In 2017, approximately 81% of all businesses in the US were organized as pass-through entities, with S-corporations (“S-corps”) and Limited Liability Companies (“LLCs”) comprising approximately 68% of all businesses. ((National Small Business Association, 2017 Year-end Economic Report 3 (2018), https://nsba.biz/wp-content/uploads/2018/02/Year-End-Economic-Report-2017.pdf.)) The passage of the Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017, presented many changes for pass-through entities to consider when determining the most efficient business structure for federal income tax purposes. This article discusses two changes in the TCJA affecting S-corps and LLCs—individual rate changes and §199A deductions—as well as areas where taxpayers will need to look to the IRS for guidance relating to these changes.
Overview of S-Corps, LLCs, and C-Corps ((Louis Vlahos, The New Deduction for “Qualified Business Income”: Tax Simplification Gone Awry?, Tax Law for the Closely Held Business (Dec. 27, 2017), https://www.taxlawforchb.com/2017/12/the-new-deduction-for-qualified-business-income-tax-simplification-gone-awry/.))
The Internal Revenue Service (“IRS”) views S-corps and LLCs as pass-through entities and C-corporations (“C-corps”) as separate taxable entities for federal income tax purposes. The IRS considers a corporation formed under state law as a pass-through entity if its shareholders elect to treat it as an S-corp. Similarly, the IRS also treats a business formed under state law and conducted through either a single or multiple member LLC as a pass-through entity for federal income tax purposes. Because S-corps and LLCs are considered pass-through entities, earnings from an S-corp or LLC are generally only taxed at the shareholder level at the individual rate and thus only taxed once. In contrast, because the IRS views a corporation that elects to be treated as a C-corp as a separate taxable entity, the IRS taxes earnings from a C-corp twice: once at the corporate level at the corporate rate, and again at the individual level at the individual rate when shareholders receive distributions.
The TCJA provides several tax breaks to non-corporate pass-through businesses in part to preserve the tax rate benefit that pass-through entities received prior to the passage of the TCJA. At the same time, the TCJA also attempts to minimize the impact of the double-tax on C-corps by lowering the tax rate on C-corps. S-corps and LLCs must consider the TCJA’s impact on pass-through entities and C-corps when making entity classification decisions in future years.
Tax Rate Changes – Individual and Corporate
The TCJA provides a tax-break to S-corps and LLCs by reducing individual tax rates. Individual rates decreased by 1% to 4% in six out of seven tax brackets, ((2017 vs. 2018 Federal Income Tax Brackets, KDP Certified Public Accountants, LLP (Feb. 6, 2018), https://www.kdpllp.com/2017-vs-2018-federal-income-tax-brackets/.)) and the House recently approved a bill that would make these tax cuts permanent. ((Jessica Jeane, House Approves Tax Reform 2.0 Bill to Extend Individual, Small Business Tax Cuts, CCH Tax Group (Oct. 1, 2018), http://news.cchgroup.com/2018/10/01/house-approves-tax-reform-2-0-bill-to-extend-individual-small-business-tax-cuts/.)) Because S-corps ((S Corporations, Internal Revenue Service (May 3, 2018), https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations.)) and LLCs ((Limited Liability Company (LLC), Internal Revenue Service (Sep. 5, 2018), https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc.)) are classified as pass-through entities for federal income tax purposes, the reduction in individual rates reduces the tax paid by shareholders/owners of S-corps and LLCs. For example, the maximum tax rate applicable to an individual on his or her pro-rata share of an S-Corp’s or LLC’s ordinary operating income decreased from 39% to 37%. ((Louis Vlahos, Choice of Entity, Shareholder Disputes, and the Discovery of Tax Returns, Tax Law for the Closely Held Business (July 2, 2018), https://www.taxlawforchb.com/tag/21-percent-flat-rate/#_ednref3.))
The TCJA also reduced the corporate tax rate, providing another potential incentive for S-corps and LLCs to reorganize as C-corps. The tax rate on C-corps was reduced to a flat rate of 21%, which is lower than the highest individual rate of 37%. That said, the effective tax rate on a C-corp and its shareholders could be as high as 39.8% when combining the 1) 21% tax on C-corps 2) 20% tax paid by C-corp shareholders on C-corp distributions received ((I.R.C. § 1(h)(1)(D) (2017).)) and 3) 3.8% tax on shareholders with net investment income and modified adjusted gross income over certain statutory thresholds (generally $250,000 for married taxpayers filing jointly). ((Questions and Answers on the Net Investment Income Tax, Internal Revenue Service (June 18, 2018) https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax.)). The combined 39.8% C-corp rate might deter S-corps and LLCs from reorganizing to C-corps because that rate is higher than the highest individual rate of 37%. Moreover, with the exception of the built-in gains tax for S-corps and depreciation recapture under §1245, most capital gain from the sale of an S-corps’ or LLC’s assets will only be taxed at the long-term capital gains rate of 20%. In contrast, a C-corp selling the same capital asset would potentially generate a combined tax rate of 39.8%, which is almost double the 20% rate paid by shareholders of S-corps and LLCs. As a result, S-corps and LLCs investing in real estate and generating significant capital gains are unlikely to find it advantageous to reorganize as a C-corp.
Finally, there are many considerations unconnected to the tax rate changes in the TCJA that an S-corp or LLC must consider before reorganizing as a C-corp. For an S-corp revoking its election under §1362(d)(1)(B) and reorganizing as a C-corp, these considerations include distributions from its accumulated adjustments account to the extent of the shareholder’s basis in the corporation’s stock, ((I.R.C. § 1371(e) (2017).)) timing regarding tax accounting differences, ((T. Christopher D’Avico et al., Converting from S corp. to C corp.: Select issues for consideration, The Tax Adviser (Apr. 1, 2018), https://www.thetaxadviser.com/issues/2018/apr/converting-s-corp-c-corp.html.)) and qualified subchapter S subsidiaries recognizing gain to extent liabilities in the subsidiaries exceed the tax basis of the subsidiaries’ assets. ((I.R.C. § 357(c) (2017).)) For an LLC reorganizing as a C-corp, these considerations include potentially recognizing gain on §351 distributions to a corporation in which liabilities exceed assets or the failing to meet the requirements of §351.
§199A Deductions – Qualified Business Income
The TCJA provides another tax-break to S-corps and LLCs by creating a new deduction under §199A for qualified business income (“QBI”) generated in each qualified trade or business (“QTB”) in which the taxpayer is an owner. In general, §199A provides that a taxpayer other than a corporation may deduct the lesser of:
(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business or (B) the greater of (i) 50 percent of W-2 wages with respect to the qualified trade or business, or (ii) 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 immediately after acquisition of all qualified property. ((I.R.C. § 199A(b)(2) (2017).))
The deduction also cannot exceed taxable income for the year over net capital gain plus aggregate qualified cooperative dividends. ((I.R.C. § 199A(a)(1)(B) (2017).)) This limitation ensures that the 20% deduction is not applied to income already taxed at preferential rates. In addition, because performing services as an employee does not qualify as QBI, ((I.R.C. § 199A(c)(4)(A) (2017).)) §199A’s 20% deduction only applies if the taxpayer is a shareholder in a pass-through entity such as an LLC or S-corp. However, owners of S-corps and LLCs can still receive wages even though these wages would not qualify as QBI. When combined with the top individual rate of 37%, the §199A deduction lowers the effective rate on QBI earned by LLCs and S-corps to 29.6% (i.e. 80% of 37%).
For example, taxpayer A earns $100 of QBI through its distributive share of Newco LLC and receives a 20% §199A deduction. If A is taxed at the highest individual of 37% on her $80 of taxable income, A pays a tax of $29.6, which is an effective rate of 29.6% on the $100 of QBI A earned through Newco LLC. This is significantly lower than the 39.8% effective rate on C-corp income and thus §199A provides an incentive for S-corps and LLCs to retain their pass-through status.
That said, an S-corp or LLC must meet several provisions of §199A in order to qualify for the 20% deduction. First, any taxpayer other than a corporation may apply the §199A deduction, including individual owners of S-corps and LLCs or an S-corp or LLC owning an interest in a pass-through entity.
Second, the §199A deduction only applies to taxpayers engaged in a QTB, which is defined as “any trade or business other than (A) a specified service trade or business, or (B) the trade or business of performing services as an employee.” ((I.R.C. § 199A(d)(1) (2017).)) The first provision prevents owners of certain specified service trades or businesses (“SSTBs”) from receiving a §199A deduction for income associated with these businesses. §199A(d)(2) defines SSTBs by referring to §1202(e)(3)(A), which includes any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, financial services, and brokerage services. ((I.R.C. § 1202(e)(3)(A) (2017).)) However, for purposes of the §199A deduction, §199A(d)(2) removes engineering and architecture from the specified service trade or business list referred to in §1202, meaning, ceteris paribus, QBI earned in an engineering or architecture S-corp or LLC may be eligible for a §199A deduction. In addition, §199A(d)(2)(B) restricts any trade or business “which involves the performance of services that consist of investment management, trading, or dealing in securities…partnership interests, or commodities” from qualifying as QTB. ((I.R.C. § 199A(d)(2)(B) (2017).)) However, a taxpayer operating a SSTB can claim the §199A deduction on income less than $315,000 (if married filing jointly; $157,000 for all other taxpayers). ((I.R.C. § 199A(e)(2) (2017).)) Also, for income below $315,000 (if married filing jointly; $157,000 for all other taxpayers), the W-2 wages limitation does not apply and a taxpayer working in an SSTB can claim the §199A deduction for any QBI.
The IRS issued proposed regulations on August 16, 2018, which provide some clarity regarding what qualifies as a QTB. ((Prop. Treas. Reg § 1.199A-5, 83 Fed. Reg. 40884, 40896 (Aug. 16, 2018), https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction.)) The proposed regulations provide an exception to some businesses that carry-on SSTBs. A trade or business will not be considered an SSTB if it has either 1) gross receipts of $25 million or less and less than 10% of the gross receipts are attributable to a SSTB or 2) gross receipts over $25 million and less than 5% of the gross receipts are attributable to a SSTB. The IRS will likely adopt the regulations by the end of 2018 but it unclear if they will change significantly before adoption.
In addition, the §199A deduction only applies to a taxpayer’s QBI. §199A(c)(3)(A) defines QBI as “income, gain deduction, and loss to the extent such items are…effectively connected with the conduct of a trade or business within the United States.” ((I.R.C. §199A(c)(3)(A) (2017).)) Certain items not included in QBI include short-term and long-term capital gain/loss, dividend income, interest income not allocable to a QTB, net gain from foreign currency transactions and reasonable compensation paid to the taxpayer by any QTB. ((I.R.C. §199A(c)(3)(B) (2017).))
Taxpayers have added incentive to use caution when electing a §199A deduction because the TCJA lowers the threshold at which a substantial-understatement penalty is applied for taxpayers claiming a §199A deduction. For a taxpayer taking a §199A deduction, the threshold for a substantial understatement of tax decreased from the lesser of $5,000 or 10% of the tax required to be shown to the lesser of $5,000 or 5% of the tax required to be shown. ((I.R.C. § 6662(d)(1)(C) (2017).)) Moreover, under the changed §6662, the substantial understatement does not have to be attributable to the §199A deduction, and thus any taxpayer who elects the deduction is subject to the lower threshold on all of their taxes, not just taxes related to §199A.
Several areas still need clarification under §199A. For example, it is unclear if rental income is a qualified trade or business for purposes of §199A. Although §199A defines what is not QTB, it does not define what constitutes a QTB. If a trade or business for purposes of §199A must align with the standard of a trade or business defined in §162, rental income may not qualify as income from a trade or business. The IRS has stated that “the Treasury Department and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law.” ((Internal Revenue Bulletin: 2013-51, Internal Revenue Service (Dec. 16, 2013) https://www.irs.gov/irb/2013-51_IRB.)) Whether rental income qualifies as a trade or business generally boils down to a question of fact in which courts look to a variety of elements “including the type of property…the number of properties rented; the day-to-day involvement of the owner or its agent; and type of rental.” ((Tony Nitti, Understanding the new Sec. 199A business income deduction, The Tax Adviser (Apr. 1, 2018), https://www.thetaxadviser.com/issues/2018/apr/understanding-sec-199A-business-income-deduction.html.)) As a result, there is still uncertainty that rental income will qualify for a §199A deduction.
However, some tax advisors point to the §199A’s provisions regarding real estate investment trusts (“REITs”) as a sign that the §199A deduction might apply to passive rental income. REITs generally produce the same type of passive income that fails to qualify as a §162 trade or business and yet taxpayers can take a 20% deduction under §199A against qualified dividends received from a REIT. As a result, some tax practitioners believe that all rental income should be treated as coming from a qualified trade or business because passive rental income is similar to dividends received from a REIT. ((Id.))
Finally, there are several areas where taxpayers need clarification from the IRS regarding the application of §199A. First, although the IRS has expressed disapproval of the so-called “crack-and-pack” strategy whereby an SSTB spins off a portion its business so a separate entity can claim a §199A deduction, further clarification is needed as to whether such a spin-off will prevent a taxpayer from taking the deduction. Second, the IRS should further clarify what is included in the definition of a SSTB and what is meant by “reasonable compensation.” Third, it is unclear if shareholder compensation is included in the W-2 wage limitation or in QBI, and it also unclear how the W-2 wage limitation should be allocated among different businesses owned by a partnership or LLC. Fourth, it is unclear if §1231 gain is included in QBI. The IRS issued proposed regulations on August 16, 2018, ((IRS issues proposed regulations on new 20 percent deduction for passthrough businesses, Internal Revenue Service (Aug. 8, 2018), https://www.irs.gov/newsroom/irs-issues-proposed-regulations-on-new-20-percent-deduction-for-passthrough-businesses.)) and has scheduled public hearing for those regulations on October 16, 2018, and will likely issue final regulations by the end of the year. ((Tax reform readiness: Understanding the Section 199A proposed regulations, PWC Tax Insights (Sept. 10, 2018), https://www.pwc.com/us/en/tax-services/publications/insights/assets/pwc-tax-reform-readiness-section-199a-proposed-regulations.pdf.))
The TCJA provides many S-corps and LLCs with intriguing planning opportunities. The §199A deduction is one of those intriguing opportunities, but it is subject to many qualifications and taxpayers must exercise caution when taking this deduction given the uncertainty and lower threshold for triggering penalties. Although lower corporate tax rates may tempt some S-corps and LLCs to reorganize as C-corps, businesses ought to take many other things into consideration—including the potential to take a §199A deduction—when contemplating a reorganization.
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