As the Tax Reform and Jobs Act clears Congress and awaits the President’s signature, taxpayers are anxiously trying to determine what this will mean for them. Many are speculating that there will be a flurry of pass-through conversions to C-Corporation taxation to take advantage of the proposed flat 21% tax rate. Will conversions to C-Corporation create the optimal taxing structure under this new tax bill? Let’s explore…
While the 21% tax rate looks appealing, C-Corporations will still be subject to double taxation. Additionally, pass-through entities may be able to take advantage of a 20% tax deduction against their flow-through income.
For tax years beginning after December 31, 2017, a new deduction of 20% would be allowed for taxpayers who have domestic “qualified business income” from a pass-through or sole-proprietorship engaged in a “qualified trade or business.”
“Qualified business income” is, generally, all domestic business income other than investment income (e.g., interest, dividends, capital gains).
“Qualified trade or business” means any trade or business income other than a specified trade or business, as defined in IRC §1202(e)(3)(A), with an exception for engineering and architecture services, or the trade or business of performing services as an employee. Specified trade or businesses income under this bill includes any trade or business income involving the performance of services in the fields of:
- Actuarial Science
- Performing Arts
- Financial Services (including Accounting)
- Brokerage Services
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.
Those who qualify for the 20% deduction will generally be limited to 50% of the taxpayer’s pro-rata share of W-2 wages paid by the Partnership or S-Corporation. Those in highly capital intensive industries with relatively low W-2 wages (think real-estate investments), the 20% deduction will generally be limited to the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition (cost basis), of all qualified depreciable property, under §167.
The deduction against qualified business income is set to expire after December 31, 2025.
Now that we’ve set the table, let’s evaluate the after tax profits under C-Corporation taxing structure compared with pass-through taxation, examining scenarios where the individual owner qualifies for the 20% deduction on their flow-through income where they do not.
- $1,000,000 taxable income before owner wages
- $200,000 owner wages
- All after-tax profits will be distributed to the owner
- Standard deduction of $24,000
While this simplified/illustrative example ignores payroll taxes on W-2 wages and self-employment taxes, this example lays the baseline for conversation around conversion. Other items to consider before changing your business taxing structure include:
- Owners’ ability to deduct losses at personal level with pass-through treatment versus having the losses trapped inside the C-Corporation structure.
- Lack of step-up on sale for buyer.
- Accumulating appreciable assets C-Corporation, double taxation structure.
At this point, it doesn’t appear clear that a flurry of C-Corporation conversions is warranted and it is worth remembering that not every business is the same. The decision regarding conversion from pass-through to C-Corporation taxation should be carefully considered with your tax advisor.
Before taking any action for 2017 or 2018, check with your Aronson tax professional. If you have any questions about how tax reform may impact you, please contact your Aronson tax advisor at 301.231.6200.