How are taxes on business income calculated under tax reform?

Dominique Molina

December 20, 2017

How are taxes on business income calculated under tax reform? By Dominique Molina

As of the time of this writing, the House has just passed its recently approved conference version of tax reform and the Senate is scheduled to vote within days.  The latest version of the bill leaves more questions than answers, particularly in the area surrounding pass-through business deductions.

On December 15, 2017 many Americans were surprised to learn the agreed upon method of applying a lower tax rate to business  income includes a flat tax method on C Corporation income, while a deduction method is used for all LLCs, Partnerships, S corporations, and Sole Proprietorships.  Although the Senate had passed a similar version of a deduction method in implementing tax reduction for pass-through businesses, the new version of the bill includes several new departures from the Senate’s proposal leaving many practitioners confused about the new formulas and how to calculate the applicable deduction.

For C corporations, the Republicans in House and Senate agreed upon a flat tax rate of 21% for corporations, this was slightly higher than the expected rate of 20%, and much higher than the plan released by Trump of 15%.  Also a surprise, a change of heart related to personal service corporations.  Originally thought to be taxed at the highest current corporate rates, Senators and Representatives instead opted for a flat tax of 25%, which is still a significant savings over current tax rates for PSCs.

Pass-through entities, however, are not so easy to calculate.  Ordinarily taxed at the individual level after separately stated items are “passed-through” via Forms K-1, current pass-through income can be taxed as high as 39.6%, the current highest tax rate.

The provision in the latest version of the bill provides for a deduction in the amount of 20% of certain pass-through company income.  However, the provision calls for a phase in of a wage and capital limitation for taxpayers with taxable income over a threshold of $157,500 for individuals and $315,000 for joint filers. 

In order to apply the wage and capital limitation for taxpayers earning over the threshold, it is first necessary to calculate 20% of the qualified net business income.  Each trade or business activity income is calculated separately.  Next, the taxpayer selects the higher of one of two factors.  Factor one equals 50% of wages paid and deducted through the company.  Factor two consists of the sum  of 25% of company wages and 2.5% of qualified unadjusted property.  Once the greater of these two factors is determined, the taxpayer uses the lesser of the wage and capital limitation or the percentage of business income factor as their deduction.

Additionally, the same threshold amounts apply to limit a personal service company’s ability to participate in the 20% deduction.  For personal service pass-through entities whose owners’ taxable income exceeds the above mentioned thresholds, an exclusion of qualified business income and wages are phased in beginning at the threshold limits mentioned, and are completely phased in when taxable incomes reach $207,500 for individuals and $415,000 for joint filers. 

Further direction will be provided by the Secretary of the Treasury for instructions on how to claim the deduction, but the bill specifies the deduction is not to be used in reducing adjusted gross income.

The method comes as a shock to many voters who assumed tax breaks would not be included in the bill for passive activities like real estate; and one might assume under the wage limitation, that real estate investment companies may not benefit from the provision given they typically have few wages.  However with the ability to use the greater of the 50-percent wage factor or a 25-percent wage plus 2.5-percent capital factor, investors can also benefit from the business income deductions.

Many tax professionals are asking similar questions such as “what is considered qualified property?” or  “which wages are used in the wage limitation calculation?”  Qualified Property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year.  The property must be used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year.   Wages paid by the company refers to all company wages including wages paid to employees of the business.

While tax pros may have a difficult time ahead getting used to the new laws (should the law pass as stated this week) there may be one group of professionals who have a more difficult challenge ahead.  The Treasury has not only been tasked with determining the compliance reporting for this and all other provisions of the tax reform package, but they also need to provide procedures and interpretations, as well as anticipate potential hole in the new methodology to ensure there are counter measures enacted to prevent abuse.  All this, and still launch tax season timely, release the 2017 compliance forms and still act as enforcement and collection.  We can all take comfort in knowing we’re not the only ones on the planet struggling with the new policy. 

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