Changes in Pass-Through Income Tax: How Do They Effect You?

LLC LLP S C Corp New Business Signs Choices 3d IllustrationPass-through business entities, garden pond professionals operating as partnerships, limited liability companies (LLCs), S corporations and sole proprietorships have long been extremely popular. In fact, one form of pass-through business entity, the S corporation, is currently the most used business entity. LLCs are also frequently chosen for pass-through income purposes.

Unfortunately, thanks to the recently enacted reforms under December’s Tax Cuts and Jobs Act (TCJA), the owners of many small businesses operating as pass-through entities will face personal tax rates as high as 29.6 percent — far above the new 21-percent corporate tax rate. There’s little wonder that many have begun considering switching to the basic C corporation for their pond operations.

Passing Through Businesses

In addition to profits being taxed only once — not at the business level, but rather only when passing through the owner’s tax returns — many pond professionals choose to operate as so-called pass-through business entities because of the protection from personal liability.

As mentioned, under the just-passed TCJA, the tax rate for incorporated businesses will be reduced from 35 percent to 21 percent for the 2018 tax year and thereafter. Unlike the TCJA’s temporary provisions for individuals that largely expire in 2026, the business tax cuts are, for the most part, permanent.

S Corporations vs. LLCs

If you have an incorporated business electing to operate as an S corporation, or if you are a pond professional who has chosen another form of pass-through entity, your business income is taxed only once, similar to the manner in which a sole proprietor is taxed. By electing to operate as a pass-through entity, a pond professional can benefit from the legal advantages available to businesses with a corporate structure, as well as the tax advantages available to a sole proprietorship.

One of the best features of a pass-through entity like an S corporation is the tax savings for both the pond business and its shareholders. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S corporation shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a distribution, which is taxed at a lower rate, if at all.

An S corporation designation allows a business to have an independent life separate from its shareholders. If a shareholder leaves the pond business or sells his or her shares, the S corporation can continue doing business relatively undisturbed. Similar rules now also apply to partnerships. Maintaining the business as a distinct, separate entity defines clear lines between the shareholders and the business, which improves liability protection for the shareholders.

An LLC, on the other hand, is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with pond business owners in partnerships and sole proprietorships, LLC members report business profits and losses on their personal income tax returns, as the LLC itself is not a separate taxable entity.

Other Partnership Taxes

As a general rule, the losses from a pass-through entity cannot be claimed by the shareholder or partner if they are in excess of the amount they have invested — or their “basis.” And, not too surprisingly, there are several tax issues that pass-through businesses must consider.

Partners, for example, are considered to be self-employed, not employees of the business. They are required to file a Schedule SE with their Form 1040 and pay self-employment taxes. Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare.

Partners are responsible for paying double what a normal employee would pay, because employers normally match employees’ contributions. Of course, the partners’ tax burden is reduced by an allowance for one-half of the self-employment tax, which can be deducted from taxable income.

While pass-through entities are generally not subject to federal income tax, they may be liable for and required to make estimated tax payments based on entity-level taxes, such as gain built in from an entity change, so-called “BIG” taxes, LIFO recapture, a tax on passive income, voluntary and involuntary terminations and a tax on earnings accumulated rather than paid out.

A Closer Look at the TCJA

The TCJA created a 20-percent deduction that applies to the first $315,000 of income (or half of this for single taxpayers) earned by pond retailers, distributors and builders operating as S corporations, partnerships, LLCs and sole proprietorships. All businesses under the income thresholds, regardless of whether they are service professionals or not, can take advantage of the 20-percent deduction.

However, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income. For pass-through income above the threshold, the new law also provides a deduction up to 20 percent — but only for “business profits.”

In other words, that 20-percent deduction from pass-through income applies only to business income that has been reduced by the amount of reasonable compensation paid to the owner. As of May 2018, this so-called “reasonable” compensation has not yet been defined by our lawmakers.

On the downside, those operating as pass-through pond businesses lose things like fringe benefits. They are also required to pay themselves “reasonable” compensation and deal with other restrictions. There’s also the elimination of a number of itemized personal deductions.

Currently, the vast majority of pass-through business owners can no longer deduct state and local income taxes and are permitted to write off only $10,000 of their property taxes. A regular C corporation faces no similar deduction restrictions.

Switching to Corporate Form

In the eyes of many experts, there is no longer a reason to operate a pond business as an S corporation or other pass-through entity. However, converting from a pass-through entity to a regular C corporation can be a complicated process, requiring quite a few adjustments.

Going the other way, a sale of assets by an S corporation that was formerly a C corporation during the “recognition period” is subject to the already mentioned BIG or built-in-gains tax. The BIG tax is imposed on the incorporated business at the highest corporate tax rate, based on the appreciation in asset value that existed on the date the corporation became an S corporation. The shareholders may then be subject to a second tax on the distribution of the sale proceeds.

This “double tax” created by the imposition of the built-in gain rules can be eliminated if the corporation holds and sells assets only after the 10-year recognition period has expired. Naturally, the longer the recognition period, the tougher it is to do.

Under the former rules, distributions made by a S corporation converting to a regular C corporation during the post-termination transition period (PTTP) can be tax-free to the shareholders. Distributed funds from those accumulated adjustment accounts can also reduce the adjusted basis of the stock.

Under the new TCJA rules, the adjustment of a terminated S corporation (even if it’s only changing accounting methods) is taken into account ratably during a six-year period, beginning with the year of change.

Decisions, Decisions

The annual tax return provides an opportunity to reconsider the options available to some pond retailers, distributors and builders. Entities with more than one shareholder or member can elect corporate status on its annual tax returns. Thus, an entity that is a partnership under state laws may elect to be taxed as a C corporation or S corporation for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified as corporations and may not elect to be treated as any other type of entity.

Changing Business Entities

Changing circumstances, revisions of the tax laws and even the success of a business might prompt a reassessment of the entity used for a pond business. And best of all, the annual tax return is not the only option when selecting the entity that makes the most economic sense.

Although many of the tax law’s provisions apply to all business entities, some areas of the law specifically target each entity. Choosing among the various entities can result in significant differences in federal income-tax treatment, but there is also more to consider when choosing the right structure for a pond business than just the taxes.

Not only will the decision to change a pond business’ entity classification have an impact on how much is paid in taxes, but it will also affect the amount of paperwork required for the business, the personal liability faced by the principals and the operation’s ability to raise money, which is especially important in today’s economy.

To switch or not to switch? If earlier tax law changes are any indication, the IRS should issue guidelines to help entities switch without a penalty. Since every situation is different, the best approach might be to choose the entity for your pond-building, retail or distribution operation based on the current tax law. To help in this decision-making process, seeking professional advice is strongly recommended.

With 25 years of professional experience in taxes and finance, Mark Battersby writes on unique and topical subjects in the industry. Although no reputable professional should ever render specific advice at arm’s length, he does craft unbiased, interesting, informative and accurate articles. Mr. Battersby currently writes for publications in a variety of fields. His topical columns are syndicated in many publications each week. He also writes columns for trade magazines and has authored four books.

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