Although lawmakers attempted to level the playing field between the new 21 percent tax rate for incorporated snow removal and ice management businesses and the tax bills of owners of pass-through businesses, confusion is the name of the game. Despite a 20 percent deduction from income passed through from entities such as S corporations, Limited Liability Companies (LLCs) and partnerships, owners of businesses operating a pass-through entity may face higher tax bills than incorporated businesses.
Pass-through owners could, in fact, face personal tax rates as high as 29.6 percent — far above the new 21 percent corporate tax rate created as part of in last December’s Tax Cuts and Jobs Act (TCJA).
An incorporated business electing to operate as an S corporation or a snow fighter choosing another form of pass-through entity, has income taxed only once, on the owner’s personal tax bill. By electing to operate as a pass-through entity, owners also benefit from the legal advantages of a corporate structure as well as the tax advantages available to a sole proprietorship.
The most attractive feature of pass-through businesses was, obviously, the tax savings for both the snow removal business and its owners. 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 business, or sells his or her shares, the S corporation can continue doing business relatively undisturbed. Similar rules also apply to partnerships. Maintaining the business as a distinct, separate entity creates clear lines between the shareholders and the business that improve liability protection for the shareholders.
A Limited Liability Company (LLC), on the other hand, is an entity that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with business owners in partnerships or sole proprietors, LLC “members” report business profits or losses on their personal income tax returns; the LLC itself is not a separate taxable entity.
As mentioned, the tax rate for a regular, incorporated business has been lowered to 21 percent. And, the special tax rate for so-called “Personal Service Corporations,” those unique entities that were dependent on the personal services of their owner, has been eliminated.
An unintended consequence of the lowered tax rate for regular corporations is that a majority of businesses currently operating as pass-through business entities will pay more in taxes by remaining as a pass-through than they would by revoking the S corporation election or switching from pass-through to regular corporate form.
An important factor in the pass-through entity/regular corporate form debate has long been fringe benefits. A more than 2 percent shareholder in an S corporation cannot participate in the operation’s fringe benefits. Health insurance, for example, is not deductible with an S corporation, but it is to a regular ‘C’ corporation.
Of course, a snow removal contractor or other business owner doesn’t have to spend a lot of money on health insurance. There are always Health Reimbursement Accounts (HRAs), allowing unlimited contributions that, if unused, can be rolled over to the next year. It’s a similar story with other fringe benefits with work-arounds available. So, why does the TCJA seemingly require switching entities?
TCIA Pass-Through Business
The TCJA created a 20 percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by businesses operating as S corporations, partnerships, LLCs and sole proprietorships. All businesses under the income thresholds, regardless of whether they’re “service” professionals or not, can take advantage of the 20 percent deduction.
The TCJA does, however, place 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 for 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 the owner. That so-called “reasonable” compensation has not been defined by our lawmakers as yet.
On the downside, those companies operating as a pass-through snow removal or ice management business lose things such as fringe benefits, plus being required to pay themselves “reasonable” compensation and deal with other restrictions. And, then, there is the elimination of a number of itemized, personal deductions at $10,000 of their property taxes. A regular ‘C’ corporation faces no similar deduction restrictions.
When to opt out
A snow removal operation can, of course, choose to revoke its so-called “subchapter S” election by March 15 to have it apply for the whole calendar year. If the owner decides mid-year it is no longer advantageous to be a S corporation, the election can be made at that point and become effective from that point on. A snow fighter choosing to terminate his or her operation’s S corporation status can’t, of course, reapply for S corporation status for five years.
The question of whether to switch entities can be especially difficult for closely-held and family businesses that are often structured as pass-throughs. In the eyes of many experts, there is no longer a reason to operate a business as an S corporation or other pass-through entity.
Some experts are advising the owners of S corporations and other pass-through businesses to sit tight and remain patient as remedial legislation may be coming. And, remember, converting from a pass-through entity to a regular ‘C’ corporation can be a complicated process.
Pass-through owners considering moving to a corporate entity should be aware of the dreaded “accumulated earnings tax,” a 20 percent tax on businesses holding onto too much cash and the personal holding company tax, another 20 percent penalty on undistributed passive income earned by a closely-held, regular incorporated business.
There is also the matter of how much of the snow removal and ice management operation’s earnings will be distributed to shareholders. While corporations will pay a 21 percent income tax rate, pass-through business owners will, as mentioned, pay as much as 29.6 percent depending on their tax bracket and the type of income.
Corporate distributions will also be taxed. Thus, if a ‘C’ corporation’s profits are going to be distributed as dividends, the tax rate will likely be higher as a pass-through. Naturally, distribution policies vary widely, especially among family businesses, requiring consideration of whether there are famuly members who are accustomed to getting distributions every year, or if there are trusts that have distribution requirements.
The annual tax return provides an opportunity to re-consider the options available. Entities with more than one shareholder or member can elect corporate status on their 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 corporations and may not elect to be treated as any other type of entity.
Determining who will benefit and who will face a higher tax bill under the new rules for pass-through income is difficult because there doesn’t appear to be a cohesive policy. Guidance is needed to define specific “service” trades or businesses because, under the new law, a service business isn’t eligible for the tax break.
Lawmakers plucked the definition for a “service business” from elsewhere in the tax law, defining them as those “where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” Unfortunately, when naming those that don’t qualify, only some were identified.
Guidance is also needed when making the accounting method changes necessary to comply with the new law. Such guidance is expected to be forthcoming soon, according to the Treasury Department and the IRS.