The U.S. tax system is an interesting thing. Much of it is designed to incentivize the kind of activities our lawmakers want the American people to do, such as save for retirement, buy a home, get an education and give to charity.
Then there’s the other side: tax loopholes that perhaps weren’t intended by Congress when the law was written, but can be used by taxpayers following the letter (if not the spirit) of the law.
Lawmakers create some of these loopholes intentionally when they cater to special interest groups and their lobbyists. Others are accidental—the unintended consequences of a complex tax system and rushed legislation.
So it’s no surprise that even before Congress finalized the Tax Cuts and Jobs Act (TCJA), accountants, tax attorneys and financial advisors were hard at work dissecting drafts of the bill in search of ways to game the system. That hard work will no doubt pay off for their clients, especially for pass-through entities.
Pass-through entities are sole proprietorships, partnerships, LLCs and S Corporations. These entities don’t pay income taxes at the business level. Instead, income from the business “passes through” to the owner or shareholder, who pays tax on business profits on their individual tax return.
One component of the TCJA includes a reduction in the corporate tax rate. Early drafts of the legislation received pushback from small business owners, who said the law favored big corporations over small businesses—many of which are pass-through entities.
In response, lawmakers added a new tax break for pass-through entities to the TCJA, allowing a deduction of up to 20 percent of income for pass-through businesses, but the rules are complicated.
The deduction may be limited or completely eliminated if the taxpayer’s income is above a threshold and it is considered a “specified service trade or business.”
If a taxpayer’s income is below the threshold amount, the law is simple: you simply deduct 20 percent of the business’ qualified business income (QBI).
QBI is generally the net income from your business without regard to any compensation or guaranteed payments paid to the shareholder or partner.
The threshold amount is $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly. To illustrate, if your income is below the threshold and your QBI is $100,000, then your deduction is $20,000, or 20 percent of your QBI.
If you are above the threshold, your deduction may be limited if you are in a specified service trade or business.
A specified service trade or business is any business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services. It also includes “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 owners.”
Simply put, if the success of your business depends on you and not on something you sell, you are in a specified service trade or business (unless your business is engineering or architecture, which were specifically excluded).
This definition also includes businesses where the performance of services consists of investing and investment management trading, dealing in securities, partnership interests or commodities.
If your business counts as a specified service trade or business, the 20 percent deduction is phased out as your income exceeds the threshold amount and is eliminated if you earn more than $207,500 for a single filer or $415,000 for a married couple.
If your business is not a specified service trade or business, the size of your deduction depends on how much you pay employees in wages or how much you’ve invested in capital like real estate.
This is where potential loopholes come into play. There are a few options business owners and their accountants have under the new law.
Currently, few small business owners opted for C Corporation status because profits from the business are subject to double taxation: once at the corporate level and again when they were distributed to shareholders.
Under the new law, double taxation still applies, but the top ordinary income tax rate for individuals (37 percent) will be much higher than the top tax rate on corporate income (21 percent). So some owners of pass-through service businesses with high-incomes may choose to shield a portion of their income from tax by incorporating their pass-through business.
Before the TCJA, people who earned income from a pass-through entity paid tax on the business profits as their individual income tax rates. Under the TCJA, they get to deduct 20 percent of this income. This could influence employees to turn into independent contractors, or band together to create their own pass-through entity.
For example, an advertising agency has six graphic designers on staff, paying them a total of $300,000 in salary. The agency’s six graphic designers decided to “quit” their jobs and set up an LLC. The advertising agency makes payments to the new LLC instead of the six graphic designers. As long as the designers are below the income threshold, they can shield 20 percent of their income from income taxes.
The new tax law spells out some examples of businesses that fall under the ‘specified service trade or business’ category, including doctors, lawyers, accountants, actuaries, performing artists, consultants, athletes, financial advisors and brokers.
But few people are really sure how “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 owners” will be interpreted. That kind of confusion creates opportunities to change the focus of your business slightly to fall outside of those excluded categories.
The bill specifically excludes architects and engineers from the specified service trade or business category. So an attorney could possibly change her business from providing legal services to clients to providing in-house legal services at an engineering firm. Is she now in the engineering business and eligible to qualify for the pass-through deduction? It remains to be seen.
Businesses are denied the pass-through deduction if their “principal asset” is the “reputation or skill” of an employee or owner. So business owners may be able to benefit by combining or separating business activities to shield part of their income from tax.
For example, a consultant who is currently prohibited from taking advantage of the pass-through deduction could combine other business activities so that the IRS can no longer claim that her reputation and skill is a principal asset. If she also owns some rental real estate, instead of keeping the real estate separate from her consulting, she might combine the two.
A doctor whose office also handles medical coding, collections, and other back-office functions might spin off those activities into a separate “management company” so that segment of the business would qualify for the deduction.
Keep in mind that none of these scenarios are recommendations. Every situation is different, and the IRS has yet to issue guidance on how to interpret the law.
The TCJA was so hastily drafted that we probably won’t know for a while which strategies will ultimately work and there are sure to be Tax Court challenges for years to come. So talk to your tax advisor before making any big moves. Anyone of these strategies could come with a host of unintended consequences.