The Tax Cuts and Jobs Act of 2017 (sometimes referred to as the “Tax Act”) is the most significant piece of tax legislation since 1986 and will fundamentally alter business tax planning, including choice of entity considerations, for most businesses. What follows is a general overview of some of the more significant changes, including changes in individual and corporate tax rates, the new 20 percent deduction for qualified business income, some other changes for individuals, corporations, and pass through entities, and some implications for business tax planning and choice of entity.
This is intended only as a general summary and not as specific tax advice that may be relied upon for any particular circumstances. For simplicity, the discussion below often assumes application of the highest rates and does not address state and local tax consequences. Should you have any questions specific to your situation, please feel free to contact Jay Nathanson or Cassie Barr of our tax group or your regular Greensfelder contact.
CHANGES IN RATES
- The maximum rate imposed upon ordinary income for individuals is reduced from 39.6 percent to 37 percent. The highest rate is applicable to married filing jointly in excess of $600,000 of taxable income and single individuals in excess of $500,000 of taxable income.
- Present law maximum rates for individuals of 20 percent for long-term capital gains and qualified dividends, 28 percent for collectibles, and 25 percent for unrecaptured depreciation, are retained.
- Present law 3.8 percent tax on certain net investment income of individuals and the uncapped 3.8 percent Medicare tax on self-employment income and wages, are both retained for married filing jointly having modified adjusted gross income in excess of $250,000.
- The 100 percent exclusion of gain from the sale of certain small business stock in a C corporation, held for more than five years, contained in Code Section 1202, remains unchanged.
- The new ordinary income tax rates are applicable for tax years beginning after Dec. 31, 2017, and ending on or before Dec. 31, 2025.
- The current four-tier structure with a top rate of 35 percent is replaced with a flat 21 percent corporate tax.
- There is no longer a special rate for personal service corporations, which were taxed at a flat 35 percent rate under prior law.
- The 70 percent dividends received deduction (DRD) is reduced to 50 percent, and the 80 percent DRD (for over 20 percent ownership) is reduced to 65 percent.
- The current law affording no special capital gains rates for C corporations is retained.
- The provisions apply to tax years beginning after Dec. 31, 2017.
- Code Section 15 provides for a blended rate for fiscal year corporations having fiscal years ending in 2018.
20 percent deduction for Qualified Business Income — New Code Section 199A:
- Income to which this new 20 percent deduction is applicable will be taxed at a maximum effective rate to individuals of 29.6 percent, i.e., 80 percent of 37 percent.
- The new deduction applies to taxpayers other than corporations, including individual sole proprietors, trusts and estates. In the case of partnerships and S corporations, the deduction applies at the partner or shareholder level.
- The deduction for a taxable year is generally equal to the sum of 20 percent of the taxpayer’s qualified business income from each qualified trade or business carried on by the taxpayer.
- The deduction for a taxable year cannot exceed 20 percent of the taxable income of the taxpayer for the tax year minus any net capital gains.
- The deduction for each qualified trade or business is further limited to a threshold based on the wages paid and qualified property used in the business. The so-called W-2 wages/qualified property limit is the greater of (x) 50 percent of W-2 wages with respect to the qualified trade or business, or (y) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis of qualified property immediately after the acquisition.
- The W-2 wages/qualified property limit does not apply if taxable income of the taxpayer does not meet the threshold amount. The threshold amount is $157,500 for singles and $315,000 for marrieds filing jointly. For singles that exceed the threshold amount by $50,000 or less and marrieds filing jointly that exceed the threshold amount by $100,000 or less, only a pro-rated portion of the W/2 wages/qualified property limit applies.
- For purposes of computing the deduction, qualified business income does not include reasonable compensation paid to shareholders or guaranteed payments paid to partners for services.
- For purposes of computing the deduction, qualified business income also excludes items that are not from a domestically operated trade or business and investment type items such as capital gains and losses, dividends, interest not properly allocable to a trade or business, income from certain commodity and currency transactions, notional principal contracts and annuities.
- The type of business to which the deduction applies, i.e., a qualified trade or business, is broadly defined as any trade or business except a specified service trade or business or the trade or business of performing services as an employee. Specified service trades or businesses include: health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage, where the primary asset is the reputation or skills of one or more employees or owners, investing and investment management, and trading, or dealing in securities, partnership interests, or commodities. Engineers and architects are excluded.
- However, if for any taxable year the taxable income of the taxpayer is less than or equal to the threshold amounts ($157,500 or $315,000), then a specified service trade or business will not fail to be a qualified trade or business for that reason. But if the threshold amount is exceeded by up to $50,000 or $100,000, a prorated portion of qualified items of income or loss, W-2 wages and unadjusted basis of qualified property shall be taken into account.
- For purposes of determining alternative minimum taxable income, qualified business income is determined without regard to the adjustments under the alternative minimum tax rules.
- The deduction is available for itemizers and non-itemizers and reduces taxable income and not adjusted gross income, i.e., the deduction does not affect limitations based on AGI. The 199A deduction does not reduce self-employment taxes or impact the computation of NOLs.
- The 20 percent deduction is applicable for taxable years beginning after Dec. 31, 2017 and ending on or before Dec. 31, 2025.
SOME OTHER CHANGES APPLICABLE TO INDIVIDUALS
- Most of the following are for tax years beginning after Dec. 31, 2017, and expiring after Dec. 31, 2025.
- Increased standard deduction to $24,000 for joint return or surviving spouse and suspended personal exemptions.
- Alternative minimum tax preserved with the AMT exemption amounts increased and the phase-out of exemption amounts increased.
- Deduction for sales, income, and property taxes limited to $10,000 generally. Property taxes and sales taxes can be deducted in connection with a trade or business without regard to the limit of $10,000.
- Miscellaneous itemized deductions subject to the 2 percent floor, and overall limit on itemized deductions (the Pease limitation), suspended.
- Mortgage deduction limited to interest on $750,000 of debt for debt incurred after December 15, 2017 and no deduction for interest on home equity debt.
- AGI limit on cash contributions to charities increased from 50 percent to 60 percent.
- Medical expense deduction floor reduced from 10 percent to 7.5 percent of AGI.
- Alimony payments no longer deductible by payor or income to payee for arrangements after 2018.
- Deduction for expenses incurred in the trade or business of being an employee suspended.
SOME OTHER CHANGES APPLICABLE TO BUSINESSES AND CORPORATIONS
- Repeal of the corporate alternative minimum tax.
- Cash accounting is now permitted for C corporations with up to $25 million annual gross receipts (up from $5 million).
- The deduction for net interest expense is now limited to interest income, 30 percent of the business’s adjusted taxable income, and floor plan financing interest. Businesses with average annual receipts of $25 million or less are exempt from this new limitation.
- The deduction for domestic production activities is repealed.
- Net operating loss deductions are limited to 80 percent of taxable income for all tax years beginning after Dec. 31, 2017, and carrybacks are eliminated other than for farm losses.
- Non-recognition of gain or loss on like kind exchanges is limited to real property that is not held primarily for sale, i.e., this favorable treatment no longer applies to exchanges of personal property.
- Certain payments to a corporation are no longer excludible from gross income as contributions to capital, including, contributions in aid of construction or other contributions as a customer or potential customer or any contributions by a governmental entity or civic group (other than a contribution by a shareholder as such).
- The Tax Act expands the definition for qualified property subject to bonus depreciation to used property new to the taxpayer and allows full expensing for property placed in service after Sept. 27, 2017, with the percentage that may be expensed after Dec. 31, 2022, reduced on a sliding scale through Jan. 1, 2028.
- The amount that may be immediately expensed under Code Section 179 is increased from $500,000 to $1 million, and the beginning phase-out level is increased from $2 million to $2.5 million. The section generally applies to depreciable personal property and certain qualified real property. The definition of qualified real property is expanded under the Act.
- The deduction for 50 percent of the cost of entertainment, amusement or recreation, even if directly related to the active conduct of a trade or business, is no longer allowed. Neither are the costs of facilities used for that purpose or membership dues to various clubs. The deduction for qualified transportation benefits to employees, such as parking, is also eliminated.
- Self-created patents, inventions, models, designs, secret formulas or processes are no longer treated as capital assets and the sale of such items generates ordinary income.
- No deduction is allowed for settlement or payments related to sexual harassment or sexual abuse, or related legal fees, if the settlement or payment is subject to a nondisclosure agreement.
- New Code Section 83(i) provides for qualified equity grants. Under that section, if qualified stock is transferred to a qualified employee that makes an election, income on the grant is deferred until the earliest of (i) the stock becoming transferrable; (ii) the employee becoming an excluded employee; (iii) stock of the issuer becoming readily tradable; (iv) five years after the stock became transferrable or not subject to a substantial risk of forfeiture; or (v) the date the employee revokes the election.
SOME OTHER CHANGES APPLICABLE TO PASS THROUGH ENTITIES
- Any C corporation that was an S corporation before the enactment of the Tax Act, which revokes its S status during the two-year period beginning on the date of enactment, with no ownership changes between the date of enactment of the Act and revocation, is given a six-year period to make the Code Section 481 adjustment occasioned by a change from cash to accrual accounting resulting from the conversion to C status. In addition, any distribution of money by such corporation shall be allocated proportionately between the accumulated adjustments account and accumulated earnings and profits.
- Code Section 708(b)(1)(B), requiring a technical termination of a partnership if within any 12-month period there is a sale or exchange of 50 percent or more of the total interests in capital and profits, is repealed. Under prior law, the result of a technical termination was generally a short taxable year, elections ceasing to apply, and the restart of depreciation recovery periods.
- New Code Section 1061 is added regarding partnership interests held in connection with the performance of services, i.e., so-called carried interests. These provisions are applicable for taxable years beginning after Dec. 31, 2017. The provision treats as short-term capital gain, taxed at ordinary income rates, the taxpayer’s net long-term capital gain with respect to an applicable partnership interest that has less than a three-year holding period.
SOME CHOICE OF ENTITY AND OTHER PLANNING IMPLICATIONS
- Loss pass through. Basically unchanged. Not available with C corporations and partnerships are generally superior to S corporations because in the case of partnerships inside debt can increase outside basis.
- Highly profitable qualified trade or business, that satisfies the wage and property limitations, that wishes to currently distribute operating profits. In the case of a C corporation, the combined federal corporate income tax rate (21 percent), individual income tax rate on qualified dividends (20 percent), and net investment income tax rate (3.8 percent) would yield an overall federal tax of 39.8 percent. (21 percent of 100 (21), plus 20 percent of 79 (15.8), plus 3.8 percent of 79 (3) = 39.8) In the case of a pass through entity, the overall federal tax rate would be 29.6 percent if the 3.8 percent tax does not apply and 33.4 percent if it does apply. (The 3.8 percent tax can most likely be avoided in the case of S corporation shareholders that are active in the trade or business of the corporation.)
- Highly profitable qualified trade or business, that does not satisfy the wage and property limitations, or highly profitable specified service trade or business, whose owners are above the threshold, that wishes to currently distribute operating profits. As in b) above, 39.8 percent in the case of a C corporation. In the case of a pass through entity, the overall federal income tax rate would be 37 percent if the 3.8 percent tax does not apply and 40.8 percent if it does apply.
- Entity that wishes to accumulate profits to expand. There would be a current 21 percent federal income tax in the case of a C corporation. In the case of a pass through, there are three possibilities:
- If the 20 percent deduction applies and the 3.8 percent tax does not apply, 29.6 percent;
- if the 20 percent deduction applies and the 3.8 percent tax applies, 33.4 percent; and
- if the 20 percent deduction does not apply and the 3.8 percent tax does apply, 40.8 percent. (Note: A C corporation that accumulates profits must plan to avoid the possibility of imposition of the accumulated earnings tax (20 percent) under Code Section 531 or the personal holding company tax (20 percent) under Code Section 541.)
- The continued viability of zeroing out entity level income with deductible payments to owners in the case of C Corporations. Previously, it was often advantageous for C corporations to maximize compensation and other deductible payments to employee-shareholders to avoid the double tax. Now, a payment of salary, rent or interest generally yields an immediate tax of 40.8 percent (37 percent plus 3.8 percent) to the employee-shareholder (in the case of wages the 3.8 percent tax is borne partially by the corporation), and simply paying dividends and incurring the heretofore dreaded double tax yields only a 39.8 percent combined corporate and individual tax with the timing of the 23.8 percent individual segment subject to deferral.
- Making deductible payments to owners in the case of pass through entities. If the 199A deduction is applicable, deductible payments to the owners, like interest and rent, will be taxed at 40.8 percent, while pass through income will be taxed at only 29.6 percent or 33.4 percent. To qualify for the 199A deduction, it will in some cases be necessary to reduce taxable income to the threshold amounts. In such case consider deductible payments to a related C corporation (taxed at 21 percent and excluded from owner taxable income) (maybe as management fees) instead of to owners (taxed at 40.8 percent and included in owner taxable income). On the other hand, owner wages in some cases will be needed to meet the W-2 wage limit.
- Entity that views asset sale and liquidation as exit strategy. In the case of a C corporation, an overall federal tax of 39.8 percent as in b) above. In the case of a pass through entity, the appreciated assets of which are capital assets, such as goodwill, an overall 20 percent tax is possible, with the additional 3.8 percent tax, if applicable. (Note: In the case of a C corporation, a 20 percent tax could also be applicable to goodwill to the extent it can be established that the goodwill is a personal asset of one or more shareholders. Also, to the extent an entity has ordinary income assets, a pass through might do no better than a C corporation in that case either.)
- Entity that views a sale of equity as an exit strategy. In the case of a C corporation: (i) generally, a 23.8 percent federal tax; (ii) no outside basis step up for undistributed earnings; (iii) no recharacterization of income as ordinary based on inside ordinary income assets; and (iv) 0 percent federal tax if the stock is small business company stock under Code Section 1202. In the case of a pass through entity: (i) generally, 23.8 percent federal tax, unless 3.8 percent tax can be avoided; (ii) outside basis step up for undistributed earnings; (iii) in the case of a partnership, if certain inside ordinary income assets, gain on sale of equity can be ordinary, and taxable at 37 percent (plus the 3.8 percent tax in some cases); and (iv) no possibility of 0 percent tax under Code Section 1202. (Note: In the case of an entity that intends to retain earnings to expand and be sold tax-free under Code Section 1202, or to be acquired in a tax-free reorganization, under the right circumstances, being a C Corporation could afford tremendous tax savings over a partnership, i.e., 21 percent overall on operations and 0 percent on sale vs. 37 percent or 29.6 percent (maybe plus 3.8 percent) overall on operations and 20 percent or 23.8 percent on sale.)
- Entity intending to use life insurance to fund a restrictive stock agreement. Prior to the repeal of the corporate alternative minimum tax, C corporations were at a disadvantage because life insurance proceeds received or accrued were subject to the corporate alternative minimum tax. This disadvantage should no longer exist. With repeal of corporate AMT, holding insurance in a C corporation might be the best option: (i) avoids transfer for value concerns with insurance held by owners; (ii) avoids wasted basis concerns with insurance held by S corporation; and (iii) avoids complexities and risks with insurance partnerships.
- Considerations involving independent contractor status vs. employee status. A self-employed individual providing personal services whether or not in a qualified trade or business (and whether or not the W-2 wages/qualified property threshold will be met), would be entitled to the 20 percent deduction as long as the income limits ($315,000 to $415,000 or $157,500 to $207,500) are met. Wages in employment are never entitled to the 20 percent deduction. On the other hand, from the standpoint of the owners, meeting the W-2 wages test, wages to employees count while payments to independent contractors do not.
- S corporations will remain the favorable pass through in terms of avoiding the 3.8 percent tax. This tax is usually avoided in the case of an S corporation if compensation is not unreasonably low and the shareholder-employees are active in the trade or business of the S corporation.
- Careful planning between an S Corporation and a partnership will be needed to maximize the benefits of the 20 percent deduction. Sometimes an S corporation will be the less favorable pass through in terms of maximizing the benefit of the 20 percent deduction because compensation cannot be unreasonably low. However, if owners must be paid W-2 wages to meet the W-2 wage threshold, Subchapter S could be more attractive because of IRS position that partners cannot be paid W-2 wages.
- Trade or business activity will be preferred over investment activity. This is because a trade or business is required for the Code Section 199A deduction. In close cases (such as rental real estate), it will be advisable to structure as an active business.
- Do not fail to consider the unknown. (i) One might convert to a C corporation for the lower 21 percent rate and suffer adverse tax consequences going back to pass through if the 21 percent rate is increased; or (ii) one might incur tax to convert a C corporation to a partnership for the 199A deduction, although the deduction could expire in 2026.