Spotlight on Pass-Through Entities Under the Tax Cuts and Jobs Act
Brian J. Kern, CPA
Wednesday, January 24, 2018
Will pass-through entities still be popular under the Tax Cuts and Jobs Act (TCJA)? The tax rules for pass-through entities, including S corporations, limited liability companies (LLCs), partnerships and sole proprietorships, have generally become more beneficial — but also more confusing under the new law.
So which type of entity is best for your business? The answers depend on several factors, which are explained in this article
New Deduction for Pass-Through Business Income
Under prior law, net taxable income from so-called pass-through business entities (meaning sole proprietorships, partnerships, LLCs that are treated as sole proprietorships or as partnerships for tax purposes, and S corporations) was simply passed through to owners and taxed at the owner level at standard rates.
For tax years beginning after 2017, the TCJA establishes a new deduction based on a noncorporate owner's qualified business income (QBI). This break is available to eligible individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels. The QBI deduction isn't allowed in calculating the noncorporate owner's adjusted gross income (AGI), but it reduces taxable income. In effect, it is treated the same as an allowable itemized deduction.
This break is subject to the following restrictions:
W-2 Wage Limitation. The QBI deduction generally can't exceed the greater of the noncorporate owner's share of: 1) 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or 2) the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property. Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of qualified business income. In addition, the QBI deduction can't exceed 20% of the taxpayer's taxable income exclusive of net long term capital gains and qualified dividends.
Under an exception, the W-2 wage limitation doesn't apply until an individual owner's taxable income exceeds $157,500, or $315,000 for a married joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint filers.
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Service Business Limitation. The QBI deduction is generally not available for income from specified service businesses, such as most professional practices. Under an exception, the service business limitation does apply until an individual owner's taxable income exceeds $157,500, or $315,000 for a married joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint filers.
Important note: The W-2 wage limitation and the service business limitation don't apply as long as taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
New Rule on Distributions after Converting from S to C Corp Status
In general, distributions by a C corporation to its shareholders are treated as taxable dividends to the extent of the corporation's earnings and profits (E&P). However, a special "posttermination transition period" rule provides relief to shareholders of a corporation that changes from S corporation status to C corporation status.
During this period, any distribution of money by the corporation to its shareholders is first applied to reduce the basis of the shareholder's stock to the extent the distribution doesn't exceed the accumulated adjustments account (AAA) balance that was generated during the company's life as an S corporation. Such distributions of AAA amounts are tax-free to recipient shareholders.
The TCJA modifies the posttermination transition period relief rule for C corporations that:
- Operated as S corporations before December 22, 2017,
- Revoke their S corporation status during the two-year period beginning on that date, and
- Have the same owners on December 22, 2017, and the revocation date.
Distributions from such corporations are treated as paid pro-rata from AAA and E&P. This can result in more of a distribution being treated as a taxable dividend and less being treated as a tax-free distribution of AAA. This change is intended to discourage the tax planning strategy of converting S corporations to C corporation status in order to take advantage of the new flat 21% federal income tax rate on C corporation income.
New Rule for ESBT Beneficiaries
As a general rule, trusts cannot be S corporation shareholders. However, an exception allows electing small business trusts (ESBTs) to be S corporation shareholders. Under prior law, an ESBT couldn't have a current beneficiary who was a nonresident alien individual.
Thanks to a change included in the new law, such individuals can now be ESBT beneficiaries. This change is effective for 2018 and beyond.
"Technical Termination Rule" Repealed for Partnerships and LLCs
Under prior law, a partnership (or an LLC that's treated as a partnership for tax purposes) is considered to terminate for tax purposes if, within a 12-month period, there's a sale or exchange of 50% or more of the entity's capital and profits interests. This so-called "technical termination rule" is generally unfavorable.
Why? First, the rule can require the filing of two short-period tax returns for the tax year in which the technical termination occurs. It also restarts depreciation periods for the entity's depreciable assets. In addition, it terminates favorable tax elections that were made by the entity.
The TCJA repeals the technical termination rule for tax years beginning in 2018 and beyond.
Substantial Built-in Loss Rule Expanded
In general, a partnership (or an LLC that's treated as a partnership for tax purposes) must reduce the tax basis of its assets upon the transfer of an ownership interest if the entity has a substantial built-in loss. (A built-in loss happens when the fair market value of the assets is less than their tax basis.)
This rule is unfavorable, because the basis reduction can result in lower depreciation and amortization deductions. Under prior law, a substantial built-in loss exists if the entity's adjusted basis in its assets exceeds their fair market value by more than $250,000.
Under the TCJA, a substantial built-in loss also exists if, immediately after the transfer of an interest, the recipient of the transferred interest would be allocated a net loss in excess of $250,000 upon a hypothetical taxable sale of all of the entity's assets for proceeds equal to fair market value. This unfavorable expansion of the built-in loss rule applies to ownership interest transfers in 2018 and beyond.
Loss Limitation Reductions for Charitable Donations and Foreign Taxes
Under a loss limitation rule, a partner (or an LLC member that's treated as a partner for tax purposes) can't deduct losses in excess of the tax basis in the partnership or LLC interest.
The new law changes the rules for charitable gifts and foreign taxes. For tax years beginning after December 31, 2017, an owner's share of a partnership's (or LLC's) deductible charitable donations and paid or accrued foreign taxes reduces the owner's basis in the interest for purposes of applying the loss limitation rule. This change can reduce the amount of losses that can be currently deducted.
However, for charitable donations of appreciated property (where the fair market value is higher than the tax basis), the owner's basis isn't reduced by the excess amount for purposes of applying the loss limitation rule. In other words, the owner's tax basis in the interest is reduced only by the owner's share of the basis of the donated appreciated property for purposes of applying the loss limitation rule.
Get Professional Help
As you can see, the tax landscape for various business entities has changed considerably under the new tax law. The type of entity that's best for you depends on the industry you're in, your income and many other factors. Consult with your tax advisor and attorney to determine the most tax-wise way to proceed.
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Brian is an experienced tax professional and devotes his professional time to structuring tax strategies in the areas of compliance, consulting, planning and transactional work. He works closely with a broad range of high net worth individuals and privately owned commercial business clients, specializing in the areas of energy, financial firms and institutions, professional services firms and real estate, and serves as the tax practice leader for our Manufacturing niche.