Changes to Flow-Thru Entity Taxation Made by the Tax Act
Rate Changes and Special Flow-Thru Entity Deduction
When the new tax bill was first proposed, many commentators were predicting that a flow-thru entity would no longer be a better tax structure than using a C corporation, and that many or even most flow-thru entities would convert to C corporation status after the new bill took effect. Now that the new law has been finalized, however, it does not appear that the predicted wholesale movement to convert flow-thru entities to C corporations will actually occur. Instead, for several reasons, a flow-thru structure will probably continue to be the best choice for most non-publicly traded businesses.
For example, regardless of the changes made under the Tax Act, most real estate businesses will want to continue to use a partnership or limited liability company structure, because of the ability to move properties in and out of those entities without any tax consequences, and in order to make the special allocations of profit and loss that are common in that industry but cannot be accomplished in a corporate structure. Likewise, any flow-thru business that is likely to be sold in the next few years will probably want to remain a flow-thru entity in order to take advantage of the single level of tax at capital gains rates upon such a sale.
Furthermore, the Tax Act itself includes significant changes designed to reduce the taxes paid by a business operating in a flow-thru form. First, the maximum individual tax rate (i.e., the maximum rate at which flow-thru entity profits are taxed) has been reduced, at least through the 2025 tax year, from 39.6 percent to 37 percent. In addition, the Tax Act provides for a special 20 percent deduction for profits of a business conducted in a flow-thru structure (including, for these purposes, a sole proprietorship).
In particular, for taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer generally may deduct 20% of “qualified business income” earned from a trade or business conducted in a flow-thru structure. Qualified business income is generally ordinary income from a trade or business conducted within the United States and does not include investment-related income, deductions or losses (e.g., capital gains, dividends and interest income). Qualified business income is reduced by reasonable compensation paid to the taxpayer for services rendered with respect to the trade or business, which raises the question of whether the IRS will try to impute a reasonable salary to a flow-thru business owner in order to reduce the effect of the deduction.
For taxpayers with taxable income above a threshold amount (described below), the deduction of 20% of qualified business income is limited for each business to an amount that does not exceed the greater of (a) 50% of the W-2 wages paid with respect to the qualified business, or (b) the sum of 25% of the W-2 wages paid with respect to the qualified business plus 2.5% of the unadjusted basis of all tangible property of a character subject to depreciation that is held by the qualified business at the close of the taxable year and which is used in the production of qualified business income. This unadjusted basis amount does not include property that has been held for a period greater than 10 years or the depreciable period of the property, whichever is longer.
The deduction of 20% of qualified business income is also limited in the case of a “specified service business.” For this purpose, a specified service business is one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management services, or 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. Notably, the term does not include engineering, architecture, or real estate businesses.
Neither the wage/asset limit nor the limitation on specified service businesses applies to taxpayers with taxable income below a threshold amount, and the deduction is then phased out ratably (in the case of a specified service business), or gradually becomes subject to the wage and asset limitation (for businesses that are not specified service businesses), to the extent the taxable income of the taxpayer exceeds the threshold amount. For 2018, the threshold amount is $157,500 for a single taxpayer and $315,000 in the case of a joint return, and is indexed for inflation for future years. The deduction is phased out completely (for a specified service business), and becomes subject to the full wage and asset limitation (for a business other than a specified service business) once taxable income exceeds the threshold amount by $50,000 in the case of a single taxpayer, or $100,000 in the case of a joint return.
To summarize, assuming a flow-thru entity can avoid the “specified business” and wage/asset limitations described above, the maximum tax rate on its profits will be approximately 29.6 percent (i.e., 80% times 37%). This represents a full 10 percent reduction from the current maximum tax rate on flow-thru business profits, which will continue to provide businesses with a strong incentive to operate in flow-thru entity form. As described below, however, other changes in the Tax Act will encourage a business to at least consider whether a C corporation might be a better form of entity to choose.
Limitation on the Use of Business Losses
Not all of the changes made to flow-thru entity taxation under the Tax Act are favorable. One significant benefit of using a flow-thru entity over a C corporation — the ability to offset flow-thru business losses against other non-business income of the taxpayer — will be strictly limited under the new law.
In particular, under the Tax Act, taxpayers will be permitted to use no more than $250,000 of flow-thru business losses from all flow-thru entities each year to offset their non-business income. Any business loss in excess of that limitation will be carried forward as a net operating loss (NOL), and will be subject to the new limitations on the deductibility of NOLs that are described further below. As a result of this new limitation, flow-thru entities have become a somewhat less favorable business structure than they were before the new law was enacted, at least for companies that generate significant losses.
Finally, it should be noted that C corporations will not be subject to these excess business loss limitations. Thus, a C corporation will be permitted to offset losses it realizes from business activities (including partnerships or limited liability companies in which the C corporation is an owner) against any non-business income it may have, including capital gains.
For more information on this topic, please contact:
Denver Mike Dubetz 303.299.8464 firstname.lastname@example.org
Denver Steven Miller 303.299.8144 email@example.com
Denver John Birkeland 303.299.8225 firstname.lastname@example.org
Aspen Joe Krabacher 970.300.0123 email@example.com
Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.
January 4, 2018