As we approach the halfway point of the 2018 calendar year, taxpayers are fully aware that in December of 2017, President Trump signed into law P.L. 115-97, known as The Tax Cuts and Jobs Act (TCJA). This piece of legislation provides for the largest change to United States tax law since 1986. The TCJA contains a significant number of rate adjustments, thresholds and provisions, many of which are scheduled to go into effect immediately.
As a substitute for tax reform’s corporate tax rate cut, the newly enacted Internal Revenue Code Section 199A allows individuals, trusts and estates a 20% deduction for domestic qualified business income (QBI) from a pass-through entity. With the new top individual rate of 37%, if an individual’s sole income source is domestic QBI, the individual’s effective top tax rate on the domestic QBI would be 29.6% IF the individual can claim the full 20% deduction. The IF in this equation deals with limitations on the pass-through deduction. When taxable income exceeds certain threshold amounts, taxpayers are not eligible for the deduction if the income is from a specified service business. Section 199A(d) defines these specified service businesses to include any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or investing, trading, or dealing in securities, partnership interests or commodities. Additional limitations may apply.
Historically, the taxable income associated with personal service corporation structures has been taxed at 35%. As you may know, personal service corporations are corporations that have a principal activity relating to the performance of personal services by their employee-owners. Because of this newly enacted piece of legislation, tax reform has reduced this rate to a flat 21%.
Knowing the nuances above and considering all additional definitions, limitations and thresholds is critical to understanding the TCJA and ultimately how it affects your business.
What can my company do now in response to The Tax Cuts and Jobs Act?
The following are a few action items taxpayers and their service businesses can do now to provide better visibility into how tax reform may affect their business currently and in the future:
- Model the impact of tax reform legislation
- With a thorough understanding of the business and owner goals and expectations, as well as concluding upon certain assumptions, an effective model can be ran to provide a detailed analysis of how reform will affect the company now and beyond.
- Compare pass-through entity status with a C corporation structure
- There are a variety of pros and cons when determining your choice of entity, both tax related and non-tax business related. It’s certainly not a one-size-fits-all scenario. The determination is very fact dependent and warrants analyzing.
- Determine impact on current and future distribution policy
- How the company has historically distributed cash and its plans to do so in the future should be evaluated for, among other things, tax purposes, estate planning and banking considerations.
- Examine state tax implications of tax reform
- We’re all too familiar with states approaching federal enacted laws in a different fashion. Conformity, or lack thereof, may have an effect on the business and its owners and should be reviewed and prepared for.
- Evaluate debt structures for tax purposes
- It’s common for service based businesses to have very little or no existing debt on the balance sheet. However, if it does exist within the business, the TCJA limits the interest deduction to 30% of adjusted taxable income. Planning considerations should be given to this new limitation.
- Communication strategy with ownership
- The Tax Cuts and Jobs Act is an incredibly large, complex piece of enacted legislation. It can be a bit overwhelming for non-tax professionals to interpret and examine recent law changes, especially ones that contain uncertainty and do not have published formal guidance. It’s important to ensure the owners of service businesses understand the effects of tax reform on the business and themselves personally.
- Plan to re-evaluate as IRS legal guidance is published and certain provisions expire in future years
- Just like the service industry and service related businesses dynamically change from one year to the next, occasionally so do the tax laws. Legal guidance provided to taxpayers by the Treasury Department and the IRS which allow the business community to interpret and implement these laws may not be valid down the road if certain provisions sunset. It’s also important to evaluate how provisions that will sunset impact your service business.
Help is on the way
Tax professionals throughout the country over the past 12-18 months have kept their eyes on both the House and Senate proposed tax plans and how these two plans may affect their clients. Congress passed the TCJA following Conference Committee reconciliation and the President signed the piece of legislation into law on December 22, 2017. At this point, tax professionals again put the accelerator down to examine this overhaul of the Internal Revenue Code and how it affects all types of taxpayers. The good news about the Tax Cuts and Jobs Act (P.L. 115-97) is that it contains hundreds of pages of new law and tax reform legislation. However, as with any new piece of legislation, details, explanations and guidance surrounding the recently passed tax reform law is lacking. During the week of June 4, 2018, David Kautter, the acting IRS Commissioner, announced that guidance would be issued in a “couple of weeks.” The expectation is that the IRS will provide taxpayers and tax professionals with proposed regulations by the end of June or early July, 2018. According to Kautter, the IRS is “focused primarily on aggregation rules, anti-abuse rules, the general rules and the definition of specified services.” Kautter fully expects future comments from both taxpayers and practitioners after the proposed guidance is released. These proposed regulations should aid both the taxpayers and practitioners in analyzing the law, providing explanations and taxpayer specific examples and fact patterns.