by Ryan R. Morton (Summer 2018)
Late last year, the Tax Cuts and Jobs Act of 2017 (the “TCJA”) dominated headlines. Most of the articles focused on how the tax reform legislation would affect individuals and large corporations. Other types of businesses, which include LLCs, partnerships, and S-corps, received less attention. As the year starts to wind down, those entities need to consider how the TCJA will affect their bottom lines.
The biggest business-related change included in the TCJA is giving pass-through entities (S-corporations, partnerships, sole proprietorships, and LLCs) a new deduction to lower their tax burden. Previously, the income from these businesses was taxed at the individual owner’s personal tax rates. Now, however, the owners of these entities might be able to receive a deduction equal to 20% of their “qualified business income” (“QBI”). This new term refers to ordinary income attributable to the business, but it does not include capital gains, capital losses, dividends, interest, annuity payments, or payments made to the owners.
This QBI deduction does not lower the individual’s adjusted gross income (“AGI”), but instead reduces the owner’s taxable income, like an itemized deduction. If an individual’s taxable income is below $157,500, or $315,000 for a married joint filer, that owner will likely qualify for the full 20% QBI deduction. If an owner’s taxable income exceeds that number, though, the full deduction would not be available in certain service industries, including most professional services. The deduction would then phase out as the owner’s income increases, disappearing at $207,000 (or $415,000 for joint filers).
Additionally, the QBI deduction will only be 20% if that is less than either 1) 50% of the W-2 wages paid to employees or 2) the sum of 25% of W-2 wages and 2.5% of the cost of qualified property (whichever is greater). Qualified property refers to depreciable property owned and used by the business during the tax year. Lastly, the QBI deduction cannot exceed 20% of the owner’s taxable income after long-term capital gains and qualified dividends have been deducted.
Essentially, this tax deduction will especially benefit small businesses that have fewer employees and more capital investments (such as real estate, manufacturing, and construction).
The “loss limitation” rule prevents partners (and LLC members in a partnership-like LLC) from deducting losses from their taxes, if those losses are greater than the tax basis of the partnership or LLC. The TCJA provides an exception to that rule for charitable donations. If the entity makes a charitable gift, the individual partner or LLC member can use that gift to reduce the entity’s tax basis, thereby increasing the amount of loss the individual can deduct. This also applies to foreign taxes. If the donated property has appreciated though, the owner does not get that extra benefit deducted from the tax basis.
The TCJA also made some statutory changes without direct tax implications. For example, the Act eliminated the “technical termination” rule for partnerships. This rule provided that a partnership automatically ended as soon as 50% or more of a partnership’s capital and profits were sold or exchanged. This created several tax-related headaches, if the partnership’s tax year ended mid-calendar year, while tax attributes of the old partnership were lost, and a new depreciation period started. Now, a partnership automatically terminates only when the partners no longer carry on the business.
There was also some negative impact from the TCJA on certain entities. For example, the TCJA made it more difficult for partnerships (and LLCs that are treated as partnerships) to be sold. The “built-in loss” rule already requires a partnership to reduce its tax basis if an interest in the partnership is transferred with a substantial built-in loss, meaning the adjusted basis of assets exceeds the fair market value by more than $250,000. Under the new law, a substantial built-in loss also exists if immediately after the transfer, the new partner would lose $250,000 under a hypothetical sale.
Converting from S-Corp to C-Corp
C-corporations, which are not pass-through entities, received a benefit from the TCJA, as all C-corps will now be taxed at a flat 21% federal income tax rate. Anticipating that this change could lead S-corps to convert to C-corps for the tax benefit, the TCJA also modified the tax implications of that process to discourage such conversions.
When an S-corp transitions to a C-corp, distributions are treated as taxable dividends, as long as they are part of the corporation’s earnings and profits (“E&Ps”). However, dividends from accumulated adjustments accounts (“AAAs”) generated during the company’s life are tax-free. Under the old law, during the “post-termination transition period,” the overall distribution of money by the corporation was first used to reduce the basis of the shareholders’ stock, up to the AAA amount, thus maximizing tax-free dividends.
The TCJA changes that post-termination transition rule by treating distributions as paid pro-rata from AAAs and E&Ps. Consequently, more of the distributions will be taxable dividends. The previous rule is still in effect, but only for C-corps that: 1) operated as S-corps before December 22, 2017; 2) revoked their S-corp status within 2 years of that date; and 3) have the same owners on that date and the revocation date. Therefore, if the owners of an S-corporation are considering becoming a C-corporation, they should do so within the next year to take advantage of the old post-termination transition period rule.
The effect of these changes could be substantial for small businesses, forcing them to reevaluate their traditional tax planning strategies. Conventional wisdom may no longer be advisable. The TCJA includes several other changes affecting tax and business law for LLCs, partnerships, sole proprietorships, S-corps, and C-corps. Please contact an Ottosen Britz attorney to help you navigate these new rules before the year ends.