This article is the second in a 3-part series concerning the implications and consequences of the Tax Reform Act recently passed by Congress. Part I focused on individual taxpayers; Part II focuses on businesses; and Part III will focus on the planning considerations for high net worth individuals.
As we discussed in Part I of this series, Congress recently passed the largest piece of tax reform legislation in more than 30 years. Though this bill will likely affect most individual taxpayers in one way or another, it will also have significant tax consequences for businesses, depending on how they are structured.
Though some of these new tax law changes are, in theory, “permanent”, I would like to point out that, in reality, permanent doesn’t necessarily mean forever. A new Administration or a new Congress, could conceivably undo many of these revisions and make their own alterations to the tax code. And so while this new legislation currently offers some favorable opportunities to businesses, it would be wise to proceed cautiously before making any substantial changes to your business in order to take advantage of them.
A centerpiece of this new legislation is a major reduction in the corporate tax rate. This bill permanently cuts the corporate income tax rate from 35 percent to 21 percent, as of January 1, 2018. The theory was that in order to compete globally, the corporate tax rate for American companies had to be reduced to bring it closer to countries like Canada, which has a 15 percent corporate tax rate, or Ireland, which has a 12.5 percent rate.
The Corporate Alternative Minimum Tax (AMT) was originally enacted to ensure that profitable corporations paid at least some taxes. The previous corporate AMT rate was 20%. However, in the new legislation, the corporate AMT has also been permanently repealed. Given that the new corporate tax rate is 21%, the AMT was deemed to be no longer necessary or relevant.
American corporations will no longer have to pay corporate taxes on money they earn abroad, ending the previous policy of taxing profits of all U.S.-based corporations, no matter where they are earned. This will align the U.S. tax code with most other industrialized nations and should also deter offshore tax-dodging strategies. However, any corporate income brought back to the United States will be taxed between 8.0-15.5 percent, instead of the previous 35 percent. The theory is that the lower tax rate will encourage corporations to invest more in the U.S. and to raise wages, increase jobs, and stimulate economic growth.
The new tax bill allows businesses to immediately write off, or expense, the full value of their investments in new plant and equipment for a five-year period. Beginning in year six, this 100 percent expensing is gradually eliminated over another five-year period. Plus, the new tax law allows small businesses to write off additional business expenses.
Another centerpiece of the new tax reform legislation concerns pass-through companies, like LLCs, partnerships, sole proprietorships and subchapter S corporations. Previously, net income of pass-through entities was generally taxed as income to the owner at their personal marginal tax rates. The new tax law provides a 20 percent deduction for the first $315,000 of qualified business income for joint filers. This new deduction results in a 28% marginal rate on qualified business income of a typical taxpayer, and 29.6% for those in the top tax bracket. In addition to pass-through companies, trusts and estates are also eligible for the 20% deduction on qualified business income.
Generally speaking, most pass-through businesses are eligible to receive the
20 percent deduction. However, there are some types of businesses that do not qualify for it – these are usually referred to as “Specified Service Trade or Business (SSTB) and they consist of the following:
With the new attractive tax rates in place, existing business owners might be tempted to change the corporate structure of their businesses in order to take advantage of the lower rates and deductions. Pass-through businesses might be tempted to convert to a C-corporation in order to take advantage of the new 21 percent rate. Or SSTB companies might be tempted to legally convert their structure to a pass-through business in order to receive the 20 percent deduction on qualified income.
But it is very important for every business owner to realize that their individual goals and personal circumstances will likely determine whether or not a conversion makes sense for them. All these new tax regulations are nuanced and there are exceptions to the rules, so there is no guarantee that an individual business will be able to qualify for or take advantage of the new lower rates. In addition, there are legal and administrative costs to consider with any changes to a business structure, and there might be capital gains to pay as well. Finally, though a 21 percent corporate tax rate is attractive, there is the issue of double taxation to consider with a C-corp. The business must pay its taxes and so too must the individuals who are employed by the corporation.
So if conversion is something you might be considering, the most prudent course of action is to consult with your team of financial advisors, CPAs and tax attorneys to make sure that a structural change is in your best short-term and long-term interests.
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