Tax Cuts & Jobs Act: Planning Strategies for Businesses
Apr 02, 2018
The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. The centerpiece of the legislation is a permanent reduction of the C Corporation income tax rate to 21%, along with other major provisions that affect businesses and business income. Below are several planning ideas to consider under the new law. Before proceeding with any of these techniques, be sure to consult with your tax advisor regarding how a strategy may apply to your particular business situation.
Qualified Business Income (QBI) Deduction
Individuals who receive business income from pass‐through entities (sole proprietors, partnerships, and S Corporations) generally report that business income on their individual income tax returns, paying tax at individual rates. For tax years 2018 through 2025, a new deduction is available equal to 20% of qualified business income.
For those with taxable incomes exceeding certain thresholds, the deduction may be limited or phased out altogether, depending on two broad factors:
- The deduction is generally limited to the greater of 50% of the W‐2 wages reported by the business or 25% of the W‐2 wages plus 2.5% of the value of qualifying depreciable property held and used by the business to produce income.
- The deduction is not allowed for certain businesses that involve the performance of services in fields including health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial services.
For those with taxable incomes not exceeding $157,500 ($315,000 if married filing jointly), neither of the two factors above will apply so that the full deduction amount can be claimed. Those with taxable incomes between $157,500 and $207,500 ($315,000 and $415,000 if married filing jointly) may be able to claim a partial deduction. Consider the following strategies to maximize your QBI deduction.
Reduce Taxable Income below the Threshold Amounts
- File Married Filing Separately: Depending on the make‐up of the income for a married couple, it may be more advantageous to file separately rather than jointly. For example, if one spouse has a specified service business with QBI of $150,000 and the otherspouse has taxable income of $200,000, their combined income is $350,000, which exceeds the $315,000 threshold. If this couple files separately, the spouse with $150,000 of QBI falls below the threshold of $157,500 (assuming no other taxable income) and can take the full deduction.
- Bifurcate the Business with a C Corporation: For example, a physician with a medical practice earning $415,000 a year could form a C corporation to provide management services for the practice or weight loss services, medical spa services, or some other services that do not constitute "health" services. Moving these activities to a separate entity would reduce the income of the practice. The C Corporation could then pay the physician W‐2 wages, with remaining income at the corporate level taxed at 21%. The physiciancould also receive deductible medical insurance, disability insurance, and certain other tax advantaged benefits from the C Corporation, reducing either her compensation or the corporation's taxable income.
- Use Qualified or Non‐Qualified Retirement Plans: Consider cash balance plans, 401(k)s, non‐qualified deferred compensation plans or other retirement savings plans that could drive taxable income below the thresholds. As part of this discussion, evaluate the impact of Roth vs. traditional savings.
- Make Use of Increased Internal Revenue Code (IRC) Section 179 Expensing & Bonus Depreciation: Small businesses may elect under IRC Section 179 to expense the cost of qualified property, rather than recover such costs through depreciation deductions. TCJA increases the maximum amount that can be expensed, the threshold at which the maximum deduction begins to phase out, and the range of property eligible for expensing. The Act extends and expands first‐year additional ("bonus") depreciation rules.
Convert to Qualified Income
- W‐2 Employees Move to Independent Contractor Status: Employees, who are not eligible for the QBI deduction because wages are not considered QBI, have incentive to become independent contractors who can use the QBI deduction if the requirements are met. Employers may not be willing to allow employees, with no change to their job or responsibilities, to become independent contractors, due to fear of an Internal Revenue Service (IRS) audit and tax liability to the employer for failure to withhold and pay income and payroll taxes on such workers. One potential way for an employer to allow this is to have the employee form an S Corporation, and the employee's S corporation would become the independent contractor. The use of a single owner LLC would not be effective for this purpose because it is disregarded for tax purposes and could be reclassified as an employee.
- Break out QBI Sources from Specified Service or Investment Trade or Business Activities: Activities that are not considered specified services could be shifted to a management company. For example, partners in a law firm could form a new entity to provide services to the law firm such as IT support, marketing, and property management (none of which are specified services) that would establish market‐rate contracts with the law firm. The division of profits between the two entities could result in favorable tax
consequences for the partners.
Increase W‐2 Wages or Property Associated with the Business
- Combine Activities within the Same Trade or Business: By combining activities, the qualifying depreciable property or W‐2 wage based could be increased to minimize the impact of those limitations on the QBI deduction.
- Convert Independent Contracts to Employees: Businesses where the owners’ taxable income is near or over the threshold that use independent contractors may consider switching to use employees and paying W‐2 wages. However, this may adversely impact retirement plan costs, health care plan costs, and other aspects of the business.
Choice of Entity Structure
With the change in corporate rates and the addition of the QBI deduction, evaluate the optimal entity structure for your business. The best solution is to run the numbers for your particular situation, taking into account use of business‐generated cash, succession plans for the business, the potential of future legislation, and a variety of other factors. The interplay of these factors could lead to vastly different conclusions on a case‐by‐case basis. For now, some taxpayers may benefit from remaining a pass‐through entity rather than changing to a C Corporation or vice versa. Before making that decision, companies and their owners will need to thoughtfully evaluate the options and their goals. Keep in mind that if you change your entity structure, there may be a waiting period before you can switch back.
Other things being equal, value should rise for privately owned C corporations as a result of lower corporate tax rates. How much values will rise will depend on actual expected taxes, as well as other factors that will impact expected future cash flows and additional items such as debt structure.
Keep in mind that transactions which closed prior to the end of 2017 reflect multiples of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or similar metrics under the old tax law. EBITDA multiples should rise under the new law, and dated transactions are not as relevant to current value.
Opportunities for Small Businesses
If your business has gross receipts under $25 million, there are many benefits available under the new law. Discuss items, such as the following, with your tax advisor.
- Exemption from new interest deduction limitation rules
- Changes to Uniform Capitalization (UNICAP) rules
- Long‐term contract accounting benefits
- Cash basis accounting options, even if the business has inventory
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