The New Tax Bill: Impact on Pass-Through Entities
One of the most talked-about aspects of the new tax bill is the effect on “pass-through” income. About 10 pages of the bill are dedicated to pass-through entities (specifically, the addition of Section 199A to the tax code). We won’t attempt to cover every detail of those revisions in this post, but will provide a general overview of the major changes, and a more detailed analysis of how “reasonable compensation” and “guaranteed payments” could limit the potential tax reductions.
First, the overview:
- Individuals who receive “qualified business income” (QBI) may take up to a 20 percent below-the-line deduction on such income
- QBI includes business income from S corporations, LLCs, partnerships, or sole proprietorships
- If an individual taxpayer makes less than $157,500 in QBI in a year ($315,000 for joint filers) (together, the “threshold amounts”), and certain other conditions are satisfied, then they may take the full 20 percent deduction.
- The deduction is phased out between $157,500 and $207,500 for individual filers, and between $315,000 and $415,000 for joint filers.
- If a taxpayer makes more than those amounts, then the amount of the deduction is limited by the amount of W-2 wages the business pays, and/or the amount of property the business owns
- If the QBI is from a “specified trade or business,” which includes attorneys, physicians, accountants, consultants, athletes, and financial advisors, among others, the taxpayer is ineligible for the deduction, unless their income is less than the threshold amounts
- In addition, QBI excludes “reasonable compensation” paid to the taxpayer for services rendered to an S corporation and “guaranteed payments” paid to the taxpayer for services rendered to an LLC or partnership
For owners of S corporations, the concept of “reasonable compensation” is not a new one. IRS regulations and court cases for many years have made clear that S corporations must pay reasonable compensation to shareholders that provide services to the corporation, before those shareholders may receive non-wage distributions. Courts have developed a multi-factor test to determine whether such compensation is “reasonable,” including training, experience, payment history, comparable businesses, and wages paid to non-shareholder employees. Tax lawyers and accountants will be familiar with how to determine the amount of reasonable compensation that should be paid. For purposes of this article, the point is that “reasonable compensation” paid to shareholders of S corporations is not QBI and therefore does not qualify for the potential 20 percent deduction.
The “guaranteed payment” concept applies to LLCs and partnerships. Section 707(c) of the tax code defines guaranteed payments as, “to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital.” The key phrase is “to the extent determined without regard to the income of the partnership.” This is often the case with “junior,” “income,” or “nonequity” partners in service businesses. They are promoted to partner from employee, and may actually own a portion of the business, but their compensation is not determined or measured with reference to the overall earnings of the company.
While guaranteed payments are a code-defined concept, there is likely more flexibility for owners of LLCs or partnerships to qualify for the new deduction, at least in the short term. As a result, S corporation owners may consider converting to an LLC. And current LLCs and partnerships should restructure their operating agreements and ownership structure if necessary, to ensure that ownership percentages at least roughly match compensation. Doing so could avoid application of section 707(c). However, it is possible (and perhaps likely) that the IRS will implement regulations that require some level of base compensation to LLC and partnership owners who provide services to the business, similar to the “reasonable compensation” requirement that applies to S corporations.
Pass-through owners would be wise to monitor the IRS’s implementation of the tax bill in 2018, then confer with their tax and accounting professionals to consider some of these issues and maximize the deduction for pass-through income.