If you watched President Trump’s State of the Union address last night, someone not following the issue of the tax reform passed by Congress just last month would naturally conclude that all businesses big and small were given a big tax cut that is translating into more employees, higher worker wages and or bonuses.
The reality is that small businesses (LLCs, S-Corps and sole proprietors) who receive profit from their businesses in the form of pass-through income were not treated the same as C-Corporations. What the latter received in the tax reform was simplicity, an enormous tax cut and permanency. What small businesses received was confusion, qualifications and temporary relief.
Read the below analysis prepared by Foxboro Consulting Group, Inc. and ask yourself if small businesses even know what their tax relief will be or if they even qualify for any tax relief.
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Corporate Tax Rates Lowered
The Act permanently reduces the corporate tax rate to a flat 21.0% beginning in 2018. When combined with the maximum 20% tax rate on qualified dividends paid by a C corporation to an individual shareholder, the effective tax rate on income of a C corporation distributed to its shareholders will be 36.8% (or 39.8% after the 3.8% Medicare tax on dividends).
Up to 20% Deduction for Qualified Business Income of Pass-Through Entities
Beginning in 2018, the Act provides for up to a 20% deduction for individuals for qualified business income earned through pass-through entities, such as partnerships and limited liability companies taxed as partnerships, S corporations, disregarded entities and trusts. This deduction (when combined with the reduction in individual income tax rates) theoretically would result in an effective maximum marginal tax rate of 29.6% (plus unearned income Medicare tax, where applicable), for taxpayers entitled to the full 20% deduction. However, the deduction is subject to several limitations that are likely to materially limit the deduction for many taxpayers. These limitations include the following:
- Qualified business income does not include IRC Section 707(c) guaranteed payments for services, amounts paid by S corporations that are treated as reasonable compensation of the taxpayer, or, to the extent provided in regulations, amounts paid or incurred for services by a partnership to a partner who is acting other than in his or her capacity as a partner.
- Qualified business income does not include income involving the performance of services (i) in the fields of, among others, health, law, accounting consulting, financial services, brokerage 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, or (ii) consisting of investing or investment management, trading, or dealing in securities, partnership interests or commodities.
- Qualified business income includes (and, thus, the deduction is applicable to) only income that is effectively connected with the conduct of a trade or business within the United States.
- The deduction is limited to 100% of the taxpayer’s combined qualified business income (e.g., if the taxpayer has losses from certain qualified businesses that, in the aggregate, exceed the income generated from other qualified businesses, the taxpayer’s deduction would be $0).
- The deduction is limited to the greater of (i) 50% of the W-2 wages paid with respect to the trade or business or (ii) the sum of 25% of the W-2 wages paid with respect to the trade or business and 2.5% of the un-adjusted basis, immediately after acquisition, of all depreciable property used in the qualified trade or business.
This last limitation does not apply to income earned through publicly-traded partnerships or to taxpayers whose taxable income does not exceed $315,000 (in the case of taxpayers filing a joint return) or $157,500 otherwise. The last limitation may particularly impact real estate private equity funds and real estate ventures that do not have their own employees but, instead, rely on services performed by employees of general partners or managing members or affiliated management companies.
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