The Act makes major changes to the taxation of individuals, pass-through entities, and corporations, the highlights of which are as follows:
Tax rates for individuals on business income earned through tax “pass-throughs”-- meaning partnerships, limited liability companies and partnerships, sole proprietorships and S corporations -- have been meaningfully reduced under the Act by two changes: (1) first, a 2.6 percentage point reduction in the top marginal income rate, from 39.6% to 37%, and (2) second, a potential further reduction to 29.6% for certain income that is “qualified business income” (“QBI”). Together, these two rate reductions for ordinary income represent a 10 percentage point reduction from the pre-Act 39.6% top individual marginal rate -- this is real relief for owners of pass-through businesses including real estate owners and investors that earn rental income. The rate reduction on QBI to 29.6% is not automatic, but rather importantly turns on the relative amounts of the underlying business’ qualifying income, wages and tangible property investment, with exception for ordinary income from REITs and Publicly Traded Partnerships (PTPs).
The potential optimum QBI 29.6% rate arises from the new deduction against taxable income generally equal to 20% of the sum of QBI from each qualified trade or business and certain income of REITs and PTPs (effective through 2025) -- the QBI deduction amount depends on the individual’s taxable income, QBI, and the applicable qualified business wage and property factor limitations.
Under the 20% QBI deduction wage and property limitation, the deduction generally may never exceed the greater of two referenced amounts, one based on “wages” and the second on a hybrid of “wages” and “tangible property” of each qualified business, as follows:
- 50% of W-2 wages paid to employees, or
- 25% of W-2 wages paid to employees plus 2.5% of the acquisition cost basis (unadjusted) of tangible, depreciable assets including personal and real property used in the business and which are not fully depreciated.
- Only when the full 20% QBI deduction is realized after application of the “wage and property” limitation does a business owner realize a full 20% QBI deduction and an effective 29.6% tax rate.
- The 20% QBI deduction does not apply for self-employment and net investment income (i.e., Medicare) tax purposes.
Dividends of ordinary income from REITs, as well as PTPs taxed as pass-throughs, are not subject to the QBI wage and property limitation (i.e., REIT and PTP ordinary income automatically receives the full 20% deduction and is taxed at the optimum QBI pass-through rate of 29.6%). The Act does not change the 20% tax on REIT distributions of capital gain. PTP distributions to the extent of qualified income and ordinary income realized by PTP holders from disposition of the PTP interest (allocable to non-capital gain assets) will receive the full 20% QBI pass-through deduction.
Income from “specified service trades or businesses” (e.g. medical, accounting, investment management, trading, and dealing in securities, and law) and the performance of services as an employee generally are not eligible for the QBI deduction except for lower income taxpayers.
Owners with taxable income below a threshold amount ($157,500 or, in the case of a joint return, $315,000) automatically qualify for a full 20% deduction, without being subject to either the “wage and property” limitation or the specified service limitation. The wage and property limit phases in proportionately and becomes fully applicable upon the first $50,000 of taxable income above the relevant threshold (or the first $100,000 of taxable income above $315,000 in the case of a joint return).
- The 29.6% rate for REIT dividends resulting from the automatic 20% deduction on REIT ordinary income dividends will allow REITs to stay largely in step with the rate reduction afforded corporations, giving REIT investors an approximate 10 percentage point tax rate reduction compared to pre-Act law and an approximate 6.4 percentage point overall rate current advantage over corporate shareholders after two levels of tax. Similar favorable treatment is accorded to PTP qualified business income such as real property rental income or oil and gas income (while fees generated by investment management PTPs would not qualify).
- Realization of the optimum 29.6% QBI rate by other categories of pass-through business owners is by no means a certainty, as the net result will be facts and circumstances based, rather than industry specific. The “wage and property” limitation alternative prong providing a 2.5% of tangible property factor (added by the final Conference agreement) might enable businesses with substantial capital investments and relatively small payrolls to better realize the full 20% QBI deduction and obtain the optimum QBI 29.6% pass-through rate. Real estate companies, with sufficient “wage and property” limitation factors, would benefit to the extent they generate ordinary income (capital gains remain taxable generally at 20%). To better reach their full 20% QBI deduction, real estate companies with small payrolls may end up utilizing the alternative prong 2.5% of tangible property cost factor, rather than the purely payroll-based factor. For example, a pass-through real estate business owned by a family may have a low payroll relative to its net rental income but a high investment in real estate that would drive the governing “wage and property” limitation amount.
- While the Act limitation on deductibility of state and local income taxes (discussed below) will impact real estate owners along with other pass-through business operators, the maximum 10 percentage point reduction from pre-Act law tax rates under the 29.6% QBI pass-through rate, where obtainable, should in terms of taxes saved more than offset the lost federal tax savings from non-deductibility of state and local income tax. However, for employee and capital “lite” businesses whose W-2 wage and property cost factors are not sufficiently large relative to business income, the loss of federal tax savings from the cap on deductibility of state and local income taxes will have a greater impact.
- For example, a California pass-through realty development business, owned by two principals, that subcontracts out many functions may have both low wage and property limitation factors leaving their effective tax rate near 37% while their California income taxes (borne at a maximum 13% rate) would no longer be fully deductible -- in that case, the lost federal tax savings from deduction of their California income taxes (representing in 2017 about 5% of their income, i.e., 39.6% of 13%) would be greater than their tax benefit under the 20% QBI deduction. Alternatively, if the California company were a tech start-up, with large option and appreciation right incentive compensation programs, but low base compensation, and low cost personal property, a pass-through tax structure may not produce any significant QBI deduction benefit, unless the business acquired real estate to house its operations. Similar effects and considerations apply to businesses operating in other high tax locations such as New York City, where the combined state and local rates together exceed 10%.
- Some businesses may determine that the lower overall Act tax burden to shareholders under a regular C corporation tax structure -- under a 39.8% combined federal rate from both corporate and shareholder level taxes -- is more beneficial or appropriate than a pass-through structure. Factors in this calculus include the (A) 8.6-to-16 percentage point spread assuming no corporate distributions when compared to the higher 29.6% QBI and 37% general individual rates, (B) capital expenditure needs of the business, projected cash flow, and likelihood of desired periodic cash distributions of earnings, (C) benefit of corporate tax deductibility of state and local income taxes, and (D) necessary amounts of wages and tangible property under the “wage and property” limitation factors to generate the maximum 20% QBI deduction under a pass-through structure.
State and Local Taxes
Individuals now face a new $10,000 cap on their deduction of certain taxes for federal tax purposes: (i) all state and local income (or sales taxes in lieu of income taxes), and (ii) state and local property taxes that are not paid or accrued in carrying on a trade or business or an investment activity. In contrast, the Act does not change the deductibility of state and local income taxes of corporations.
- The new $10,000 cap for individual deductions applies to taxes paid directly with regard to income earned via pass-through entities as well as to an allocable share of income tax paid by a pass-through entity.
- Congress, as part of the final bill reconciliation maneuvers, preserved the deductibility of property (but not income) taxes paid in carrying on a business or an activity related to the production of income.
- The limitation on state income tax deductions will increase the effective cost of the state and local tax burden by 39.6 cents per state income tax dollar (representing the pre-2018 federal tax savings from the deduction of state and local tax under pre-Act maximum individual federal rates) -- e.g., assuming a state individual income tax rate of 5%, the loss of deductibility at the federal level would raise the cost of such taxes from $3.02 to $5 per $100 of income. Real estate owners (both operators and regular businesses) otherwise fare well to the extent that state and local property taxes incurred in a trade or business or an investment activity remain fully deductible outside of the $10,000 cap.
The Act doubles the estate tax exemption to $22.4 million for married couples and to $11.2 million for unmarried individuals. The Act does not eliminate the income tax basis step-up to fair market value for property held at death, which will therefore continue to shelter appreciation on such assets.
- The Act lessens the estate tax burden on all business property owned by the family, whether farms, real estate, or closely held businesses, while continuing the valuable basis step-up for property passed on to the next generation, a feature on the chopping block whenever estate tax repeal is discussed.