Spotlight on Pass-Through Entities under the Tax Cuts and Jobs Act

Copyright 2018

Will pass-through entities still be popular under the Tax Cuts and Jobs Act (TCJA)?  The tax rules for pass-through entities, including S corporations, limited  liability companies (LLCs), partnerships and sole proprietorships, have  generally become more beneficial — but also more confusing under the new law.

So  which type of entity is best for your business? The answers depend on several  factors, which are explained in this article.

New Deduction for Pass-Through  Business Income

Under  prior law, net taxable income from so-called pass-through business entities  (meaning sole proprietorships, partnerships, LLCs that are treated as sole  proprietorships or as partnerships for tax purposes, and S corporations) was simply  passed through to owners and taxed at the owner level at standard rates.

For  tax years beginning after 2017, the TCJA establishes a new deduction based on a  noncorporate owner's qualified business income (QBI). This break is available  to eligible individuals, estates and trusts. The deduction generally equals 20%  of QBI, subject to restrictions that can apply at higher income levels. The QBI  deduction isn't allowed in calculating the noncorporate owner's adjusted gross  income (AGI), but it reduces taxable income. In effect, it is treated the same  as an allowable itemized deduction.

This  break is subject to the following restrictions:

W-2 Wage Limitation. The QBI deduction generally can't exceed the greater of the noncorporate  owner's share of: 1) 50% of the amount of W-2 wages paid to employees by the  qualified business during the tax year, or 2) the sum of 25% of W-2 wages plus  2.5% of the cost of qualified property. Qualified property means depreciable  tangible property (including real estate) owned by a qualified business as of  the tax year end and used by the business at any point during the tax year for  the production of qualified business income. In addition, the QBI deduction can't  exceed 20% of the taxpayer's taxable income exclusive of net long term capital gains and  qualified dividends.

Under  an exception, the W-2 wage limitation doesn't apply until an individual owner's  taxable income exceeds $157,500, or $315,000 for a married joint filer. Above  those income levels, the W-2 wage limitation is phased in over a $50,000  phase-in range or a $100,000 range for married joint filers.

Service Business Limitation. The QBI deduction is generally not available for income  from specified service businesses, such as most professional practices. Under  an exception, the service business limitation does apply until an individual  owner's taxable income exceeds $157,500, or $315,000 for a married joint filer.  Above those income levels, the W-2 wage limitation is phased in over a $50,000  phase-in range or a $100,000 range for married joint filers.

Important note: The W-2 wage limitation and the service business limitation  don't apply as long as taxable income is under the applicable threshold. In  that case, you should qualify for the full 20% QBI deduction.    

New Rule on Distributions after Converting  from S to C Corp Status

In  general, distributions by a C corporation to its shareholders are treated as  taxable dividends to the extent of the corporation's earnings and profits  (E&P). However, a special "posttermination transition period" rule  provides relief to shareholders of a corporation that changes from S  corporation status to C corporation status.

During  this period, any distribution of money by the corporation to its shareholders  is first applied to reduce the basis of the shareholder's stock to the extent  the distribution doesn't exceed the accumulated adjustments account (AAA)  balance that was generated during the company's life as an S corporation. Such  distributions of AAA amounts are tax-free to recipient shareholders.

The  TCJA modifies the posttermination transition period relief rule for C  corporations that:

  • Operated as S corporations before December 22, 2017,
  • Revoke their S corporation status during the two-year period  beginning on that date, and
  • Have the same owners on December 22, 2017, and the revocation  date.

Distributions  from such corporations are treated as paid pro-rata from AAA and E&P. This  can result in more of a distribution being treated as a taxable dividend and  less being treated as a tax-free distribution of AAA. This change is intended  to discourage the tax planning strategy of converting S corporations to C  corporation status in order to take advantage of the new flat 21% federal  income tax rate on C corporation income.

New Rule for ESBT Beneficiaries

As  a general rule, trusts cannot be S corporation shareholders. However, an  exception allows electing small business trusts (ESBTs) to be S corporation  shareholders. Under prior law, an ESBT couldn't have a current beneficiary who was  a nonresident alien individual.

Thanks  to a change included in the new law, such individuals can now be ESBT  beneficiaries. This change is effective for 2018 and beyond.

"Technical Termination Rule"  Repealed for Partnerships and LLCs

Under  prior law, a partnership (or an LLC that's treated as a partnership for tax  purposes) is considered to terminate for tax purposes if, within a 12-month  period, there's a sale or exchange of 50% or more of the entity's capital and  profits interests. This so-called "technical termination rule" is generally  unfavorable.

Why?  First, the rule can require the filing of two short-period tax returns for the tax  year in which the technical termination occurs. It also restarts depreciation  periods for the entity's depreciable assets. In addition, it terminates  favorable tax elections that were made by the entity.

The  TCJA repeals the technical termination rule for tax years beginning in 2018 and  beyond.

Substantial Built-in Loss Rule  Expanded

In  general, a partnership (or an LLC that's treated as a partnership for tax  purposes) must reduce the tax basis of its assets upon the transfer of an  ownership interest if the entity has a substantial built-in loss. (A built-in  loss happens when the fair market value of the assets is less than their tax  basis.)

This  rule is unfavorable, because the basis reduction can result in lower  depreciation and amortization deductions. Under prior law, a substantial built-in loss exists if the entity's  adjusted basis in its assets exceeds their fair market value by more than  $250,000.

Under  the TCJA, a substantial built-in loss also exists if, immediately after the  transfer of an interest, the recipient of the transferred interest would be  allocated a net loss in excess of $250,000 upon a hypothetical taxable sale of  all of the entity's assets for proceeds equal to fair market value. This  unfavorable expansion of the built-in loss rule applies to ownership interest transfers  in 2018 and beyond.

Loss Limitation Reductions for  Charitable Donations and Foreign Taxes

Under  a loss limitation rule, a partner (or an LLC member that's treated as a partner  for tax purposes) can't deduct losses in excess of the tax basis in the  partnership or LLC interest.

The  new law changes the rules for charitable gifts and foreign taxes. For tax years  beginning after December 31, 2017, an owner's share of a partnership's (or LLC's)  deductible charitable donations and paid or accrued foreign taxes reduces the owner's  basis in the interest for purposes of applying the loss limitation rule. This  change can reduce the amount of losses that can be currently deducted.

However,  for charitable donations of appreciated property (where the fair market value  is higher than the tax basis), the owner's basis isn't reduced by the excess amount  for purposes of applying the loss limitation rule. In other words, the owner's  tax basis in the interest is reduced only by the owner's share of the basis of  the donated appreciated property for purposes of applying the loss limitation  rule.

Get Professional Help

As you can see, the tax landscape for various business  entities has changed considerably under the new tax law. The type of entity  that's best for you depends on the industry you're in, your income and many  other factors. Consult with your tax advisor and attorney to determine the most  tax-wise way to proceed.