The Tax Cuts and Jobs Act changes much of our nation’s tax law. One of the most discussed changes is the new flat corporate tax rate of 21%, which is a permanent change in the new law. To take advantage of this new rate, many businesses may consider converting from a pass-through entity to a corporation. However, the new law also provides a benefit to owners of pass-through entities. The Tax Cuts and Jobs Act includes the new Internal Revenue Code Section 199A, which provides a deduction for entity taxpayers, other than corporations, in an attempt to maintain the desirability of pass-through entity business structures. This deduction may provide business owners greater tax benefits than converting to corporations. However, the deduction is temporary. After December 31, 2025, it will no longer apply.
Generally, Section 199A allows taxpayers to reduce their income by 20% of their business income from a pass-through entity. The deduction decreases taxable income rather than adjusted gross income (AGI). Pass-through entities benefitting from the deduction include partnerships, LLCs, S corporations, and sole proprietorships. The deduction has promising aspects, yet there are several limitations to note.
Limits of the New Deduction
- Employees of a business are not eligible for the deduction. Rather, only the owners of a business are eligible. In the case of a partnership for example, the partners may be entitled to the deduction because they are the legal owners of the business.
- Not all forms of income are included in qualified business income, which determines the amount of the deduction. For example, reasonable compensation paid to S corporation shareholders and guaranteed payments paid to partners are excluded when calculating the deductible amount. In addition, interest income and dividend income are excluded. If you believe you have a high amount of business income from a pass-through entity that may be subject to the deduction, you should carefully consult the new law to determine if all the income is eligible for the deduction.
- Individuals engaged in service businesses are subject to more limitations than those not in service businesses. Individuals working in service businesses include lawyers, doctors, actuaries, accountants, consultants, athletes, performing artists, financial planners, brokers, and those working for a trade or business “where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” I.R.C. §1202(e)(3)(A). Architects and engineers are specifically excluded from the definition of service businesses for purposes of the pass-through entity deduction, so they are still eligible for the full benefits of the deduction.Due to this limit, taxpayers working in a service business will only be able to take a deduction if their taxable income is under certain threshold amounts. If an individual works in a service business and has taxable income of $157,500 or less ($315,000 for married taxpayers filing jointly), then she will be able to obtain the full benefits of the deduction. However, if an individual working in a service business has taxable income over that amount, then she may receive a limited deduction for her business income. But, the limited benefits are entirely lost if an individual working in a service business has taxable income over $207,500 ($415,000 for married taxpayers filing jointly).
- All individuals, regardless of the business they work in, are subject to limits on their deduction if their taxable income exceeds $157,500 ($315,000 for married taxpayers filing jointly). The benefit of the deduction decreases as the taxpayer’s taxable income increases.
- The taxpayer’s allocable share of W-2 wages paid by the business to its employees and her allocable share of depreciable business property affect the extent of the taxpayer’s deduction. This W-2 limit and depreciable business property limit cap the deduction at an amount equal to the greater of: (1) 50% of the individual’s share of W-2 wages paid by the business or (2) 25% of the W-2 wages paid by the business plus 2.5% of the individual’s share of depreciable business property.
Considerations for Entity Structure
Because of the limitations discussed above, the deduction is dependent on a taxpayer’s income level, her share of W-2 wages, her share of depreciable business property, and her line of work. Thus, conversion to a C corporation may be beneficial in some circumstances. For example, if a business pays little to no W-2 wages to employees and holds little to no depreciable business property, then the caps on the deduction will be very limiting to its value. Additionally, if the owners of the business have taxable income significantly above the thresholds, the deduction is inapplicable.
Keep in mind that converting to a C corporation brings the double tax regime into play: an income tax at the corporate level and another at the shareholder level. Yet, if a business plans to reinvest its earnings into the business without making distributions to shareholders, then conversion to a C corporation may be beneficial because the shareholder level tax will be minimal.
Choosing how to structure a business entity is a complex decision with many different considerations. The new deduction for business income of pass-through entities is one of many considerations. While the deduction has the potential to level the playing field for corporations and pass-through entities, it comes with several limitations. The deduction’s benefits will differ greatly between taxpayers of various income levels as well as taxpayers working in service and non-service industries. In addition, all taxpayers should be cautious because even permanent provisions of the new law, like the reduced corporate tax rate, may be amended in the future.