Architects and engineers are special in several ways, including:
- Unlike most professional service firms, they tend to accumulate earnings over time (often to fund redemptions at retirement) instead of maximizing current salaries; and
- The new tax law treats them more favorably than just about every other type of professional service firm.
In this piece, we don’t attempt to understand or explain the rationale for accumulating earnings by architectural and engineering companies — let’s just call it tradition. What we will do, is attempt to factor this tradition into some tax elections that you should assess ASAP.
Before we dive in, we need to cover a few bits about the new tax law. On December 22, 2017 President Trump signed into law what has affectionately been referred to as the “Tax Cuts and Jobs Act” (TCJA).
The TCJA changed the business landscape in at least three major ways of direct consequence to architects and engineers:
- The corporate tax rate dropped from a high of 35 percent to a high of 21 percent.
- Individual rates changed, mostly downward, though the removal of several tax deductions means that some individuals will see an increase in federal income taxes.
- A special deduction, in new Internal Revenue Code (IRC) Section 199A, is provided for certain sole proprietors (i.e., independent contractors), owners of S corporations, partnerships and business trusts.
Only the third item requires illumination. For those who appreciate simplicity or loathe details of tax law, here is the minimum of what you need to know about the new IRC Section 199A deduction:
IRC 199A provides many business owners, other than those in specified personal service industries, a deduction equal to the lesser of: (i) 20 percent of their earnings from business operations, i.e., excluding investment gains and interest income, or (ii) 50 percent of W-2 wages paid.
Significantly, architects and engineers are excluded from the carve-out that denies the benefit of this deduction to most other professional service providers!
We’ve provided some examples below of how the new tax rules may apply to architectural and engineering firms, but it’s important to remember that one size does not fit all.
1. Firms eager to retain earnings should consider C corporations.
Architectural and engineering firms that want to retain earnings (e.g., to invest in growth or cover a rainy day) should consider electing C corporate status. C corporations now pay tax on their net earnings at the extremely favorable federal tax rate of 21 percent, but amounts distributed to shareholders are subject to an additional tax of up to 23.8 percent federal tax. For example, after paying all expenses, including salaries to employee-shareholders, a C corporation would pay tax of $21 on $100 of earnings. If the same C corporation then decides to pay a dividend of the remaining $79, the shareholders will pay a second-level tax of as much as 23.8 percent or $18.80. Thus, the combined corporate and individual federal tax on the $100 of earnings would be $39.8 — almost 40 percent. If the same corporation could justify paying its shareholder employees $100 more in the aggregate, then the same amount of earnings would be taxed in the hands of the shareholders at about the same 40 percent rate (37 percent maximum federal income tax rate plus about 2.4 percent net medicare tax on amounts over the social security wage limit).
2. Firms that pay out most earnings as compensation should consider S corporations or possibly an LLC taxed as a partnership.
Non-C-corporation firms that strip out all of their net earnings at the end of each year, on the other hand, will generally benefit from the new IRC 199A deduction. The choice for firms in this second category is basically between a corporation making a subchapter S election and an LLC taxed as a partnership. Continuing the above example without trying to pay the employee-shareholders an extra $100, and assuming sufficient W-2 wages to support a full 20 percent IRC 199A deduction, the effective federal tax rate on the $100 of net earnings would be less than $30. ($100 * 37 percent maximum individual rate * 80 percent after the 20 percent reduction). In other words, this firm has shaved its tax liability by 10 percent on distributed earnings.
3. What should you do?
These general rules are fine for firms that are starting fresh. But what about firms with some history?
Firms organized as S corporations that want to retain earnings might consider revoking their S election and thereby become C corporations. Such S revocations can be made retroactive to the beginning of the year if they file the S termination paperwork before March 15 (assuming they are a calendar year taxpayer). After five years, the shareholders could again elect S status if they so choose, e.g., because the C corporation has accumulated sufficient earnings.
Firms organized as LLCs and taxed as partnerships could also similarly elect to be taxed as a C corporation within the same time limits. Such conversion would require the LLC members to pay themselves reasonable compensation, which also helps increase the W-2 wage base and could reduce self-employment taxes.
On the other hand, firms organized as C corporations might now want to convert to S corporations to maximize the benefit of the new IRC section 199A deduction. Assuming sufficient W-2 payroll to support the full deduction, distributions of S corporation earnings would be far more tax-efficient means than compensation to “manage” the amount of earnings retained.
In sum, one size will not fit all here. Firms eager to retain earnings will find a C corporation structure more tax-efficient whereas firms desiring to maximize shareholder income will likely benefit from an S election. Firms doing business in multiple states will have a little more complicated math but face similar issues.
Finally, architects and engineers operating as sole proprietors, including those operating through single member LLCs that have not made an election to be taxed as a corporation, should definitely consider the IRC 199A benefits of converting to an S corporation and paying themselves reasonable compensation.