Do New Tax Laws Mean It's Time for a New Identity?
When business owners see headlines proclaiming a 14-percent drop in the highest corporate tax rate, it’s only natural for them to assume that they can benefit from such a significant opportunity. The federal corporate tax rate, now at a flat 21 percent, has been significantly reduced from the previous top corporate rate of 35 percent. CPAs getting calls from clients saying “we need to convert my company to a C corporation to take advantage of this” already know that the tax code is never that simple, and the response should be something to the effect of “let’s run the numbers first.”
Running the Numbers
An important consideration when running the numbers is that C corporations are not the only taxpayers that are benefiting from tax reform. Pass-through entities, which include partnerships, LLCs, sole proprietorships and S corporations, now benefit from a new Qualified Business Income (QBI) deduction. This can be up to a 20-percent deduction on QBI. Table 1 shows a simple example of how a business owner’s income would be taxed for a pass-through entity versus a C corporation.
This overly-simplistic example shows that the cash available after tax in the C corporation is lower than a partnership with QBI. From a strictly cash-flow perspective, this is a simple choice. However, when comparing a partnership without QBI to a C corporation, the after-tax cash is effectively the same so other factors need to be considered including state income tax implications, flexibility in exchanging ownership, anticipation of future income or losses, anticipation of distributing accumulated earnings, whether corporate dividends would be subject to net investment income tax, the expiration of the QBI deduction in 2025, and several other factors that have always had to be considered when analyzing entity selection.
What is QBI?
QBI is the net amount of qualified items of income, gain, deduction and loss with respect to a qualified trade or business that is effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments are excluded from QBI. A highly questionable exclusion from QBI is income from a “specified service” trade or business: those involving the performance of services in the fields of health, law, engineering, architecture, 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 one or more of its employees.
When you consider the value of the reputation or skill of a company’s employees, things can get very tricky. Service providers such as hair stylists, personal trainers, handymen, masseuses and mechanics make up a small sample of professions that would proudly say that their employees, as service providers, are the most valuable piece of their business…except when it means they have to pay more in taxes. As a result, in August 2018, the IRS proposed and submitted for approval regulations that limit the meaning of the “reputation or skill” clause to: (1) earnings for endorsing products or services; (2) earnings for licensing the use of an individual’s personal brand; or (3) appearance fees. The proposed regulations also clarify several other questions prompted by the enactment of the QBI deduction.
What are the Differences in Entities?
If it is determined that a pass-through entity is more advantageous than a C corporation, consideration then needs to be given to whether the entity should be taxed as an S corporation or a partnership. Below are a handful of differentiators between S corporations and partnerships:
- Ownership of an S corporation is limited to 100 members and some owners, such as foreign residents, cannot qualify as S corporation shareholders.
- Partnerships can have different classes of ownership; all of the S corporation’s stock must have the same economic rights.
- Partnership income allocation does not necessarily have to correspond with equity ownership as it would with an S corporation.
- Partners can generally increase their basis for partnership liabilities, which may allow them to deduct business flow-through losses on their individual returns. S corporation owners can only increase their basis with loans they make directly to the corporation.
- An individual can receive a “profits interest” in a partnership for services performed with a tax consequence. This would be taxable if an individual receives an ownership share in exchange for the services.
The choice of an entity, one of the more important decisions to be made right after deciding to start a business or consider a structure change, is not an easy selection. The decision depends on the client’s individual circumstances and how to maximize benefits to the owners.
Robert L. Gilbert
Robert L. Gilbert, CPA, is a director of Citrin Cooperman where he specializes in federal, state and local tax planning, profit analysis, systems streamlining and implementation, and cash flow projections. He is a member of the NJCPA and can be reached at email@example.com.
This article appeared in the November/December 2018 issue of New Jersey CPA magazine. Read the full issue.