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Paul Zimmerman

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The Tax Cuts and Jobs Act: What Investors Need to Know

Once upon a time investors had fairly straightforward choices when it came to investing in business. There were C corporations, (“C Corps”) as well as S corporations (“S Corps”), limited liability companies (“LLCs”), partnerships and sole proprietorships. Of course, all of these business organizations still exist, but in the wake of the new Tax Cuts and Jobs Act (the “Act”), the decision as to which type of entity to use as an investment vehicle has become much more complex.

Taxation of Flow-Through Entities

Given that both C Corps and their shareholders are subject to taxation, small businesses lean toward S Corporations, LLC’s and partnerships (flow-through entities not subject to a “double tax”). Without question, there are a number of important operational differences between these different flow-through business structures, but up until 2018, income tax calculation on all three was rather clear-cut. Then came Section 199A of the Act.

Section 199A provides that owners of any one of these flow-through entities are entitled to take a deduction equal to 20% of the "qualified business income" (“QBI”) earned from the business. For the uninitiated, QBI can best be described as the ordinary, non-investment income of the business, less any business expenses – it excludes passive income like interest, dividends or capital gains.

Section 199A: A Closer Look

This is a bit more complicated than it seems, as Section 199A limits the 20% deduction to the lesser of:

  • 20% of QBI, or
  • 50% of the total W-2 wages paid by the business and allocated between the business owners, or
  • 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis, immediately after acquisition, of certain business assets (such assets are referred to as “Qualified Business Property” or “QBP”).[1]

Confused? Well, there is also this: Section 199A provides that if your “taxable income for the year” (e.g., your total income subject to tax and net of payments to 401(k) plans, IRAs and social security and other deductible expenses) is less than the "threshold amount" for the year ($315,000 if filing jointly and $157,500 for all other taxpayers in 2018), then you can simply ignore the two W-2- and QBP-based limitations.

Ready for more? Certain specified trades or businesses are excluded from the benefits of Section 199A altogether; specifically:

"any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, 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 owners or employees (excluding engineering and architecture), or any business that involves the performance of services that consist of investment and investment management, trading or dealing in securities, partnership interests or commodities."

Never fear, if your income is derived from one of the foregoing excluded businesses, you can still claim the 20% deduction, provided your taxable income is less than $315,000 for married filers filing jointly, or $157,500 for single filers. In fact, you can even get the deduction if your taxable income is up to $415,000 for married filers filing jointly, though the income between $315,000 and $415,000 is subject to a phaseout.

By virtue of Section 199A, taxpayers have much to think about when evaluating an investment into a flow-through entity. Which begs the question: might a C Corp be a more straightforward play? The Act is instructive.

Does a C Corp Mean Lower Tax Rates?

C Corps now benefit from a 21% flat tax rate versus individual income tax rates of up to 37%, plus a 3.8% Obamacare Medicare tax. Consequently, many tax pundits suggest that investors with pass-through entities will switch to C Corps to avail themselves of the lower corporate rate. However, that 21% tax may not be as appealing as it seems at first glance. That is because double taxation can wipeout any savings given that qualifying dividends are subject to a 20% tax plus the 3.8% Obamacare surcharge (a tax not applied to dividends from pass-through entities). Investors must also factor in state taxes on corporations and dividends, which are likely to be taxed at ordinary rates. The moral of this story: the headline rate of tax may be misleading. Yes, the devil is in the details.

Foreign Investment

The Act does give C Corps a clear advantage over flow-through entities in one specific situation – it shifts the US international corporate tax system closer to a territorial system by providing a participation exemption better referred to as a “dividend-received deduction.” This means that if a C Corp holds the requisite percentage of shares (the participation) in a foreign corporation, then any regular dividend the C Corp receives (not a deemed dividend) will be free of tax. This is so even if the foreign corporation is operating in a non-tax jurisdiction and therefore has paid no corporate income tax on the earnings and profits distributed to the C Corp. Of note, the required minimum participation by the C Corp in a foreign corporation is 10%, and the U.S. corporate shareholder must have owned his/her/its shares for at least 365 days. Also, foreign branch income is not eligible for the dividend-received deduction.

To be clear, when a C Corp pays out the foreign dividend-received as a U.S. dividend, the shareholder will be responsible to pay the qualifying dividend rate of 20% plus the 3.8% Medicare tax. Still, under the Act, the impact of the traditional (U.S. corporate) double taxation regime would generally be eliminated, which is why investors may now want to consider the use of a C Corp for foreign investment.

Net Operating Losses

Investors must also be mindful of the usefulness of net operating losses (NOLs). Currently, the Act limits the deduction against ordinary income for NOLs to 80% of taxable income for the tax year 2018 and beyond. Further, it eliminates the two-year carryback of NOLs that previously existed. The Act does not, however, limit the three-year capital loss carryback available to C Corps, though the 80% loss limitation would not seem to apply to C Corps. What is more, the 20-year carryforward life of NOLs is extended so that NOLs for all businesses carryforward indefinitely. This would seem to give a C Corp a clear advantage as an investment vehicle if the investment is going to generate losses for a number of years. Still, it is important to remember that since a C Corp will deduct its NOLs against taxable income, and from 2018 the tax rate on the C Corp income is reduced from 39.6% to 21%, the NOL’s are going to take much longer to be fully deducted.

The Takeaway

All of the foregoing leads to one simple conclusion: the Act has certainly muddied the waters when it comes to decisions on how to structure an investment or business for tax purposes. Such decisions now require professional advice – advice that will be very fact-dependent. No doubt, failure to heed it may prove to be pennywise, but pound foolish.

This blog post is not offered as, and should not be relied on as, legal advice. You should consult an attorney for advice in specific situations.

[1]“Qualified Business Property” is generally all depreciable property owned by the business.