New pass-through rules cut taxes for entrepreneurs large and small
Some workers may consider becoming independent contractors
INSIGHT ARTICLE |
The new pass-through rules of the Tax Cuts and Jobs Act substantially reduces the tax burden on the income of businesses and independent contractors of all sizes and income levels, compared to the taxes imposed on wages and salaries or portfolio income. For business owners with higher incomes many restrictions apply, but many individual business owners or contractors with moderate incomes – generally under $315,000 for a joint return or $157,500 for other returns – may qualify under simpler, more generous rules. Some long-time employees of larger firms may even begin to consider starting businesses of their own, or become independent service-providers treated as independent contractors, to enjoy these benefits. Here are answers to some of the questions that individuals and businesses, large and small, may be asking.
Q. How does the new rule work for a business person making under $315,000 (married) or $157,500 (single)?
A. A full time, independent contractor engaged in almost any trade or business can exclude or deduct 20 percent of his or her income from that business. If the income from that trade or business is the sole or principal source of income, that could easily mean a 20 percent cut in the taxpayer’s total income tax bill.
Q. What is an example of the maximum benefit for someone with joint taxable income exactly equal to $315,000?
A. Assume a married couple with no dependents who both work exclusively and full-time in their jointly owned kitchen remodeling company, organized as a family partnership or LLC, with a net income of $339,000 before taking a $24,000 standard deduction, leaving taxable income of $315,000 before the special deduction for pass-through business income. Without that special deduction their income tax bill would be $64,179.
Their new 20 percent deduction for qualified business income would be 20 percent of $315,000 or $63,000. Because they would be in the 24 percent tax bracket, the resulting tax savings would be $15,120. As a result, their total income taxes would decline from $64,179 to $49,059 – a tax cut of roughly 23.5 percent.
Because of their income levels, they would not be required to have any assets in the business or pay wages to any employees. In addition, various restrictions on ‘service businesses’ applicable to higher income individuals would not apply. Those requirements apply only to business owners with incomes above the $315,000 threshold for joint returns, and $157,500 for other returns.
Q. What is an example with a couple earning much less?
A. Assume a married couple with no dependents who both work exclusively and full-time in their jointly owned gift shop, organized as a family partnership or LLC, with a net income of $124,000 before taking a $24,000 standard deduction, leaving taxable income of $100,000 before the special deduction for pass-through business income. Without that special deduction their income tax bill would be $13,879.
Their new 20 percent deduction for qualified business income would be 20 percent of $100,000 or $20,000. Because they would be in the 22 percent tax bracket, the resulting tax savings would be $4,400. As a result, their total income taxes would decline from $13,879 to $9,479. This is a smaller absolute number than the first couple, but it would be a proportionally much larger tax cut of roughly 32 percent.
Because of their income levels, they would not be required to have any assets in the business or pay wages to any employees. In addition, various restrictions on “service businesses” applicable to higher income individuals would not apply. Those requirements apply only to business owners with incomes above the $315,000 threshold for joint returns, and $157,500 for other returns.
Q. Is that it? No other limitations?
A. You must qualify as an independent contractor and not an employee, which means satisfying certain substantive requirements. It is much more than just calling yourself an independent contractor or getting your current employer to use the tax forms for independent contractors. In addition, you must be engaged in a trade or business other than the trade or business of being an employee.
Q. Why did Congress provide this substantial benefit for independent contractors as opposed to employees who perform similar services and make similar amounts of income?
A. The final legislation does not specify a ‘reason for change.’ Regarding individuals providing personal services, the original Unified Framework for tax reform appeared to be oriented against granting any special tax benefits, such as a reduced tax rate or special deduction, for personal services income earned in a trade or business by an independent contractor. The House bill generally took that approach with an exception for certain taxpayers with joint incomes below $75,000 who were granted a special 9 percent rate instead of the otherwise applicable 12 percent rate on a portion of their income, even if it was derived from their personal services. This was apparently to recognize the entrepreneurial risk associated with small or startup businesses. The final version of the Senate bill allowed a similar exception for taxpayers with joint income as high as $500,000 – evidently for the same reason. The final compromise provided the benefit for taxpayers with joint incomes as high as $315,000 and $157,500 for single filers. Above those levels, various rules are provided that tend to limit the benefits to the owners of non-personal service businesses with either substantial wage payments to employees or substantial investments in depreciable, physical assets such as vehicles, buildings or equipment.
Q. Are those independent contractor and ‘trade or business’ tests complicated or difficult to apply?
A. In the past, these status issues have been some of the thorniest questions for taxpayers and the IRS. However, in some cases it will be highly likely that you are engaged in a trade or business as an independent contractor and not as an employee, such as if you own and operate a retail gift shop in a shopping mall on a full-time basis. In other cases it will be highly likely that you are an employee, such as if you work as a security guard for a single company, wear a company uniform and are required to perform your job in certain specific ways at times set by the company. The difficult cases are in the middle, and in all cases you may need to consult your tax advisor before you take the deduction on your return.
Q. Are there any limits on the type of entity my business can use?
A. Unfortunately, it appears that S corporations may be subject to additional restrictions. S corporations are still required to pay their active shareholders a reasonable wage or salary for any services they provide to the company. Any amount treated as ‘reasonable compensation’ is ineligible for the new benefit, and in some cases that might be 100 percent of the S corporation’s income if the business is a personal service business.
Those requirements do not appear to apply to sole proprietorships with no formal, legal entity, to partnerships or multiple-member LLCs treated as partnerships or to single-member LLCs that are sole proprietorship for tax purposes. Thus, taxpayers looking to maximize the deduction may need to switch or convert from an S corporation to another legal entity to do so, in which case tax advice should certainly be obtained.
Also, if a partnership (or multiple member LLC treated as a partnership) pays a guaranteed payment or other essentially fixed salary to a partner, that amount does not qualify for the 20 percent deduction. But if two equal partners in a partnership that provides computer repair services simply split the net income of the partnership, whatever it happens to be in any year, their entire income will qualify for the 20 percent deduction, assuming all other requirements are satisfied.
Hopefully, the IRS will clarify that the ‘reasonable compensation’ requirement applies only to S corporations.
Q. Does the taxpayer have to apply for this benefit or fill out any special forms?
A. Apparently not. It is simply a deduction taken on the taxpayer’s regular tax return.
Q. If I qualify, can I start reducing my estimated tax payments now?
A. It appears so. The benefit is automatic and starts on January 1, 2018.
Q. What if I make more than $315,000/$157,500 – or more than $415,000/$207,500?
If you are above the basic income limits, additional restrictions apply. The restrictions are ‘phased-in’ as income increases from $315,000/$157,500 and apply in their entirety once income reaches $415,000/$207,500.
Under those rules, in general, certain professional businesses such as law, accounting and medicine are completely excluded. Other professional businesses providing services in the fields of health, performing arts, consulting, brokerage, financial services, actuarial science and athletics are also excluded. In addition, services involving investing, trading or dealing in various financial instruments are excluded. In contrast, authoring novels or non-fiction works, engineering and architecture are not expressly excluded. These rules may be difficult to apply, however. Writing plays or screenplays, for example, might arguably be excluded as part of the ‘performing arts.’
There is also another category of prohibited businesses under a rule that is still quite difficult to understand absent IRS guidance. That rule excludes businesses whose ‘principal asset’ is the skill or reputation of their employees or owners. It is difficult to tell at this time exactly how that rule will apply. Hopefully guidance will be forthcoming from the IRS. In all events, potentially affected taxpayers should consult their tax advisors.
Q. What if I’m on the prohibited list of professional service fields or fail the principal asset or wage and asset tests, but my income is only a little bit over $315,000/$157,500?
Again, the benefits of the largely unrestricted deduction are phased-out rather quickly as your income increases to $415,000/$207,500, at which point no benefits remain, and the more restrictive rules discussed above fully apply. At the halfway point of the phase-out range about half the benefits would be left.
Q. What about a business whose ‘principal asset’ is clearly not the skill or reputation or its employees or owners, and is not on the list of forbidden service businesses, but where the owner’s income exceeds the income tests? An example might be a business that builds, owns and operates a parking structure.
For such businesses, the business must either pay substantial wages or salaries to its employees in an amount at least twice the amount of the 20 percent deduction actually claimed on the return or must have substantial investments in tangible, depreciable property, such as buildings, equipment or vehicles – but not including items such as land or goodwill. Thus, a business consisting of an unpaved parking lot with no employees might not qualify for the deduction, a business consisting of an unpaved parking lot that made substantial wage payments to its attendants and security guards might qualify, and a business consisting of a fully automated parking structure might also qualify even though it pays no wages or salaries. Keep in mind that ‘wages and salaries’ means payments to employees reported on an IRS Form W-2. Payments to independent contractors, such as a security company or parking management company, will not count.
The technical rule is that the 20 percent deduction is allowed to the extent it does not exceed either 50 percent of the wages paid by the business, or the sum of 25 percent of the wages paid by the business plus 2.5 percent of the original cost of tangible, depreciable assets used in the business (without reduction by depreciation allowed or allowable).
Q. Can you give me an example involving real estate if the land and building is my only or principal asset in the business and no one is providing any personal services?
A. Consider this example. You are a passive investor who buys land for $300,000 and erects a building costing $700,000. Your rental income is $50,000. That is about a 5 percent return. Your twenty percent deduction of $10,000 can be taken as long as that amount does not exceed 2.5 percent of the $700,000 building or $17,500. In this example that test is met.
Q. What happens if I’m in a disqualified business or I fail the principal asset or wage and asset test and I start out below the income thresholds, but later start exceeding them?
A. You will lose the benefits for your annual operating income, after the phase-out. But if the business becomes very successful, other benefits may be available. For example, assume that your family-owned optometry or real estate brokerage business starts out generating only $315,000 of joint, taxable income. In that case, assuming you have no other income, you can still enjoy the benefits. If your spouse then took a job with another company making $100,000 or more you would lose your benefits. However, if the business was so successful that it produced $315,000 of income without any work by you or your spouse, you might be able to sell the business for a significant multiple of $315,000 – perhaps $3 million – and that could qualify as a long-term capital gain taxed at a top rate of 20 percent. Thus, you may be able to take advantage of the new deduction to help grow your business, reach a period when your income is too high to keep enjoying the benefits, but later sell it using the more traditional benefits of the tax rules for long-term capital gains.
Q. Based on that asset test, it sounds as if a passive real estate investment will qualify, as will investments in other property that may be leased, such as construction equipment or rental cars, even if no wages are paid and no value is associated with the skill or reputation of the owners or employees. Is that right?
A. As long as it is a trade or business, and satisfies the 2.5 percent asset test, and does not use or rely on any of the skills or talent or reputation of its owners or employees, it appears so. Also, similar investments in REITs or certain publicly traded partnerships and cooperatives will also qualify without specific reference to the wage or asset or principal asset or service business limitations.