Imagine a successful paper sales company, Dunder Mifflin, Inc. (a C corporation). In 2017, Dunder Mifflin had taxable income of $3MM, resulting in an effective federal corporate tax rate of 34%. In addition, since corporations are double-taxed, distributions will be subject to another layer of tax in the hands of individual shareholders.
Dunder Mifflin’s local competitor, Prince Paper LLC, is a family business owned equally by Mr. and Mrs. Prince and their adult son, Junior. Prince Paper also employs one receptionist and two warehouse workers. Prince Paper is treated as a pass-through entity for tax purposes, with each of the three LLC members reflecting their proportionate share of the company’s net income on his/her own tax return. For 2017, Mr. and Mrs. Prince (who file jointly as a married couple) pay taxes based on an effective federal rate of approximately 36% on their combined income of $2MM.
Following the passage of the Tax Cuts and Jobs Act of 2017, however, Dunder Mifflin Inc. would be taxed at the new 21% flat corporate rate – a significant tax cut that will allow the company to reinvest funds back into the business, hire better paper salespeople and purchase new office equipment. In order to level the playing field for its competitor, Prince Paper LLC (which does not benefit from the new corporate tax rate), Congress introduced a new deduction for certain income earned by businesses structured as pass-through entities. Whether and how the deduction applies to you and your business is influenced by a number of factors. The discussion below is meant to provide general guidance on the new deduction.
The (Complicated) “Basics”
As recently noted in the Journal of Accountancy,
“For tax years after 2017 and before 2026, individuals will be allowed to deduct 20% of ‘qualified business income’ from a partnership, S corporation, or sole proprietorship1, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income … A limitation on the deduction is phased in based on W-2 wages above a threshold amount of taxable income. The deduction is disallowed for specified service trades or businesses with income above a threshold.”
In practice, this means that beginning in 2018, individuals who receive pass-through income may generally deduct the lesser of (a) and (b) below:
(a) 20% of the taxpayer’s “qualified business income,” or
(b) the greater of
- 50% of W-2 wages, or
- 25% of W-2 wages plus 2.5% of all qualified property.
In order to determine whether a deduction is permissible and whether it will be limited, the following variables must be considered:
1. What type of income is being generated?
2. How much in W-2 wages is the business paying? The deduction could be subject to what some have referred to as the “W-2 limitation” in (b) above depending on how the amount of the taxpayer’s share of “qualified business income” compares to W-2 wages being paid to employees.
3. What is the individual taxpayer’s income? If it’s above a certain threshold, a phase-out may apply to reduce the deduction.
4. What type of business is it? Taxpayers in a service business with income above a certain threshold are precluded from taking the deduction at all.
5. What is the value of the business’s tangible assets or “qualified property”? Depending on the value, the deduction may be further limited.
In order to determine whether the owners of Prince Paper LLC are eligible to claim the new deduction, we need to look at each of these questions and subject the business – and the members personally – to a number of tests. Spoiler alert: The good news is that, since they are not a service business, they will be eligible for a deduction. The bad news is that because their taxable income is above a certain threshold, the deduction will be subject to the W-2 limitation in (b) above.
1) What is “Qualified Business Income” or “QBI”?
“Qualified Business Income refers to the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.”
QBI does not include “reasonable compensation” paid to a taxpayer or guaranteed payments to a partner for services, so one can’t simply suppress wages and reclassify the remaining income as QBI.
Assume that, for 2018, Prince Paper will have $3MM of qualified business income, and Mr., Mrs., and Junior Prince are all equal-part owners.
2) Does Prince Paper LLC have any W-2 wages?
Yes. Prince Paper will pay out $500,000 in W-2 wages in 2018 among its six employees. Prince Paper also pays a sales/management consultant $30,000, but this is not includable in the W-2 wage calculation since the consultant is employed as an independent contractor.
3) Does the taxable income of Mr. and Mrs. Prince, who file jointly, exceed the threshold of $315,000 ($157,500 for singles)?
Yes. Mr. and Mrs. Prince expect combined taxable income of $2MM for 2018. This includes $2MM of income from Prince Paper LLC, in addition to $50,000 income from another source, which is then reduced by their itemized deductions of $50,000. Because they will exceed the income threshold, their deduction will be limited by the W-2 wages that Prince Paper pays out. If their income were below this threshold, they would not be subject to the W-2 limitation; their deduction would be calculated simply by taking 20% of their proportionate share of QBI.
Junior Prince, who is unmarried, also exceeds this threshold.
A key distinction is that the QBI deduction is based on business income, but the phaseout is based on the taxpayer’s taxable income. Additionally, the QBI deduction is not an “above-the-line” deduction in computing AGI, but rather a “below-the-line,” non-itemized deduction.
4) Is Prince Paper considered a “specified service trade”?
No. A service business is generally one where the main asset of the business is the skill or reputation of its employees. Lawyers, doctors, accountants, and financial advisors are just a few examples. While Prince Paper is undoubtedly known for its great customer service, its principal asset is its paper inventory, not the reputation of its employees.
This is a critical question because, if Prince Paper were a service business, the owners would not be eligible for any deduction because taxable income is above the applicable threshold. For a service business – for example, the management consultant who designed Prince Paper LLC’s sales training program – the calculation is as follows:
- If taxable income exceeds $207,500 (single) or $415,000 (married), the deduction is completely disallowed (rather than subject to the W-2 limitation, as it would be for a non-service business).
- If taxable income is between $157,500 and $207,500 (single) or between $315,000 and $415,000 (married), then a phase-out kicks in.
- If taxable income is below $157,500 (single) or $315,000 (married), however, the taxpayer is entitled to a deduction equal to 20% of qualified business income.
5) How much does Prince Paper LLC hold in tangible assets?
The company currently owns approximately $1MM (unadjusted cost basis) of paper and related equipment. Given this fact pattern, we can calculate the Princes’ eligibility for the pass-through deduction as follows.
Mr. and Mrs. Prince, married filing jointly:
Junior Prince, filing single:
Thus, for 2018, Mr. and Mrs. Prince may deduct $250,000 of qualified business income, resulting in net taxable income of $1,750,000. Junior Prince may deduct $197,600, resulting in net taxable income of $790,400. The Princes are now free to reinvest their tax savings back into the business in order to keep pace with their competitor, Dunder Mifflin.
Consider the difference in the ultimate federal tax burden for Junior Prince compared to his Dunder Mifflin counterpart, Michael Scott. Michael is a regional branch manager and C corp employee, though he is not an owner. Given an otherwise similar fact pattern, as a result of the new law, Junior will ultimately pay less in federal taxes despite paying the same 37% marginal tax rate as Michael:
It is worth noting, however, that executives often derive a portion of their compensation from company stock. As a result of corporate tax cuts, it is reasonable to assume that such stock might now be more valuable than it otherwise would have been absent the new law. Additionally, increases in executive and employee compensation could result from the lower corporate rates, though this is, of course, at the discretion of Dunder Mifflin.
Employees who might otherwise be tempted to re-classify their status as an independent contractor in order to take advantage of the new deduction should keep in mind potentially unintended consequences of such a shift – particularly the parent company’s lack of obligation to provide healthcare, retirement savings matches, and other typical employee benefits to those not considered an employee. In addition, the IRS has provided guidance in order to determine whether someone is really an independent contractor or not – meaning that you can’t just change your job status on a whim; there has to be a substantive change in the degree to which you operate autonomously (among other criteria). Furthermore, remember that most independent contract work would be considered a “service business,” and the QBI deduction is only meaningful for those who stay under the income thresholds.
Some service businesses, however, may wish to consider whether conversion to a C corp structure would result in tax savings given the new flat corporate rate. In addition to the lower corporate tax rate, shareholders of corporations with less than $50MM in assets (“qualified small business corporations”) may be eligible for special tax breaks. The benefits of conversion to a C corp would of course have to be weighed against the double layer of taxation imposed on c-corps, as well as the fact that the reduced rate is set to sunset in 2026.
As you can see, the new law is quite complex and requires a thorough understanding of both the structure/assets of the business entity as well as the individual circumstances of the taxpayer receiving the pass-through income. As a result, careful thought and analysis should be undertaken by your tax advisor in order to determine which – if any – planning opportunities exist for you under the new law.