The Tax Cuts and Jobs Act made over 100 changes to the federal tax rules when it was enacted on December 20, 2017. The most significant change was the creation of an income tax deduction for nearly all businesses that both operate in the United States and that employ workers and/or place in service significant depreciable assets. A deduction is available to all taxpayers, other than C-corporations, equal to 20 percent of the qualified business income of a trade or business for tax years 2018 through 2025. This 20 percent deduction has the effect of lowering the taxpayer’s effective tax rate attributable to the qualifying business from 37 percent to 29.6 percent.
Like many changes in the tax law, this new incentive did not come without complexity, as there were many questions regarding who would qualify and how to calculate the deduction.
“The IRS did a commendable job on publishing the final rules in the early part of 2019 to provide much needed clarity,” says Carlo R. Ferri, director, Tax Strategies, at Kreischer Miller. “Although this addressed many of the questions that existed at the time, there still are a number of open issues that need further guidance.”
Smart Business spoke with Ferri about some of the more common issues and where guidance on those issues stands today.
What businesses qualify for the deduction?
Companies that mainly focus on manufacturing and distribution of their product within the United States that have employees and/or have significant fixed assets generally will qualify for the 20 percent deduction. Companies that generate revenue by providing a service generally will not qualify for the deduction.
The final rules provide comprehensive examples of which service businesses will not qualify with a narrower definition to give more clarity in this area.
This sounds very straight-forward until you start having conversations with real taxpayers with real facts. Their facts become quite messy because they may operate multiple trades or businesses, which can make applying the new rules to determine if they qualify very complex.
Does rental real estate qualify for the deduction?
Determining if rental real estate qualifies for the deduction is still challenging. If you own real estate that rents to your business, then the final rules clearly allow you to take the 20 percent deduction. However, if you own rental properties outside of the context of your business, then the rules are not very kind. The final guidance released by the IRS provided a safe-harbor for taxpayers to follow in determining if the rental property qualifies, but this analysis is quite complex, which often results in many taxpayers being unable to qualify. The taxpayer’s only alternative is reviewing the inconsistent tax case law in this area to make a determination for inclusion.
Does switching to a C-corporation now bring any advantages?
With the lowering of the corporate tax rates to 21 percent, many taxpayers have inquired if it would be best to convert their S-corporation or Partnership business to a C-corporation to save on income taxes. After going through the analysis for many companies, it became quite clear that if these companies were going to fully benefit under the 20 percent pass-through deductions, there would have been a significant reducing effect on the overall individual effective tax rate, and that lowering of the tax rate would make conversion to a C-corporation less advantageous. Also, it became quite clear that many business owners desired the tax efficiency and flexibility to take profits out of an S-corporation or Partnership compared to the double-taxation in a C-corporation. Therefore, business owners concluded it’s better not convert to a C-corporation.
Much progress has been made by the IRS and the business community on addressing the major issues and questions that existed in determining the new 20 percent deduction. Even though the final rules have been published by the IRS, there are still many open questions that have not been addressed and are left to taxpayers to make a reasonable interpretation of the rules.
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