Even if you have been in a “media blackout” for the past six months, you probably still heard that Congress enacted major tax changes to the Internal Revenue Code in the form of the Tax Cuts and Jobs Act (the “Tax Act”). Effective January 1, 2018, the Tax Act created many new planning considerations for accountants and attorneys to consider, especially regarding pass-through entities such as S-Corporations, partnerships, and most limited liability companies. Additionally, significant modifications to the tax auditing procedures for pass-through entities also went into effect on January 1, 2018, because of the Bipartisan Budget Act of 2015 (the “Budget Act”). We have been monitoring these changes closely in order to advise clients on the impact to their businesses.
The Tax Act
The objective of the Tax Act was to provide dramatically lower tax rates for business owners. For instance, the corporate tax rate was cut to a flat rate of 21% from a previous maximum rate of 35%. Since pass-through entities do not pay federal income tax, but rather pass through income to their owners, Congress also passed along a deduction to their owners in the form of the new Section 199A.
Section 199A generally functions as a deduction equal to up to 20% of the pass-through income an owner is allocated from a pass-through business. However, the language of the statute is full of complex limitations, creating a metaphorical minefield for business owners. Owners with greater than $207,500 of taxable income (or married taxpayers with greater than $415,000) may only take the deduction to the extent of (i) 50% of the proportionate W-2 wages of the business allocated to their ownership interest; or (ii) 25% of the proportionate W-2 Wages plus 2.5% of the value of the proportionate cost basis of the depreciable property of the business (e.g., commercial real estate).
Similarly, if an owner with taxable income greater than $207,500 (or married taxpayers with greater than $415,000) works in a “specified service trade or business,” which includes professional services such as doctors, lawyers, accountants, and even entertainers (e.g., a clown performing at birthday parties), then the owner cannot deduct any of the pass-through income from that business. Given these limitations, certain owners may consider operating as a C-Corporation instead.
For many years, advisors have cautioned clients of the downside of double taxation applicable to a C-corporation (i.e., once to the corporation, once to shareholders upon receiving dividends). Those operating in a C-corporation often utilize strategies to reduce the double-tax (such as paying year-end bonuses to reduce corporate income).
However, the new 21% tax rate substantially lessens the sting of double taxation. Thus, certain owners that would not qualify for the 199A deduction (e.g., low W-2 wages paid, service businesses) may consider operating as a C-Corporation in order to defer the tax upon dividends until the owners wish to withdraw the proceeds of the business. This is especially helpful where the owners relocate to a state that does not impose a personal income tax at a later date. It should be noted that there are still other substantial drawbacks to operating a C-Corporation taxation that should be carefully considered prior to any business converting its operating structure (e.g., taxation upon appreciated assets).
Given the hoopla surrounding the Tax Act, the Budget Act has flown somewhat under the radar. Essentially, the Budget Act replaced the complex pass-through entity audit rules that had been in place for three decades with new rules designed to streamline audits.
Under the old rules, owners of pass-through entities were audited at an individual level, and the IRS was not required to make consistent determinations regarding the treatment of each individual owner’s share of business income. For example, in the audit of LLC Member A, the IRS may determine that the LLC had $200,000 of income, whereas, in an audit of LLC Member B for the same tax year, the IRS may determine that the LLC had a loss of $200,000.
Under the new rules, pass-through entities are generally audited at the entity level, rather than at the owner level. Congress likely provided this change due to the difficulty in auditing multi-layer partnerships, as the audits generally required tracing complex income allocations to individual partners. Relatedly, under the proposed regulations, pass-through entities with less than 100 partners may elect out of the new audit rules provided that all partners are individuals, C-Corporations, most S-Corporations, and estates of deceased partners.
Additionally, the Budget Act replaced the former tax matters partner with a partnership representative, whose rights and responsibilities are greater than that of the former. For instance, a partnership representative may generally make decisions binding upon the flow-through entity and all of its owners, whereas a tax matters partner served more akin to a point of contact for the IRS. As a result, many businesses with operating agreements providing for a tax matters partner should consider whether their operating agreement should be updated to provide for contingencies in the event of an audit.
Given these seismic shifts, now may be the time to consider whether your business is operating within a tax-efficient structure that has adequately provided for each owner’s rights and responsibilities in the event of an IRS audit. We are available and happy to help with any questions or considerations that you may have.
Mitchell Emmert is an associate in the Business Law & Taxation practice group. The information in this article is not intended to provide legal advice. For a professional consultation, please contact Caleb Williams or Mitchell Emmert at Saalfeld Griggs PC. 503.399.1070. email@example.com © 2018 Saalfeld Griggs PC