New tax legislation signed into law by President Trump and Congressional Republicans provides a $1.5 trillion tax cut that favors wealthy Americans and large businesses. It is also so complex that accountants, tax lawyers and tax planners will be busy for years finding ways to benefit their clients.
While the Internal Revenue Service must still issue guidance interpreting the new law, tax pros are busily working to create strategies that will both save clients’ cash and hold up to legal scrutiny. Some pass-through business owners will be coached to minimize their tax bills by grouping together diverse businesses, whereas others may be instructed to split off pieces of their businesses.
One thing is clear: there will be those who attempt to push the envelope.
What is a Pass-Through Business?
A pass-through is a business that does not pay corporate income tax, such as sole proprietorships, partnerships, limited liability companies and S-corporations. Approximately ninety five percent of U.S. businesses are categorized as pass-throughs. Profits are “passed through” to the business owners who report their income on individual tax returns and pay tax on that portion of income along with the remainder of their normal income.
Specifically, the new provision allows owners of pass-through to deduct 20 percent of their pass-through income up to a maximum amount. The deduction does not apply to certain professional businesses like lawyers and accountants. This topic is hotly debated, given that fourteen Republican senators hold financial interests in qualifying real-estate partnerships to the tune of $105M in value. President Trump also owns or directs more than 500 companies, the majority of which are LLCs or LPs. They all stand to benefit from this new tax law.
How Does the Pass-Through Loophole Help Businesses?
Taxpayers owning pass-through businesses and earning less than $157,500 (or $315,000 for a married couple) can deduct twenty percent of income from their overall taxable income. If income is higher and the taxpayer is not a service professional (such as a lawyer or accountant), he or she must qualify to take the full deduction which is dependent on the amount paid in employee wages or invested in capital like real estate. For service professionals, the tax break fully phases out if the single taxpayer earns more than $207,500 ($415,000 for married couples).
The rules, however, are somewhat ambiguous. For example, which factors qualify a company as a service business? The tax code officially specifies businesses such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services, but the language is broad and lacks IRS guidance. To complicate matters, the meaning of some statements within the new law are baffling. For example, “any trade or business” where the “principal asset” is the “reputation or skill” of its employees or owners is excluded. Ask ten professionals about the meaning, and you would hear ten differing opinions.
Types of Strategies Qualifying for the Tax Break
Elements of the law that confuse the typical taxpayer, however, are precisely the elements spelling opportunity for tax professional, who are scrambling to build services around the new law and to recast businesses outside the parameters of excluded categories.
One strategy is to combine diverse businesses into a single entity. How would this work? Let’s use the example of an accountant. This person may also invest in real estate or hotel management or may specialize in commercial properties. Depending on how regulations are written by the IRS, it might make sense to put everything in one company. Instead of categorizing the business as “accounting”, which would not qualify for the pass-through break, the business can be recast as a real estate venture, potentially qualifying because of large capital investments.
Another example is the physician’s office whose employees also perform debt collection or administrative support. These divisions could be classified a “management firm”, potentially qualifying for the tax break.
Alternatively, the service professional might consider purchasing real estate. One company considered purchasing an office condominium through a newly created entity and leasing it back to the company, qualifying for the twenty percent deduction. When using this type of strategy, keep in mind that the IRS enforces rules regarding transactions with yourself, and you must use market prices.
Tax lawyers can be quite creative when developing paths around the new tax law. To overcome the professional services restriction, a service business might create an employee leasing entity which profits from charging a markup. For example, rather than paying attorney salaries at $175,000, a law firm might create a leasing entity that marks up those salaries to $225,000, shifting profits to the leasing entity. Although the lawyers continue to perform the same work, their “new” employer would qualify for the twenty percent deduction as an employee leasing firm.
Not all tax planning strategies must be creative under this new law. A married physician earning $500,000 might consider maximizing her contributions to retirement plans and a health savings account, and strategically donating to charities through a donor-advised fund as a means of lowering her taxable income below the threshold.
Converting from an LLC to a C-corporation, which now provides for a twenty-one percent rate under the new tax law, may be a useful strategy. Keep in mind, however, that corporate profits are taxed twice – once by the corporation, then again by the individual receiving dividends.
Of course, many of these strategies are theoretical. Some loopholes may be closed by stricter IRS regulations, compelling tax planners to invent riskier strategies to circumvent the rules. An aggressive tactic would be a legal fight with the IRS…unless you’re outright lying about your business, you won’t go to jail due to your creativity.
Can the IRS Keep Up with These Changes?
Adjusting for inflation, the Taxpayer Advocate Service approximates a twenty percent cut to the IRS budget since 2010. The estimated cost of the pass-through deduction will reach $415 billion over the next ten years and could become even more expensive if IRS regulations fail to minimize gamesmanship.
Certainly, one must proceed cautiously when developing creative tax strategies. Tax planners are incentivized to bend rules, yet they are excluded from benefitting from the new law. That has to hurt, and so we can expect to hear of many examples of creative tax strategies in the coming months.
If you are in need of tax law help, contact a law firm in your area.