the IRS, a C-corporation would not have such implications

FAQ’s on choosing between an S or C corporation organization

Question: If I lose part or all the new section 199A deduction, will I be able to recoup it in future years?

Answer: No, once you lose the deduction, it is lost for good.

Question: Does it usually make sense to operate as an S-corporation as opposed to operating as a C-corporation?

Answer: Yes, in almost all cases. When we look at the numbers side by side, it is still better to be organized as an S-corporation. There are specific situations that may not apply, so, make sure to discuss your specific dealings with a tax and legal professional before you commence making any decisions.

Question: If my income is typically under the $315,000 limitation and I am not a professional service firm as defined by the code, does it always make sense to operate as an S-corporation as opposed to operating as a C-corporation?

Answer: Rarely will it make sense to operate as a C-corporation.

Question: Can you give an example of when it would make sense to start as a C-corporation and perhaps switch in 5 to 10 years to an S-corporation?

Answer: For example, the owner is in a higher tax bracket vs. a flat C-corporate rate of 21%. Assuming no distributions of profit triggering the double tax from the C-corporation. This can happen when all profit would revert to pay back any debts used to start-up or build-up the business.

Question: Will it make sense to be a C-corporation as opposed to a S-corporation if my business is a professional service firm that is subject to the income limitations, and all or part of my deduction will be lost?

Answer: In most cases, it will not make sense to be organized as a C-corporation for tax purposes, as the effective tax rates would be higher as a C-corporation, given the double tax. There can be certain situations that this would not apply.

Question: If the tax rate of a C-corporation is a flat rate of 21%, I am in the top marginal bracket of 37%, and with the new deduction, I am paying an effective rate of 29.60% on my S-corporation, why would I not want to switch over to a C-corporation? You state that in almost all cases it will be best to organize as an S-corporation, unless specific business reasons exist.

Answer: Simply put, the only way to distribute money from a C-corporation is by distributions of cash. Distributions of cash are deemed to be qualified dividends, subject to capital gains taxes. Therefore, we say that C-corporation pays a double tax.

For example, Joe S. has taxable income greater than $600,000, and his S-corporation passes through income of $100,000 ($80,000 taxable after the 20% deduction).

Joe would pay taxes at the top marginal rate of 37%. Assuming no W-2 wages or assets, his effective tax rate would be 29.60% on income from the pass-through entity at $100,000 (29.60% = ($80,000 * 37%)/$100,000).

If Joe S. operated his business under a C-corporation structure, his tax on $100,000 would be 21%, or $21,000. Joe would need to distribute these amounts and pay taxes at the capital gains rates, for him, these taxes would amount to 23.80% on the remaining $79,000 distributed ($100,000 – $21,000 in corporate taxes). 23.80% of taxes in $79,000 equals $18,800 in federal capital gains taxes. The combined tax exposure would be higher as a C-corporation at 39.80% (($18,800 + $21,000 = $39,800)/$100,000) as compared to 29.60% taxes, or $29,600.

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