On Dec. 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act. One of the key provisions in the Act is a 20 percent deduction for the qualified business income of non-corporate taxpayers under new Internal Revenue Code Section 199A. This section is effective for tax years after 2017 and, unless Congress acts sooner, it sunsets on Dec. 31, 2025. And, the Internal Revenue Service just issued proposed regulations on Aug. 8 regarding IRC Section 199A. If enacted, the proposed regs, along with the Section 199A provisions already enacted, should provide new estate planning opportunities.
Tax Break for Pass-Through Entities
The most important goal of the Act was to reduce the tax rates on C corporations to make them more competitive in world markets. Reducing the top C corp rate from 35 percent to 21 percent, however, puts pass-through businesses at a disadvantage relative to C corps. Thus, the 20 percent deduction was added to the Act to give pass-through entities a comparable tax break. The 20 percent deduction, in theory, reduces the tax rate from a maximum of 37 percent to a maximum of 29.6 percent.
The deduction applies to non-corporate taxpayers, including sole proprietorships, partnerships, most limited liability companies , S corporations, trusts and estates. It’s calculated on an annual basis and will be reported as a line item on Form 1040. For partnerships or S corps, the deduction applies at the partner or shareholder level, and each partner or shareholder takes into account his allocable share of the deduction (Section 199A(f)).
The 20 percent deduction applies only for income tax purposes and doesn’t reduce the net investment income tax, Medicare tax or the self-employment tax (IRC Section199A(f)(3)). The deduction isn’t allowed in computing adjusted gross income, but rather is applied against taxable income.
Limitations on the Deduction
The statute generally gives taxpayers a deduction for 20 percent of their pass-through income from a QBI. However, the deduction is subject to three important limitations:
- It can’t exceed 20 percent of a taxpayer’s taxable income in excess of capital gains.
- It can’t exceed the lesser of QBI or the greater of: 50 percent of the taxpayer’s allocable share of the wages paid by the business with respect to QBI, or 25 percent of the taxpayer’s allocable share of wages plus 2.5 percent of the unadjusted basis of qualified property owned by the business (IRC Section 199A(b)).
This limitation begins to be phased in at taxable incomes of $157,500 for single taxpayers and $315,000 for married taxpayers filing jointly and is fully phased in at income levels of $207,500 and $415,000, respectively.
- It’s completely phased out for income from specified service businesses, subject to the same phase-in levels as the W-2 wage/unadjusted basis limitation. Taxpayers with taxable income below the applicable threshold receive a full deduction, and taxpayers above the full phase-out levels receive no deduction.
Specified service businesses include any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading or dealing in securities. Also included is any trade or business in which the principal asset of the trade or business is the reputation or skill of one or more owners or employees.
As noted above, proposed regs were issued under Section 199A on Aug. 8. These regs generally confirmed the availability of planning strategies suggested by commentators following enactment of the Act, but to the surprise of many, effectively blocked the “crack and pack” strategy, which involved spinning off non-service components of specified service businesses (for example, administrative functions) to qualify for a partial section 199A deduction.
The key planning opportunities under the new law are: (1) designing trusts to create additional threshold amounts; (2) selecting the most favorable entity for operating a business; and (3) managing income to eliminate or reduce the effect of the limitation amounts.
The proposed regs make it clear that a trust receives the same $157,500 threshold amount as a single taxpayer for purposes of applying the W-2 wage/unadjusted basis and SSB limitations, and the threshold amount is determined at the trust level without taking into account any distribution deductions. Thus, by transferring business assets to trusts, taxpayers may be able to multiply their Section 199A threshold amounts and create substantial tax savings.
The amount of tax that an extra limitation amount would save depends on the wages paid by the business and on the unadjusted basis of the entity’s depreciable assets. If the business has a W-2/unadjusted basis amount of $0, the tax benefit of shifting business income to a trust could be as high as $11,655 per trust ($157,500 x .2 x .37).
It may be possible to greatly expand the tax benefits illustrated above by creating multiple trusts. For example, the maximum tax savings illustrated above would be $116,550 per year if the taxpayer created 10 trusts (10 x $11,655) instead of one.
To make this multiple trust strategy work, however, taxpayers must plan around the anti-abuse rule in IRC Section 643(f) and new proposed regulation Section 1.643(f)-1, which provide that two or more trusts will be aggregated and treated as one trust if (1) the trusts have substantially the same grantor or grantors (for purposes of applying this rule, spouses are treated as one person) and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of the trusts is the avoidance of federal income tax.
A principal purpose will be presumed if creating or funding the trusts results in a significant income tax benefit, unless there’s a significant non-tax benefit that couldn’t have been achieved without the creation of the separate trusts.
This means that taxpayers can create multiple trusts without violating the anti-abuse rule if (1) the primary beneficiaries of the trusts are sufficiently different, or (2) there’s a significant non-tax reason for creating more than one trust.
Private Letter Ruling 200209008 (March 1, 2002) provides an example of the second possibility. The taxpayer in the ruling created two trusts instead of one because of the need to resolve a dispute among beneficiaries over investment strategies. The IRS ruled that there was a significant non-tax reason for creating more than one trust and, therefore, no aggregation.
Choice of Entity
The enactment of Section 199A may cause taxpayers to re-evaluate the decision of whether to operate a business as a C corp or as a pass-through entity. As noted above, the Act made comparable reductions in the tax rates for C corps and pass-through entities. Before the Act, the top C corp tax rate was 35 percent. If this income was then distributed to shareholders or the shareholders sold their stock, a second level of tax was paid. This made the total tax payable 35 percent plus 23.8 percent on the after-tax amount left for distribution, or 50.47 percent (.35 + (.238 x .65)). By contrast, the highest tax rate on pass-through income was 39.6 percent, a spread of 10.87 percentage points. This substantial rate differential led many taxpayers to convert from C corps to pass-through entities.
Following enactment of the Act, the spread between the highest rates for C corps and pass-through entities remains about the same. The top rate for C corps is 39.6 percent (21 percent + (.238 x .79)), a spread of 10.2 percent compared with 10.87 percent before the Act. This spread calculation makes two important assumptions, however. First, it assumes that C corp shareholders pay a second level of tax on the corporate income. But, as noted above, the second level of tax isn’t payable until the income is distributed as a dividend or until the stock is sold. If the shareholders don’t need the income, payment of dividends could be substantially deferred, reducing the present value of the second level of tax. If dividends were never paid at all, the retained income would stay in the company and increase the value of the shareholders’ stock. This increase would be reflected in the value of the stock, but wouldn’t be taxed until the shares were sold, again producing tax deferral. If dividends weren’t paid and the shareholders died with the stock, their heirs would receive a stepped-up basis and there would never be a second level of tax. In that case, the maximum tax rate on C corp stock would be 21 percent compared with a top tax rate of 29.6 percent on the income from pass-through entities.
The spread calculation also assumes that the taxpayer can take full advantage of the 20 percent Section 199A deduction. If this deduction isn’t available because of a lack of W-2 wages or because the business is a service business, the top pass-through rate would be the new top individual rate of 37 percent. This means that the top C corp rate could be as much as 16 percentage points lower than the top rate on pass-through income (21 percent versus 37 percent). In addition, owners of C corps may qualify for a 100 percent gain exclusion under Section 1202. Thus, depending on distribution policies, the ability of the business to use the Section 199A deduction and the availability of the Section 1202 exclusion, taxpayers might wish to consider a switch from a pass-through entity to a C corp following the Act.
The limitations on the QBI deduction can be managed by: (1) increasing or decreasing W-2 wages, (2) increasing adjusted basis, (3) reducing taxable income to avoid the W-2 wage/unadjusted basis and SSB limitations, and (4) increasing ordinary income to avoid the 20 percent of net income over capital gains limitation.
Increasing or decreasing wages. If 20 percent of QBI exceeds 50 percent of W-2 wages, it may be possible to increase the limitation amount by increasing wages. One way to do this would be to substitute employees for independent contractors. It may also be possible to increase owners’ salaries. This would only work for owners of S corps, however, because partnerships, LLCs and sole proprietorships can’t pay W-2 wages to owners.
If, on the other hand, 20 percent of QBI is less than the 50 percent W-2 wage limitation, it may be advantageous to reduce wages and treat such amounts as pass-through income instead. Because wages aren’t included in QBI, this will increase pass-through income and the amount of QBI. A word of caution is in order, however. In the case of an S corp, the IRS will take the position that the business owners must be paid reasonable compensation and try to convert pass-through income back to wages.
Increasing unadjusted basis. Unadjusted basis can be increased by either acquiring depreciable property or by owning property instead of leasing it.
Decreasing taxable income. Two easy ways to reduce taxable income to avoid or minimize application of the W-2 wage/unadjusted basis and SSB limitations are making charitable contributions and making contributions to qualified plans.
A more complex strategy for reducing taxable income is making an oil and gas investment. Investors can deduct 100 percent of their share of intangible drilling costs in the year they are incurred. IDCs include expenses for labor, drilling rig time, drilling fluids, removing the oil rig, plugging the well if it’s dry and repairing surface and crop damage to landowners. IDCs typically produce deductions equal to 65 to 85 percent of the total investment. Thus, a $100,000 investment could produce an immediate deduction of $65,000 to $85,000.
Taxpayers might also consider gifting shares of a business to family members. This would spread income from the business among several taxpayers, making it easier to stay below the phase-in of phase-out threshold amounts.
Increasing taxable income. Even if QBI isn’t limited by the W-2 wages/unadjusted basis limitation, it may be limited by the 20 percent of taxable income over capital gains limitation. In this situation, an owner of a non-service business may wish to earn additional income outside the pass-through business.
One way to increase QBI would be to convert guaranteed payments in a partnership into pass-through income. While guaranteed payments don’t count as QBI, distributive shares are included. Unlike S corps, partnerships aren’t required to pay reasonable compensation.