One of the most significant changes under the new tax rules is the reduction in the maximum federal income tax rate for Subchapter C corporations to 20%, together with the elimination of the corporate alternative minimum tax (“AMT”). In an apparent effort to mitigate the potential disparity for the owners of flow-through business entities, individual owners can deduct 20% of domestic qualified business income (“QBI”) from a partnership, S corporation or sole proprietorship (“qualified business entities”), subject to certain limitations.
Qualified Business Income – Defined
QBI is equal to the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. QBI does not include specified investment-related income, deductions or losses. QBI also does not include an S corporation shareholder’s reasonable compensation, guaranteed payments or payments to a partner who is acting other than in his or her capacity as a partner.
Limitation of Deduction Based on Wages and Capital
However, not all flow-through business entities will be treated equally under the new tax law. The 20% deduction is generally limited to the greater of the individual owner’s share of (i) 50% of the W-2 wages paid with respect to the pass-through business and (ii) 25% of the W-2 wages paid by the business plus 2.5% of the tax basis of the business’s tangible depreciable property. The deduction is also available fordinary dividends received from either a real estate investment trust (“REIT”) or qualified cooperative, and income from a publicly traded partnership.
Disallowance of Deduction for Specified Service Trades or Businesses
The 20% deduction generally does not apply to income received from certain personal service businesses designated as “specified service trades or businesses.” Rather, the provision significantly favors passive owners over active owners who actually participate in the day-to-day operations of the business.
Specified Service Trades or Businesses – Defined
“Specified service trades or businesses” include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services or any business where the principal asset of the business is the reputation or skill of one or more of its employees. The Conference Report specifically removed engineering or architecture firms from the enumerated list of personal service businesses that are not eligible for the 20% deduction.
No Limitations for Taxpayers with Income Below Threshold Limitations
Pass-through owners with taxable income that does not exceed the threshold limitations of $157,500 for individuals and $315,000 for individuals filing a joint return are permitted to claim the full 20% deduction for QBI, without regard to the limitation for W-2 wages. Such individuals are also exempted from the general disallowance of the deduction for anyone in a specified service trade or business, with an additional phase-in of $50,000 for individuals and $100,000 for joint filers.
Planning Implications
The owners of businesses currently organized as partnerships or other types of unincorporated entities will have a compelling incentive to consider reorganizing as C corporations to take advantage of the reduced maximum tax rate for corporations of 20%. Similarly, certain high-net-worth individuals may seek ways to structure their business and investment activities as corporations eligible for the 20% tax rate.
Pass-through owners receiving wages may now have an incentive to recharacterize their wages as business profits to avoid the wage-based limitation, and qualify for the 20% pass through deduction. Conversely, qualified business entities may consider converting non-owner employees to LLC members or partners to enable them to benefit from the 20% deduction.
Finally, personal service businesses that own their own office building or other business real estate used in the business may consider holding the property through a REIT, and charging rent to the business. This would shift some of the service business profits to a passive business. Further, last minute changes in the conference committee created preferential treatment for REITs.
Anti-Abuse Provisions
The 2017 Tax Act places limits on the amount of income that qualifies for the deduction to discourage the individual owners of pass-through businesses from attempting to recharacterize their wages as business profits to get the benefit of the 20% deduction. There are general provisions under the IRS employment tax rules and case law that scrutinize characterization of wage and non-wage payments. See, for example, Moorman and Lickiss.