The Tax Cuts and Jobs Act (TCJA), or what’s referred to as the new tax reform law, was signed into law on December 22, 2017. Since that time, taxpayers and tax professionals alike have been mulling what the provisions of the new law might mean – and how to be best get around them. Tops in the minds of many taxpayers:
Should I incorporate to save money?
There is no one size fits all answer to this question. But here are some general guidelines:
If you are a sole proprietor who files a Schedule C and your only concern is a loss of deductions on that Schedule, there is no tax benefit to incorporation. There’s some confusion relating to the elimination of deductions for unreimbursed employee expenses: The elimination of those deductions only affects taxpayers who claim an employee-related deduction on Schedule A. If, as a business owner, you typically file a Schedule C, your business-related deductions are not affected by the elimination of Schedule A deductions.
If you have rental properties and typically file a Schedule E and your only concern is a loss of deductions on that Schedule, there is no tax benefit to incorporation. Schedule E remains as is: The limits and caps on mortgage interest and real estate taxes apply to residential properties which would normally be reported on a Schedule A. Your rental property mortgage remains reportable and deductible on a Schedule E and the $10,000 aggregate cap for state and local property taxes does not apply to properties used in a trade or business.
If you have a farming business and typically file a Schedule F and your only concern is a loss of deductions on that Schedule, there is no tax benefit to incorporation. Schedule F remains as is: The limits and caps on mortgage interest and real estate taxes apply to residential properties which would normally be reported on a Schedule A. Your farm-related expenses remain deductible on a Schedule F and, as above, the $10,000 aggregate cap for state and local property taxes does not apply to properties used in a trade or business. The takeaway: Don’t equate the changes on Schedule A to changes on other schedules.
If you are an employee who normally claims unreimbursed employee expenses on a Schedule A and your only concern is a loss of deductions on Schedule A, there might be a benefit to incorporating depending on your circumstances. Before you rush to make a change, ask yourself a few questions:
- How much are you really losing in tax deductions? Keep in mind that deductions reduce your overall taxable income: They are not a dollar-for-dollar reduction in your tax bill. For example, if you lose out on $1,000 in deductions and you are in a 22% tax bracket, the real tax difference, by dollars, is a bump in $220 in taxes paid. Since there are also costs involved in incorporating and maintaining a separate tax entity (more on that in a moment), run the numbers – remembering to factor in the option of the increased standard deduction – and make sure that you’re not simply replacing one expense with another.
- Are you a highly compensated individual at the top of your game? Bill Self, who coaches basketball at the University of Kansas, pulls in $230,000 in annual salary. By directing the majority of his related compensation – at least $2.75 million annually – into a separate corporate entity, self-avoided income tax under a tax-favorable Kansas law. The now-defunct law, considered a forerunner of the new federal tax law, inspired some to contemplate a similar strategy. While there may be advantages to doing so, realistically, this isn’t an option for most taxpayers. If you don’t pull the strings at your company – you’re not an owner, officer, or key employee – chances are that your employer will not be persuaded to pay your salary over to an entity.
- Are you ready to be an independent contractor? Some tax professionals have suggested that there might be significant tax savings in stepping away as an employee and instead, opting to be an independent contractor. The idea is that you could then recategorize certain lost Schedule A deductions as business expenses on a Schedule C. Assuming that you meet the criteria to be an independent contractor (there are a number of factors when determining whether a worker is an employee or an independent contractor), don’t just look at your paycheck – and those lost deductions – before making the switch. There are advantages, including those that aren’t so obvious, to being an employee. For starters, as an employee, your employer pays half of your FICA (Social Security and Medicare) taxes. The employer portion of Social Security tax is 6.2% with a taxable wage base of $128,400 (wages over that amount are not subject to Social Security tax) while the employer portion of Medicare tax is 1.45% with no wage base limit (all wages are subject to Medicare tax). The employee portion is the same, with an additional Medicare surtax (.9%) tacked on to wages which exceed $200,000, or $250,000 for married taxpayers. As a self-employed person, or independent contractor, there is no employer assistance: You are responsible for paying both portions. And your health insurance? If provided by or supplemented by your employer, that’s tax-free to you as an employee. Ditto for other fringe benefits like parking and reimbursements for certain expenses, as well as employer matches for retirement accounts. Look at all of the numbers – not just those lost Schedule A deductions – before deciding to take the plunge.
The takeaway: Run the numbers and then take a breath. Almost anything can be up for negotiation. If you’re a dependable employee, chances are that your employer won’t want to lose you over the cost of a cell phone or mileage that’s no longer deductible. Before making a big change, consider asking your employer to pay lost expenses directly for you or boost your salary to make up the difference.
So far, I’ve used the term incorporation fairly broadly. Technically, you incorporate when you’re forming a corporation and you organize when you’re forming a limited liability company (LLC) or other partnership. You elect S corporation status. Not all of those entities are equal but for the sake of simplicity, I’ve used the word incorporate above to mean a change of entity. But as we get into the more complicated bits, I’m going to make some distinctions. Specifically, moving forward, the term “pass-through business” is intended to apply to businesses which report income on an individual tax return from a pass-through entity (like a partnership or LLC), as well as a sole proprietorship. The term “corporation” means, again for purposes of this discussion moving forward, a C corporation.
As a reminder, the new law provides for a flat 21% rate on corporations beginning in 2018. Pass-through business income (again, including income attributable to a sole proprietorship) is taxed at individual tax rates subject to a deduction which is intended to bring the tax rate on pass-through business income lower.
Here are some additional guidelines:
If you are a pass-through business and your taxable income is below the threshold amount, and your only concern is whether you qualify for the pass-through deduction, there is likely no tax benefit to incorporation. If you aren’t otherwise excluded, you should benefit from the deduction. The threshold amount is $157,500 for individual taxpayers and $315,000 for married taxpayers.
If you are a pass-through business and your taxable income is above the threshold amount, and you are a specified service business, and your only concern is whether you qualify for the pass-through deduction, there might be a tax benefit to incorporation. Congress reduced the benefit of the deduction for high-income taxpayers in a specified service business, defined as any trade or business involving the performance of services in the fields of health, law, 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 employees or owners.” The definition also includes a trade or business where the performance of services consists of investing and investment management trading or dealing in securities, partnership interests, or commodities. Under the new law, if you fall into that category, you lose the benefit of the deduction over the threshold amount (subject to the phase-in ranges of $50,00 for individual taxpayers and $100,000 for married taxpayers filing jointly) which opens up some planning opportunities.
Should you just incorporate as a C corporation and pay the lower 21% corporate tax rate? It’s not quite that simple. If you incorporate, the conventional wisdom is that you’re setting yourself up for a potential double tax. And that’s somewhat true: In addition to the tax on your wages, you pay at the corporate level on any “profit” and you also pay at the individual level on dividends or distributions. There’s very little voodoo that you can do to change that result under the new law. The key to getting ahead? It’s the same as under pre-tax reform law: Utilize effective tax planning to maximize expenses attributable to the corporation. And here’s where there may be a benefit. Remember Schedule A? Under the new law, deductions for unreimbursed employee expenses have been eliminated and some remaining deductions might not be as attractive or beneficial as before (like the medical expense and charitable deductions). Corporations, and specifically C corporations, retain most deductions for benefits paid to employees. And while deductions may be limited for fringe benefits inside an S Corporation (more on those in a moment), a C corporation can generally deduct the costs of health insurance for employees (including employees who are also owners), employee-owned vehicles, certain life insurance plans, long-term care plans and more. Additionally, a C corporation may be able to set up certain kinds of benefit plans for medical expenses and retirement plans that may not be allowed or may be limited for an individual or pass-through business.
What about an S corporation? You could elect S status which would help you whittle down some taxes – namely, payroll taxes. With an S election, you’ll file a form 1120-s corporate income return, treating some of what you earn as salary or “reasonable compensation” (those rules haven’t changed under the new law). The remainder of your net earnings would pass through and be reported on your individual income tax as business profits not subject to payroll taxes. The result is that you won’t get a break on your federal income taxes as compared to being self-employed but you could save a bundle on payroll taxes. Even if you don’t get to take advantage of the pass-through deduction because of your income or occupation, you could save enough in payroll taxes as a high-income wage earner to make it worth your while. If you earn, for example, $1.25 million and treat $1 million of that as profits, you’ve avoided paying $38,000 in Medicare taxes. Not too shabby. Don’t forget, however, that S corporations may be subject to increased compliance issues and other limitations. For more on S corporations and payroll taxes, check out this prior post.
What about an LLC? Qualified business income (QBI) is generally net income from your trade or business but does not include any amount paid by an S corporation treated as reasonable compensation. Some tax professionals see a planning opportunity here because there’s no “reasonable compensation” limiting language in the new law for an LLC (though the new law does exclude guaranteed payments paid to a partner for services from QBI) and the IRS doesn’t impose such a requirement on an LLC for income tax purposes (keeping in mind, again, guaranteed payments). In theory, if you are subject to limitations as a specified service business, you could classify funds paid to you out of an LLC as QBI instead of wages to take advantage of the deduction. But as my friend, Don, is fond of saying, “We don’t live in theory.” I’d tread carefully.
Finally, what about spinning off part of your business as a separate entity? This could result in tax savings for some businesses, especially if you have employees with different kinds of jobs (for example, you offer accounting and business consulting services which are easily bifurcated) or easily divisible categories of assets and income (like real estate rentals or royalties). The result could be even better if you can spin off a piece of your business that isn’t a specific service business. But be careful: Some states regulate certain of the specified service businesses and there may be prohibitions (or other costs, like increased professional liability bills) if you serve in multiple capacities across a number of companies. There are other non-tax issues to consider, too: If you successfully split your company in order to keep individual profits low, you may also be lowering the value of your company for purposes of sale, future investment, and branding.
The takeaway: Planning opportunities exist but maintain a little perspective. If you’re trying to save 20% of $1,000,000, that’s $200,000 and is likely worth the fees and continuing compliance costs moving forward. But what if you’re trying to save 20% of $5,000? At $1,000, it might not be worth the added costs and hassle.
If you are a pass-through business other than a specified service business and your taxable income is above the threshold amount, and your only concern is whether you qualify for the pass-through deduction, there might be a tax benefit to incorporation. The same general analysis and potential solutions apply as immediately above – but without those pesky occupational restrictions.
The takeaway: When it comes to incorporating or forming a pass-through business entity, tax savings may vary depending on your circumstances. But don’t get so hung up on the federal tax consequences that you ignore the potential for added costs – including taxes and fees at the state or local level. Some states charge annual fees per partner or LLC member, while others charge a minimum annual fee per entity. And in some municipalities, operating a business – even from your home – may result in more local taxes and fees. Do your homework and figure out all of the costs before deciding that incorporating or forming an entity is a money-saver.
That said, I’d be remiss if I didn’t point out that there may be also non-tax benefits to incorporating or forming a pass-through business entity. You might be able to limit your liability. You may get better rates on health insurance plans, lines of credit, and even attract more favorable lease options. And, if you’re focused on long-term growth, certain kinds of business entities can offer attractive debt, equity and start-up options.
And if you’ve read this far and your fingers are hovering above the keyboard so that you can write in to tell me that I’m wrong because your situation is different, I get it. The IRS expects to process 155 million individual income tax returns during the 2018 filing season, not including corporate returns. And those returns are going to vary in terms of complexity – the slightest variation could result in a different answer. No single article can address all of the potential consequences and “what if scenarios” (no matter how hard Tony Nitti tried in his exceptionally thorough piece). So with that, I will give you the best tax advice I can: If you have questions, you should consult with your tax professional.