Tax Reform, Pass-Throughs and Retirement: What Does It All Mean?
The recently enacted tax reform legislation has prompted a great deal of focus on the impact to pass-through entities. And for good reason: the pass-through provision affects many types of entities from a tax perspective, and may also have an impact on retirement plans. While the provision of the new tax law is quite complicated, below is a simplified overview of what it means for these organizations.
Basic Definition of a Pass-Through Entity
Simply put, a pass-through is a form of business entity that is not taxed at the corporate rate. Instead, income is “passed through” the company to the individual, and generally taxed at the individual rate. Examples of pass-through business entities are sole proprietorships, partnerships, S-Corporations, and limited liability companies (LLCs).
The Impact of Tax Reform
Tax reform lowered the corporate tax rate from 35% to 21%. Normally, this would have been bad news for pass-through entities, since they are taxed at the individual rate (rather than the corporate), which is as high as 37%, making the pass-through structure less attractive from a tax perspective. However, tax reform also amended the Tax Code so that certain pass-through entities, such as non-professional partnerships, S-Corporations, and sole proprietorships, benefit from a 20% tax deduction on their net business income. This causes the income of their business to be taxed at a lower rate than the individual tax rate, although not as low as the new corporate tax rate.
However, some pass-though entities do not fully benefit, or do not benefit at all, from the 20% deduction. These include:
- Specified Service Business — Most businesses that provide personal services, such as law firms, accounting firms and physicians practices, are subject to a phase-out of the deduction, starting at income levels of $157,500 for single filers and $315,000 for joint filers. The deduction gradually decreases until it is phased out completely at income levels of $207,500 for single filers and $415,000 for joint filers. If income exceeds these latter amounts, there is no deduction at all. The only exceptions to the phase-out are for engineering and architectural firms.
- Non-Specified Service Business — For those non-specified businesses who exceed the higher income thresholds described above ($207,500 for single filers, $415,000 for joint), the deduction is limited to the greater of 50% of W-2 wages, or the sum of 25% of W-2 wages and 2.5% of the unadjusted basis of all qualified business property (i.e., depreciable property available for business use). The latter provision is a concession to real estate firms, since qualified property would potentially increase the deduction for these firms. Note that for entities whose income is greater than the $157,500 single or $315,000 joint limit, but less than the $207,500 single or $415,000 joint limits, the deduction is calculated according to a formula that will result in a deduction somewhere between 20% of income and the wage limit.
To summarize, businesses that make a lot of money (above the thresholds listed above) may have their deduction reduced or potentially eliminated. Businesses that make less will receive the full deduction. If a business loses money, it may not receive a refund, since the deduction may not exceed the taxable income for the year. However, the business can carry the loss forward to the following year to reduce taxable income in the future.
Potential Retirement Plan Impact
While the 20% deduction is generally a good thing for the small businesses that qualify, a presumably unintended consequence is that it provides these business owners with less incentive to shelter income in vehicles such as qualified retirement plans. The reason being that the owner would be deferring income that would be taxed at a lower rate to a time period when it would presumably be taxed at a higher rate (since retirement plan distributions are not income that is eligible for the pass-through deduction).
Although there are many other reasons for small businesses to establish retirement plans (such as to attract and retain employees), removing some of the direct tax incentive for business owners to establish these plans may result in fewer retirement plans being established, which would not be a good thing for affected employees.
Higher income pass-through businesses are unlikely to benefit from tax reform and will remain taxed at individual tax rates (business expenses remain deductible, as only the 20% deduction on income is affected). For small businesses with income in the low six-figures (or lower), the pass-through deduction provides a welcome tax relief, although not as much as if they were organized as a C-Corporation. While these entities’ owners may benefit from tax reform, they may also find that establishing and maintaining retirement plans is not as attractive, from a tax-perspective, as it was prior to the new legislation.
Please note that this is a simplified version of the impact of tax reform on pass-through entities. The provision of the new law is quite confusing, and errors in its interpretation are likely until there is regulatory guidance to provide clarity. Pass-through entities should contact their tax professional for advice on their specific situation.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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