The Tax Cuts and Jobs Act of 2017 was supposed to provide tax simplification. Yet, it’s full of phase-outs, phase-ins, threshold limitations and ill-defined terminology. Instead of tax simplification, many taxpayers and advisors are faced with tax complication.
New planning opportunities, and pitfalls, have presented themselves. This dichotomy is perhaps best encapsulated by the newly added Internal Revenue Code Section 199A, which covers deductions for qualified business income. Providing proper planning advice in view of the sundry of complexities of this section is likely beyond the skills of any single professional and will require greater collaborative efforts by the multidisciplinary team.
IRC Section 199A
During business planning, advisors have long focused on intrafamily discounts of closely held business interests. Recapitalizing closely held companies into voting and non-voting interests and then gifting or selling the non-voting interests for discounted values into intentionally defective grantor trusts, for example, has been a staple business and estate tax planning strategy for many years. In the past, this planning primarily focused on the succession of the entity, not on the revenue and the operation of the business or the income tax intricacies regarding the choice of the business entity. That all changed, however, with the Act’s new Section 199A. Planning advice must now factor in the more complicated choice of entity and the operational revenue of the business. With business planning complexity increasing, collaborative team efforts should likewise increase, including the business owner as operator and stakeholder and perhaps senior level managers with active day-to-day management roles.
From a business planning standpoint, the provisions that will most commonly impact the choice of entity are the flat 21 percent corporate rate for C corporations and the potential deduction of 20 percent regarding QBI for pass-through entities. In many instances, choosing to conduct business through a C corp or a pass-through entity will depend on whether the Section 199A deduction will be available.
Consider that without the Section 199A deduction, the combined effective tax rate of a C corp, even taking into consideration the double tax, is slightly more favorable than the highest marginal tax rate for individuals with pass-through income—39.8 percent versus 40.8 percent, respectively. And, C corps offer another advantage over pass-through entities because earnings can grow on a tax-favorable basis before being subject to a second tax on distribution.
At first glance, Section 199A seems to be straightforward. In general, it provides a deduction equal to the sum of 20 percent of the QBI of each of the taxpayer’s qualified businesses that operates as a pass-through entity, such as sole proprietorships, S corporations, limited liability companies, trusts, estates or partnerships. Thus, eligible taxpayers can claim a 20 percent deduction and realize a maximum effective tax rate of 29.6 percent (37 percent times .80) on a taxpayer’s QBI earned in a qualified trade or business.
But, first glances can be deceiving. Section 199A is extraordinarily involved, and it should be approached with great caution in light of the significant understatement penalty that comes with it.
Critical definitions regarding this new section are less than clear. For example, QBI is generally the net amount of income, gain, deduction and loss from an active trade or business in the United States, but it excludes certain types of investment income such as capital gains, dividends and interest. Notably, however, there are a multitude of deductibility limitations on wages and qualified property that are allocable to particular qualified trade or business activities that must also be considered.
Now consider QTBs, which include all trades and businesses except the trade or business of performing services as an employee and specified service businesses, such as health, law, accounting, consulting, athletics, financial services, brokerage services, investing, investment management, trading and dealing in securities or any business in which the principal asset is the reputation or skill of one or more of its owners.
Importantly, any business that isn’t an SSB is considered to be a QTB. Therefore, if the taxpayer has QBI exceeding the threshold amount, determining whether his business is an SSB or a QTB is critical in determining whether the QBI from that business will qualify for the 20 percent deduction. However, distinguishing an SSB from a QTB can be tricky, and much more guidance is needed from the Internal Revenue Service.
Under Section 199A, many planning considerations, questions and issues arise for the multidisciplinary team, such as:
- Whether a business entity should be structured as a C corp to take advantage of the lower tax rate on current income (perhaps investment income), understanding that a subsequent dividend tax applies when dividends are withdrawn by shareholders.
- Should business owners of pass-throughs allow more employees to become partners so that some or all of their compensation will constitute a QBI. If so, what might be the impact on the control of the entity, the owner’s estate plan, buy/sell planning and other ancillary concerns? Could more workers possibly be paid as true independent contractors?
- Whether the taxpayer may consider a management company to be an integral part of the operating trade or business (and thus, not an SSB) if substantially all of the management company’s income is from that other trade or business.
- Should an SSB be sliced and diced into separate firms that might provide ancillary support services (for example, IT or accounting), in the hopes that the ancillary support services charged to the SSB would quality for the 20 percent deduction?
- What will be the impact on buy/sell agreements, life insurance arrangements and estate plans should a client restructure his business entity to capitalize on Section 199A?
- Should closely held ownership interests be gifted to irrevocable non-grantor trusts as each trust is considered to be a separate taxpayer and has its own independent threshold amount? What about step-up and carryover basis considerations in making a gift?
Achieving optimal results under the many nuances and planning pitfalls of Section 199A will likely require CPAs, tax attorneys and others on the multidisciplinary team to more intentionally collaborate with the business owner. While these concerted efforts may be considerable, they’re typically worth it. After all, closely held family businesses are often the most valuable assets in the family enterprise and in a taxpayer’s estate.
This is an adapted version of the authors’ original article in the September 2018 issue of Trusts & Estates.