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NEWS

NEWS

20% Pass Through Deduction Available for Select Owners of LLCs,
S Corporations, Partnerships and Sole Proprietorships Under New Tax Act

The Tax Cuts and Jobs Act (TCJA) creates a brand-new tax deduction for owners of pass-through entities, including partners in partnerships, shareholders in S corporations, members of limited liability companies (LLCs) and sole proprietors.  However, this part of the tax code is so complex that even tax experts are challenged by it.

To begin, owners of pass-through entities are effectively taxed on earnings at individual tax rates similar to the way corporate owners are taxed on wages. Under the TCJA, tax rates for individuals are generally lowered over seven brackets, featuring a top tax rate of 37%. In contrast, C corporations will be taxed at a flat rate of 21%, which might be considerably lower than a business owner’s individual rate.

To balance things out, lawmakers have provided a deduction of up to 20% for pass-through entities on “qualified business income” (QBI), subject to certain limits and restrictions. QBI is generally defined as net income from your business without counting amounts in the nature of compensation (W-2 wages and guaranteed payments from LLCs and partnerships), in addition to excluding any investment income from the pass-through entity. Note that QBI is figured separately for each business activity rather than on a per-taxpayer basis.

But there are two main hurdles for claiming the full 20% deduction (referred to as “the deduction” throughout this article). The deduction may be reduced or even eliminated under a test for “specified service businesses” and a “wage and capital” limit.

  1. Specified service businesses: This includes virtually every occupation that provides a personal service other than engineering and architecture. If your taxable income exceeds a threshold of $157,500 for single filers and $315,000 for joint filers, the deduction is reduced pro-rata under the “phase-in rule.” The phase-in is complete when income reaches $207,500 for single filers and $415,000 for joint filers. Above these upper thresholds, you get no deduction.
  2. Wage limit and capital limit: The deduction is limited to the greater of (a) 50% of W-2 wages for your business or (b) the sum of 25% of W-2 wages and 2.5% of the unadjusted basis of all qualified business property (i.e. the cost basis of depreciable property available for use in your business). This limit is phased in pro-rata based on the same income thresholds as the ones stated above for personal service businesses. Once you exceed the upper threshold, the phase-in of the limit is complete.

Taxpayers who have income below the lower income threshold ($157,500 for single filers and $315,000 for joint filers) have no worries at all. They are entitled to the full deduction. However, individuals in certain service professions that are traditionally high-paid may not qualify for any deduction. The deduction for taxpayers in other businesses can vary widely.Business that qualify for the deduction means any trade or business other than any trade or business involving the performance of services in the fields of health, law,accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. However, it does not include engineering or architecture.So if you don’t qualify for the deduction because you are a personal service business the trick would be to tax plan to get your income to be below the income threshold amounts above.

In addition, the deduction can’t exceed your taxable income for the year (reduced by net capital gain). If the net amount of your QBI is a loss, you can carry it forward to the next tax year.

The wage limits rules are designed to curb abuses, such as having business owners who do substantial work artificially reclassifying wages as QBI eligible for the deduction. Nevertheless, taxpayers may be tempted to establish themselves as independent contractors, further increasing the number of conflicts with the IRS on this issue. Independent contractor status has already been a point of contention in recent years.

The wage limit component discussed above presents issues for independent contractors, sole proprietorships and single member LLCs that are above the income thresholds of $157,500 for single filers and $315,000 for joint filersand that have no W-2 wages in that it eliminates the availability of the deduction all together.  One of the solutions to this would be to shift to an S corporation and re-characterize some of your compensation as W-2 wages.  

The 2.5% of the capital limit component discussed above presents a lucrative tax break for some, including wealthy owners of commercial property. This opens the deduction up to commercial property businesses, where there aren't a lot of workers, but there is a lot of valuable property around.  As discussed above, the pass-through caps can be eligible for the 20-percent deduction based on a formula: 50 percent of employee wages paid; or 25 percent of wages plus 2.5 percent of the value of qualified property at purchase, whichever is greater.  The idea is for these entities to use the sum of the '2.5 percent rule' plus 25 percent of wages to get the full 20-percent deduction.

In addition, the deduction is:

  • Done on a separate entity basis and not in the aggregate

  • Allowed for both regular and alternative minimum tax purposes

  • Allowed whether taxpayer is an active or passive owner in the business

  • Eliminated beginning after December 31, 2025

  • Available to both non-itemizers and itemizers.

With the C corporation tax rate lowered to 21% some lawmakers had predicted that the steep corporate tax cut would cause pass-through entities to convert to C corporations to take advantage of the lower rate.

That’s unlikely to come to pass, as S corporations, limited liability companies, and partnerships would likely continue to be advantageous structures for most businesses, despite the proposal to drop the corporate rate to 21 percent from 35 percent.  C corporations would face a lower rate under the tax plan, but C corporations face a second level of tax on the dividends distributed to investors. Pass-through status has become the entity of choice in recent decades because of the single layer of tax and a more malleable structure for distributing cash and assets.

These are just the basics on this complex new deduction. It is expected that the IRS will soon issue guidance for pass-through entities, especially regarding rules for re-characterization of wages. As the year unfolds, we will highlight strategies for maximizing the deduction under IRS-prescribed guidelines.

IRS to Target Specific S Corporation Areas as Part of New Compliance Campaign

The Internal Revenue Service’s Large Business and International Division has approved five new compliance campaigns in several areas including specific areas related to S corporations. The LB&I Division has been moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues present enough of a risk to require a response in the form of one or multiple treatment streams to achieve tax compliance objectives. The five new campaigns were identified through data analysis and suggestions from IRS employees. The goal is to improve return selection, identify issues representing a risk of non-compliance, and make the best use of the division’s limited resources.

As part of the S corporation campaign, the IRS noted that S corporations and their shareholders are supposed to properly report the tax consequences of distributions. The service has targeted three issues as part of this campaign:

  • When an S corporation fails to report gain upon the distribution of appreciated property to a shareholder.
  • When an S corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend; and,
  • When a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation.

For this campaign, the IRS plans to conduct issue-based examinations, suggest changes to tax forms, and conduct stakeholder outreach.

As part of the campaign, any examinations that result from this campaign will probably touch upon other S corporation related issues including the methods S corporations use to determine reasonable compensation and its impact on potential under-reported FICA taxes.

Taxation of Cryptocurrency Mining Activities

There are new rules which the US Congress passed in December 2017 that change the way the IRS treats cryptocurrency. Before the US Congress put forth a clearer ruling in 2017, the classification category of cryptocurrency assets was up for interpretation according to many tax experts. That’s because many cryptocurrency miners and traders treated cryptocurrency similar to real-estate for tax purposes by citing the like-kind exchange rules of IRS Code Section 1031.

Following this ruling a miner could theoretically trade a mined cryptocurrency for another cryptocurrency without having to pay taxes. With 1031 exchanges limited to real estate transactions under the recent tax act this treatment is now out the window. Now anyone with cryptocurrency mining operations in 2018 will have to pay taxes beginning in 2019.

There are a couple of things to consider when paying taxes for cryptocurrency mining. You have two different income streams to consider. The first taxable event occurs whenever a miner mines a new coin. The IRS considers this to be income even if the miner decides to only hold the coins as “inventory”. When you mine the coins, you have income on the day the coin is "created" in your account at that day's exchange value. If you are reporting activity as an individual taxpayer, you can report the income as a hobby or as self-employment. If you report as a hobby, you include the value of the coins as "other income" on line 21 of form 1040. Your ability to deduct any expenses is limited -- expenses are itemized deductions subject to the 2% rule.

If you report as self-employment income (you are doing work with the intent of earning a profit) then you report the income on schedule C. You can fully deduct your expenses. The net profit is subject to income tax and self-employment tax. Similar treatment occurs if you operate as a multi-member LLC except that the transactions are reported on the LLC’s tax return with the individual members having their shares of the net profits or losses reported on individual K-1s.

Your second income stream comes when you actually sell the coins to someone else for dollars or other currency. Then you have a capital gain or a capital loss.

Finally, if you immediately sell the coins for cash, then you only have income from the creation and you don't also have a capital gain or loss.

Now, as far as expenses are concerned, if you are doing this as a business, you can take an expense deduction for computer equipment you buy (as depreciation) and your other expenses (for example electricity and other business expenses). But if you are doing this as a home-based business you need to be able to prove those expenses, such as with a separate electric meter or at least having your computer equipment plugged into a portable electric meter so you can tell how much of your electric bill was used in your business. Unless your expenses are very high, they won't offset the extra self-employment tax, so you will probably pay less tax if you report the income as hobby income and forget about the expenses.

Supreme Court Rules States Have Authority To Require Online Retailers To Collect Sales Taxes

The U.S. Supreme Court, in a 5-4 decision, has held that states can assert nexus for sales and use tax purposes without requiring a seller’s physical presence in the state, thereby granting states greater power to require out-of-state retailers to collect sales tax on sales to in-state residents. The decision in South Dakota v. Wayfair, Inc., et al overturns prior Supreme Court precedent in the 1992 decision Quill Corp. v. North Dakota which had required retailers to have a physical presence in a state beyond merely shipping goods into a state after an order from an in-state resident before a state could require the seller to collect sales taxes from in-state customers. That was before the surge of online sales, and states have been trying since then to find constitutional ways to collect tax revenue from remote sellers into their state.

The Court noted: “When the day-to-day functions of marketing and distribution in the modern economy are considered, it is all the more evident that the physical presence rule is artificial in its entirety”. The Court also rejected arguments that the physical presence test aids interstate commerce by preventing states from imposing burdensome taxes or tax collection obligations on small or startup businesses. The Court concluded that South Dakota’s tax collection plan was designed to avoid burdening small businesses and that there would be other means of protecting these businesses than upholding Quill.

In his dissenting opinion, Chief Justice John Roberts argued that, although he agreed that the enormous growth in internet commerce in the interim years has changed the economy greatly, Congress was the correct branch of government to establish tax rules for this new economy. He also took issue with the majority’s conclusion that the burden on small businesses would be minimal.

Prior to the decision, many states had already begun planning for the possible overturn of Quill.

Congress may now decide to move ahead with legislation on this issue to provide a national standard for online sales and use tax collection, such as the Remote Transactions Parity Act or Marketplace Fairness Act, or a proposal by Rep. Bob Goodlatte, R-Va., that would make the sales tax a business obligation rather than a consumer obligation. Under that proposal, sales tax would be collected based on the tax rate where the company is located but would be remitted to the jurisdiction where the customer is located.

 

C Corp vs S Corp or LLC:
How The Tax Cuts and Jobs Act Impacts This Decision

The Qualified Business Income Deduction section of the Tax Cuts and Jobs Act included a new deduction meant for S corps, LLCs, partnerships and sole proprietorships (commonly referred to as pass-through entities). The deduction is calculated at 20% of the trade/business income of these entities. There are limitations based on owner’s taxable income, W-2 salaries of the business, assets in the business and whether or not the business is a service or non-service entity.

Accordingly, not all pass-through entities will qualify for the 20% deduction.

The Tax Cuts and Jobs Act has also dropped the C corporation tax rate to 21% and a lot of questions have arisen from closely held business owners about converting their limited liability company (LLC) or S corporation (S corp) to a C corporation (C corp) including questions from the owners of entities that don't qualify for the 20% deduction. Does it make sense to switch to or start a C corp? The answer is not that simple. Much depends on your business and the business model you operate under.

While the federal tax rate for C corps has dropped favorably to a flat 21%, there are still limitations to a C corp’s tax structure. C corps are subject to double tax. When a C corp issues dividends on their profits, the shareholders receiving the dividends are then taxed on their personal tax return, while the C corp receives no deductions for these payments. Whereas, if you are structured as an LLC or an S corp, you are taxed on the net taxable income that flows through to the owner’s individual tax return and you can distribute the funds out of your company, without double tax. If the goal of the business is to reinvest the earnings back into the company, C corps are a favorable option to take advantage of the lower tax rates.

As a practical matter, for current operations, closely held C corporations do not normally pay dividends. Owners in these entities are often active in the business and draw a salary. The corporation gets a deduction for the salaries, but owners receiving the salary pay federal tax on that salary at a rate as high as 37%.

Upon exiting a closely held business, the sale of the assets of the business are, normally, the only viable option. Very few buyers will want to buy the ownership interest in a closely held business. If you decide to sell your business as a C corp, income generated from the sale of assets is taxed at the corporate level first and then taxed again when the net cash is distributed out to the shareholders.

Also, consider the timing issues when switching to and from a C corporation. Let’s say your business is currently structured as an S corp. You and your shareholders deem your business is better suited as a C corp and you want to convert your organization. It is fairly easy to switch to a C corp. But there is a “buyer beware” with that enterprise. You must wait five years after the switch to a C corp to switch back to an S corp. Once you switch back to an S corp, you could be subject to double taxation on built-in gains (unrealized appreciation on assets held while the entity is a C corporation) for an additional five years after the switch. At a minimum, you will need to live with the possibility of some degree of double taxation for up to ten years.

So what is the bottom line on all of this?

If you have a business that you plan on keeping fairly small, with fewer than 100 shareholders and located in the U. S, you probably want to be an S corp or an LLC. But if your goal is to reinvest profits back into your business to finance future organic growth then the C corporation is probably a good fit. If you have big plans for growing your company to position it for future sale or to go public, you might want the flexibility to take on investors, raise capital, issue different kinds of stock, and invite foreign investors into your business as a C corp.

As always, it is best to consult your advisors before commencing any changes in business structure.