Some of the most controversial provisions of The Tax Cuts and Jobs Act of 2017 (the “Act”) relate to providing tax relief to small business entities. Some of the impactful changes effecting small businesses are as follows:
- Lowers the income tax rate applicable to C corporations to twenty-one percent (21%), starting in 2018 and continues permanently thereafter.
- Establishes a twenty percent (20%) deduction of “Qualified Business Income” (a/k/a “QBI”) from businesses operating through pass-through entities, such as S corporations, LLCs, and partnerships.
- Allows full and immediate expensing of short-lived capital investments for five (5) years, and increases the section 179 expensing cap from Five Hundred Thousand Dollars ($500,000) to One Million Dollars ($1,000,000).
- Limits the deductibility of net interest expense to thirty percent (30%) of earnings before interest, taxes, depreciation, and amortization (EBITDA) for four years, and thirty percent (30%) of earnings before interest and taxes (EBIT) thereafter.
- Eliminates net operating loss carrybacks incurred after December 31, 2017, and limits carryforwards to eighty percent (80%) percent of taxable income.
Among those tax law changes for businesses noted above, the most relevant may be the twenty percent (20%) deduction of Qualified Business Income for pass-through business entities. Like most things in life, nothing is as simple as it seems, and true to form, Congress has placed substantial limitations on the deduction of QBI for pass through entities, including the following:
- Investment income from pass-through businesses is not eligible for the Qualified Business Income deduction.
- Qualified Business Income deduction does not include: (i) reasonable compensation paid to an S corporation shareholder/employee, or (ii) any guarantee payments for services in a partnership or LLC.
- QBI deductions are limited to the lesser of: (i) twenty percent (20%) of its business income, or (ii) fifty percent (50%) of the total wages paid by the business to its employees. Thus a high-income business with very few employees might have its deduction limited to only 50% of its payroll.
- For those taxpayers providing professional services, the QBI deduction is significantly limited (and ultimately phased-out based on earnings).
o Specific service industries, including health, law, accounting, consulting, financial, and other professional service businesses, are expressly excluded from taking this deduction, provided, however, joint filers in these service industries with income below $315,000 and single filers with income below $157,500 can still claim the full QBI deduction. Beyond those thresholds the QBI deduction phases out, and is fully phased out for individual filers who earn $207,500, and $415,000 for joint filers.
o The above income limitations are calculated individually (based on each partner/member/shareholder share of all income, deductions, W-2 wage allocations), which could mean lower income owner-employees may be eligible for the QBI deduction even as higher income owner-employees are not.
- This deduction is set to expire on December 31, 2025.
For many smaller pass-through businesses, the new deduction on QBI will be material (or at least modest) tax relief. As a twenty percent (20%) deduction against all QBI, the deduction itself will scale to the size of the business. A pass-through entity earning $100,000 of income will obtain a $20,000 deduction (worth $4,400 in the new 22% tax bracket); whereas a pass through entity earning $10,000,000 of income will obtain a $2,000,000 deduction (worth $740,000 at the new 37% top tax bracket). Given that each owner-employee calculates their own deduction based on their own income, the value of the QBI deduction itself will vary from one equity owner to the other. Consequently, this may introduce a number of new family business planning opportunities by distributing ownership to multiple family members who are all below the threshold.
With the deduction on QBI, smaller self-employed individuals doing business through a pass-through entity may actually have a lower tax rate than their non-owner employees doing similar work. For many workers earning less than the applicable income thresholds noted above, there may be a desire to recharacterize their working relationship from employee to independent contractor, or otherwise form a separate pass-through business entity that contracts back with their former employer to take advantage of the QBI deduction. This sort of restructuring is sure to amplify an already active battleground that the IRS has with businesses that improperly characterize employees as contractors for FICA purposes. Nevertheless, there may be instances where a worker earns less than the relevant income thresholds and would be eligible to take advantage of the deduction, and where such recharacterization to contractor status is legitimate and justified under the relevant facts and circumstances.
On the other hand, for larger service businesses with substantial income, and whose owners are beyond the relevant income thresholds and thus phased out, they will obtain no benefit from the QBI deduction. To that end, many larger service businesses may end up considering a conversion to a C corporation (with a top tax rate of 21%) under the new rules.
If you have questions regarding any of the above, or other tax-related issues, feel free to give us a call.