By Helen Moulis
As most of us know, we’ve entered a new era of tax rules with the passage of the Tax Cuts and Jobs Act in 2017. The last major change to the tax code happened in 1986, so there’s been ample time to get comfortable with the old structure. Have you considered how the new rules impact you and your business?
Architecture, engineering and design firms tend to be structured as partnerships or maybe even a sole proprietorship. If you operate a limited liability company, limited partnership, general partnership, S-corporation, or sole proprietorship, there is a new provision in the tax code that will be beneficial to you and your fellow owners. The provision is commonly referred to as the pass-through deduction or Section 199A deduction and is effective for tax years beginning after December 31, 2017. Many items in tax, such as bonus depreciation, are only timing differences—the same amount of net income or loss will be reported just at different times. This new pass-through deduction offers a permanent reduction in the amount of income to report and expires in tax year 2025, so it’s best to take advantage of it now!
You may be asking what this deduction is and who can take advantage of it. The pass-through deduction was added to the tax code as a result of the corporate tax rate reduction. Unless you’ve been completely shut away, you’ve seen that the corporate tax rate dropped from a whopping 35 percent down to 21 percent. With individual tax rates at 37 percent, there could be a tax-driven incentive to convert businesses to corporations and take advantage of the lower rate. Thankfully, before we could file our articles of incorporation, Section 199A was introduced. It added a 20 percent deduction for qualified income received from a pass-through trade or business. Put another way, the new rule allows you to potentially only tax 80 percent of certain qualifying income from a pass-through trade or business. Corporations already receive the reduced tax rate, so only non-corporate taxpayers can receive the benefit (think individuals, estates and trusts). If you are a partnership that invests in another partnership, the income and necessary information will continue to flow up via a Schedule K-1 until it is received by a taxpayer. A partnership does not pay tax, so it cannot take the deduction.
Does this mean all of your W-2 employees should become “partners” so they can get a deduction on the income they receive? Unfortunately, no. The rules only apply for qualified business income (“QBI”) received from a qualified trade or business. A qualified trade of businesses is any trade or business other than the trade or business of performing services as an employee or a specified service trade or business (“SSTB”). Very clear, we know. The former, put simply, says employees cannot take their wages as QBI. As an example: Employee A was working for Firm B during 2017 as a CAD technician and was paid via a W-2. Firm B decided to terminate all support staff and bring them back as limited partners of the Firm in 2018. Employee A does substantially the same work after being admitted as a partner. Firm B is not considered a qualified trade or business for purposes of Employee A, since Employee A is presumed to be in the business of providing services as an employee to Firm B.
The drafters of Section 199A had architecture firms in mind when they wrote the rule, as architecture and engineering are specifically excluded from the definition of a SSTB. That means, architecture and engineering firm owners can receive a deduction of up to 20 percent of the income they receive from their business. Depending on the structure of your firm and the services offered, it’s important to note that consulting is not a qualified trade or business. There are de minimis exceptions, but firms should be cognizant of what and how much they’re invoicing for. If one firm has more than one trade or business (for example, sustainability consulting and architecture design), each trade or business should be separately reported to owners for purposes of pass-through deduction computations.
To further complicate things, not all income, deductions, gains and losses are considered qualifying income. To be QBI, it must be effectively connected to the U.S., allowable in computing taxable income, and generally must not include investment items or compensation received. Examples of excluded items are:
- Guaranteed payment income (the deduction is allowed)
- W-2 wage income
- Any item of capital gain or loss including Section 1231 amounts treated as capital gain or loss
- Dividends and interest (with some exception)
- Reasonable compensation received by a shareholder from an S-corporation
For non-corporate taxpayers with taxable income above $157,500 ($315,000 filing jointly), it gets even more complicated. As they say, all the best things are worth working for. The final computation requires information on W-2 wages paid per trade or business (remember that separate reporting) and unadjusted property basis numbers for property used in each trade or business.
Writing out the rules of computation is sure to lull even the most devoted reader to sleep, so here are a few items firms should be considering instead:
- Do we operate more than one trade or business?
- What are our W-2 wages and how do we assign them to each trade or business?
- Do we have qualified property and how much is our unadjusted basis?
- Are we earning interest or dividends on investments and how will we separately report this?
- Are our S-corporation shareholders being reasonably compensated?
- Do we make guaranteed payments to partners and should we? (remember, guaranteed payment income does not qualify for the deduction)
- Does our CPA know they have to include this on our Schedule K-1 footnotes?
The information contained here is not all encompassing and does not contain all of the requirements and definitions included in the full Internal Revenue Code section and regulations. It is recommended that businesses and their owners consult with their tax advisors. The 2018 tax year is almost over, and you know that means? Taxes!
Helen Moulis is a Director in Tax at BPM. She can be reached at HMoulis /at/ bpmcpa.com.