The Tax Cuts and Jobs Act of 2017, or TCJA, will have a profound impact on business owners, investors and professionals alike. Defining the impact is another issue altogether. The legislation was passed with breakneck speed, leaving many questions unanswered. Now the real work begins: interpreting the wide-sweeping tax overhaul. It will take years to get it all sorted out, but here’s some of what we know now.
If you haven’t heard of new Code Section 199A, consider this the first of many introductions. The reduction in the C corp tax rate gets all the press, but this section is really the nuts and bolts of the new legislation. It provides owners of pass-through entities (including sole proprietors) a deduction equal to 20 percent of Qualified Business Income, or QBI, effectively dropping the top marginal tax rate to 29.6 percent. This is subject, of course, to limitations, thresholds, phase-ins/outs and a litany of definitions (classic hallmarks of the Internal Revenue Code). If the goal of tax reform was simplification, here the mark was missed entirely.
So what’s QBI? At the grave risk of generalization, QBI is pass-through business income less wages and investment income. However, once taxable income exceeds a threshold, certain professions are excluded from the 20 percent deduction. Spoiler alert: Condolences to doctors, accountants, financial advisers, brokers, lawyers, or the ambiguous “any business where the principal asset is the skill of its employees.” (Kudos to engineers and architects, who are specifically unscathed.) Even outside of the “blacklisted” professions, there are other limitations, the extent of which is too drawn-out to outline here.
Current business structures will need to be analyzed, and in some cases modified, to maximize the deduction. Furthermore, because this provision is inapplicable to non-owner employees, key employees might look to alter the employment relationship to fit within the deduction parameters.
Mass conversion from pass-through to C corp form?
With the reduction in the C corp tax rate from 35 percent to a flat 21 percent, is it now advantageous to convert a pass-through entity to a C corp? The short answer: It depends, but probably not. C corps are subject to a second level of tax on dividend distributions to shareholders, whereas pass-through entities will continue to enjoy a single layer of tax. The primary question will be how quickly the business plans to distribute earnings. The second level of tax doesn’t materialize until cash is distributed. If the business is continuously reinvesting cash and expects to do so for the foreseeable future, a C corp conversion might make sense. But for most, owners need the cash in the shorter term, and for this reason they will likely be encouraged to preserve pass-through status.
REIT dividends and publicly traded partnership income
The 20 percent pass-through deduction applies to any REIT dividend that is not a capital-gain dividend or a qualified dividend. The deduction also applies to qualified income from publicly traded partnerships, or PTPs, plus any gain on the sale of a PTP interest that is included in ordinary income. Strictly from a net-tax standpoint, these investments will now be more desirable than under prior law.
Often publicized as one of the most brazen loopholes in the tax code, carried interest endured the TCJA largely intact. A carried interest is a contractual right that entitles a partner to an allocation of future profits in exchange for services performed. In many instances, the tax is paid long after the services are rendered and then at capital-gain rates. In order to secure capital-gain treatment, the TCJA increases the hold period of the underlying assets from one year to three. Because hedge fund managers, real estate managers and private equity sponsors often have a hold period in excess of three years, it is anticipated this modification will have minimal impact on the taxation of carried interests.
Roth IRA recharacterization repeal
Pre-TCJA, taxpayers were permitted a “do-over” with respect to a Roth IRA conversion, meaning they could execute a conversion as early as Jan. 1 and had until October of the following year to undo the conversion. If the value of the investments had declined, the conversion could be undone, allowing the taxpayer to convert again at the lower asset value (reducing the tax liability on the conversion). For taxable years after Dec. 31, 2017, recharacterization for a contribution to a Roth IRA is not permitted.
Unreimbursed business expenses
Pre-TCJA, taxpayers could deduct unreimbursed business expenses to the extent miscellaneous itemized deductions exceeded the 2 percent floor. This deduction is now suspended. Therefore, business owners can expect pressure from employees to reimburse some of these expenses.•
Halstead, an attorney, is a partner in Katz Sapper & Miller’s tax-services group.