Tax Simplification? Definitely Not!



Photography by Ali Wolfe

 

There is no doubt that the major push behind the new tax bill was to benefit businesses and to spur further growth in the economy. We’ve already seen some of the tax law’s effects with companies announcing one-time bonuses to employees, additional matching of retirement contributions, and significant investment in the U.S. with repatriated profits from abroad. Below we explore three specific provisions in the tax bill that directly impact businesses.

 

Given the lowering of the corporate tax rates, should I convert my S Corporation to a C Corporation?

 

A very significant aspect of the new tax bill was the lowering of the corporate tax rate to a flat 21%. With individual rates still at 37%, it’s natural to think that perhaps my flow through S corporation should be a C corporation. Given the rate differential, wouldn’t the owners/company save a ton of tax dollars? As with most tax laws, the situations are very situation specific. Here is a simple example that shows how an S corporation may still be beneficial for a company that pays out all of its annual profits even without the new 20% qualified business income deduction (discussed below in more detail).

 

 

John D. Dovich & Associates, LLC and MCM CPAs & Advisors

 

The above example shows that even with the significantly lower C corporation rate, the double taxation of a C corporation results in an S corporation structure still being more beneficial. Of course, we assumed that the business distributed all profits whereas many businesses are capital intensive and those profits would be reinvested in the company vs. distributed. 

 

While we encourage a thorough review of your entity structure, we do not encourage short term decisions that could negatively impact long-term opportunities. Revisit the fundamental reasons you initially chose a certain entity structure. Re-validate them and keep your structure as is or determine that those fundamental reasons no longer are valid with tax implications being one, but not the only, factor.

 

One such situation may be where the profits of the company will not be distributed and would be used to pay down debt. This may warrant a conversion from S to C status to take advantage of the lower tax rate. Keep in mind there is a minimum five year period before S status could be re-elected. Additionally, if built-in gains are present when S status is re-elected, the company would want the five year built-in gain recognition period to pass before liquidating assets. So this decision is potentially a 10 year decision. One final note is that a S election must be filed by March 15 to be effective for that tax year.

 

How does the new 20% deduction on qualified business income from pass-through entities affect my business?

 

The entity structure example above did not even contemplate that the S corporation income may have a 20% deduction applied to it. We have heard much about wanting to simplify the tax code, but this specific provision does the complete opposite. The effect of the qualified business income deduction (QBID) on your business depends on a few facts. These include the entity type under which the business files its taxes, the amount of wages paid to employees, and the amount of income earned by the business. Consider a scenario where two spouses own a non-service related business:

 

 

 

John D. Dovich & Associates, LLC and MCM CPAs & Advisors

 

 

In the above example, when organized as a sole proprietorship or partnership, the initial inclination is that the business owner would receive a QBID of $120,000. However, when joint taxable income is above $415,000, wage and capital limitations must be applied. In this example, our sole proprietor and partnership entities would not qualify for any deduction since there are no wages to apply for a sole proprietor and guaranteed payments in a partnership also do not qualify. The winner in this example is the S corporation as shareholder/employees of the business must be paid reasonable compensation. Thus, the shareholder’s wages are used in calculating the 50% wage limitation, giving the S Corporation owner a deduction of $80,000.

 

Entity choice alone will not be enough to ensure you are a winner (or loser) when calculating the QBID. Income amounts are also critically important. Let’s consider the same facts as above, but this time our married couple only earns half as much and we assume their overall taxable income is under $315,000.

 

John D. Dovich & Associates, LLC and MCM CPAs & Advisors

 

When taxable income is below $315,000 for joint filers, wage and capital limitations don’t apply. As a result, the sole proprietor is the big winner since 20% of the business income is fully deductible. 

 

It seems unlikely the intent of the law was to create such disparity between entity types; however, unless and until there is a technical correction issued to the law, the applicability of the laws as written means all pass-through entities are not created equal.

 

How does the new interest expense limitation affect my business?

 

The new law introduced a change to the interest expense deduction for businesses having average three-year gross receipts exceeding $25 million. These businesses will now only be allowed to deduct net interest expense (interest expense minus interest income) up to 30% of their adjusted taxable income. For the next four years, adjusted taxable income is equivalent to EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization), after which the limitation is applied to EBIT. Any unallowed interest under this provision will be carried forward indefinitely for eligibility in future years where there is not a limitation. However, since certain real property trades or businesses often involve significant leverage, an election is provided under the new law to have the interest limitation not apply. The tradeoff for not having a limitation is that residential rental and nonresidential real property (including qualified improvement property) must be depreciated over longer depreciable lives and will not be eligible for bonus depreciation.

 

Here are two simplified examples to show how this might impact a real property trade or business:

 

 

John D. Dovich & Associates, LLC and MCM CPAs & Advisors

 

 

 

John D. Dovich & Associates, LLC and MCM CPAs & Advisors

 

 

As you can see from these examples, careful consideration should be given to determine whether or not making the real property trade or business election will be advantageous to your circumstances, as the difference can be dramatic.

 

It is clear from the examples above that the tax law has some unintended consequences. As a result, there is more, not less, tax planning that needs to be done. It’s not simply whether you should be a corporation or a pass through. It’s also about the type of pass through. Additionally, the type of business you have, like a real property business, has some significant elections to consider around deprecation and interest deductions. We highly recommend you work collaboratively with your team of advisors as you sort through the impact of the new tax law on your business.

 

John D. Dovich & Associates, LLC is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202. You can reach them at 513.579.9400 or visit their website at www.jdovich.com. MCM CPAs & Advisors is located at 3536 Edwards Road, Cincinnati, OH 45208. You can reach them at 513.768.6796 or visit their website at www.mcmcpa.com. Disclosure: All opinions and views mentioned in this report constitute our judgments as of the date of writing and are subject to change at any time. This material is not intended as, and should not be used to provide investment advice and is not an offer to sell a security or a recommendation to buy a security. John D. Dovich & Associates, LLC is a Federally Registered Investment Adviser. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information within this material is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Please remember that past performance may not be indicative of future results.