Key considerations to discuss with your clients.
Private business owners typically have a lot on their plate. Now, with the new Tax Cuts and Jobs Act1 (the Act), there’s even more. As if building, running and planning for a business weren’t enough, the Act has added several new and complicated tax wrinkles to the discussions advisors should be having with their business owner clients.
Here’s an overview of the main provisions of the Act relevant to private business owners. We’ll also go through the central discussions advisors should be having with their business owner clients, flagging the key considerations now in play under the Act and how they can be used to address the issues all private business owners face.
The Act
The Act, which became law on Dec. 22, 2017, and is effective for tax years beginning after Dec. 31, 2017, made significant changes throughout the Internal Revenue Code. From a private business owner’s perspective, these include changes to the individual income and transfer tax rules, general business taxation rules and rules specific to the taxation of corporations and pass-through entities. While certain changes are permanent, a large number are temporary and only apply to tax years beginning before Jan. 1, 2026.
Individual rules. The changes in the Act directly affecting most people, including private business owners, are those to the individual income tax rules. Under the Act, the individual income tax brackets are adjusted for the temporary period, with the top bracket set at 37 percent, down from 39.6 percent. In addition, the standard deduction for individuals has been essentially doubled, with many itemized deductions limited or eliminated. The deduction for state and local tax payments has been limited to $10,000 per year. Meanwhile, the deduction for miscellaneous itemized deductions subject to the 2 percent floor has been eliminated entirely. The thresholds for application of the individual alternative minimum tax also were raised.
These changes may not impact a private business owner’s handling of her business, but they may impact certain decisions, such as the sale of all or portion of a business, as the owner runs the numbers for her specific situation. More likely to impact a private business owner’s planning is the temporary increase of the exemption from gift, estate and generation-skipping transfer (GST) tax from its level of $5.49 million in 2017 to approximately $11.2 million in 2018. The repeal of the tax penalty for the failure by an individual to maintain minimum health insurance coverage may also impact a business owner’s operation of a business and employee arrangements as the effect impacts the country’s health insurance system.
Business rules. As widely discussed, the Act is generally favorable for businesses. While certain business deductions and credits have been limited or eliminated, the Act includes a variety of provisions that will result in tax savings for businesses.
The most sweeping of the changes to the taxation of businesses is the reduction of the corporate income tax rate from a top rate of 35 percent to a flat 21 percent, while also eliminating the corporate alternative minimum tax. This is one of the changes that won’t sunset after 2025. The potential effect of this change on publicly traded corporations as well as domestic and global economies has received significant attention. But, the change also applies to privately held C corporations, regardless of size.
Along with the change of the corporate tax rate, the Act also effectively decreases the tax rate on certain income received through pass-through businesses, such as partnerships, limited liability companies (LLCs), S corporations (S corps) and even sole proprietorships. Under the new Internal Revenue Code Section 199A, taxpayers are able to deduct 20 percent of their “qualified business income,” a term that includes income from a “qualified trade or business” other than specified services, businesses or “the trade or business of performing services as an employee.” The deduction is subject to limits based on allocable shares of “W-2 wages” of the business as well as the “unadjusted basis” of certain “qualified property” held by the business. There are other nuances that apply as well, all of which will require advisors to run detailed numbers both to determine the benefits of the new deduction and to guide their clients around the decisions on employment arrangements, depreciation schedules and net income levels that now have a new level of tax complication tied into them. Notably, this change will sunset in 2025.
Other changes that now apply to businesses, regardless of form, include:
• More favorable depreciation and expensing rules;
• Like-kind exchanges limited to real property not held primarily for sale;
• New limits on the application and deduction of net operating losses as well as interest expense; and
• Increase in the threshold permitting businesses to use a cash accounting method.
The Discussions
For advisors who know they need to speak to their clients about planning for their businesses, the Act provides an opportunity to start those discussions. But, once those discussions are underway, it’s important to develop and retain a focus on the key business considerations that create the need for planning in the first place, with the tax implications of the Act one of what are usually a variety of factors.
Identifying the business. The first part of any discussion about a private business is to identify the business. This step is so obvious it’s easy to overlook. But, identifying and segregating the different businesses of a client is crucial to structuring those businesses appropriately, ensuring the right management arrangements are in place and planning for the ultimate disposition of the business, whether it involves a sale to a third-party, transaction with an unrelated person involved in the business or passage of the business through the client’s family for generations.
Under the Act, identifying what are or may be separate, distinguishable businesses could become relevant in navigating the limits around the IRC Section 199A deduction. It could also be relevant in deciding the type of entity used to hold or operate a business or restructuring the entities currently in place. With the “permanent” decrease of the corporate income tax rate, more businesses may elect to be treated as corporations for tax purposes. These abstract decisions begin to take form only when the details of a business or businesses are well-defined.
For example, if you have a client who owns a building in which she operates an architecture practice and sells a variety of home design products from the space adjacent to her reception area, the client may conceive of her day-to-day activities as a single business. But in reality, she’s likely operating a minimum of three separate businesses: (1) the architecture practice; (2) the ownership of the building; and (3) the retail business of selling the home design products adjacent to the reception area.
From the tax perspective, the numbers may compel separation of the architecture practice from the other endeavors to enable a deduction under Section 199A. From a liability protection perspective, it likely makes sense to protect the real property from the risk associated with the retail or professional business. And, from the planning perspective, the real property may be an asset the client wishes to pass on to her family, potentially during her lifetime, while her architecture practice is unique to her and will likely neither be passed down nor sold. But, until the client separates the different businesses in her head, she won’t be in a position to address any of those goals.
Identifying the business begins by identifying the different endeavors a client is involved in. From there, it involves understanding in detail the assets and liabilities of the business, valuation concerns, income tax basis and depreciation schedules of the assets, management and employee arrangements, legal structures, tax filing status and contractual arrangements both internal to the business and with third parties. Last, but certainly not least, it involves understanding the cash flows and purpose of a business, amid the typical mix of income generation, asset preservation and growth and personal satisfaction. In a family-owned business, with multiple owners and generations, this becomes even more complicated and therefore important to identify.
Choosing the right structure. In recent years, the decision on the legal structure and tax filing status for a private business has been relatively straightforward. Most were formed as pass-through entities such as LLCs, S corps and partnerships. Private businesses typically haven’t been formed as corporations, or treated as such for tax purposes, due to the double layer of taxation, high corporate tax rates and ability to achieve similar liability protection through an LLC.
Now under the Act, the calculation isn’t necessarily as clear. With a “permanent” corporate tax rate of 21 percent and the ability to shift income as a corporation, and a top effective tax rate of 29.6 percent for “qualified business income” from a pass-through entity after the deduction under Section 199A, having a business taxed as a corporation may be advantageous, depending on the particular circumstances of the business and its owners. Year over year, income-producing assets taxed as a corporation would grow at a greater rate after tax than the same assets held within a pass-through entity. Only when the assets are distributed from the corporation to the shareholder, and the second layer of tax comes into play, do the numbers become more complicated and potentially favorable to the pass-through.
The decision on the type of entity (including jurisdiction) includes considerations other than taxes, such as capital needs, employee benefits, liability exposure and preferred accounting methods. But in 2018 and going forward, the Act has made it necessary to compare corporate and pass-through treatment and the resulting tax implications by considering the cashflows of the business, distribution needs and other income levels of the owners. This applies both to new entities and businesses being formed, as well as to evaluating existing businesses and structures in place.
The choice of entity may also have relevance as individuals look at qualification for the deduction under Section 199A in relation to income they previously may not have thought to segment as a separate business. The client with a small retail or services business may now be compelled to form an LLC to reinforce the fact she’s engaged in a business. Or, as mentioned in the example above, entities may be formed to more clearly segregate the different businesses involved in what might otherwise be considered a single endeavor. If a client decides to restructure, it’s worth also considering the tax implications of unwinding that structure should the laws change. Finally, a seemingly obvious but sometimes overlooked step is to be sure to notify the applicable state tax entity, as well as the IRS, of the change.
Management and operation. After an advisor has assisted a client in identifying the client’s business and determining the proper structure and tax filing status for it, the next set of concerns involve the actual running of the business. In relation to the Act, a key consideration is the level of debt associated with the business. With the new limits on the deduction of interest expenses, the economics of carrying debt may shift for a business. Similarly, with Section 199A, the economics of debt will shift as the decrease to net income also decreases the 20 percent deduction.
Another item for attention is a business’ employee and independent contractor relationships. Under Section 199A, the 20 percent deduction may be limited to the greater of 50 percent of “W-2 Wages” or 25 percent of “W-2 Wages” plus 2.5 percent of the “unadjusted basis” after acquisition of the business’ “qualified property.” If a client is the sole owner of the business, and she’s employing a variety of independent contractors in connection with a business producing substantial income, the client may want to consider hiring the contractors as employees or hiring employees in lieu of the contractors to create a more favorable situation in relation to Section 199A. The economics of the purchase of qualified property may also desire attention for the same reason.
These decisions are all very granular. But, each of them can be used to initiate a broader discussion with clients on the management and operation of their businesses on an ongoing basis. The client who expends significant energy to take advantage of the tax benefits under the Act should be spending similar, if not greater, energy to ensure there’s a viable succession plan for the management of the businesses in place as well.
The temporary nature of many of the changes under the Act is an opportunity to remind clients of the need for management succession planning. The business that elects to be taxed as a corporation to take advantage of the lower corporate tax rate, unloads debt to maximize its deduction under Section 199A or hires as employees a set of contractors for the same reason, needs to have someone in charge who’ll recognize when those decisions may cease to make sense, whether in 2026 or on some earlier change in the tax law.
All too often, inattention leads to private businesses being run by people, sometimes consisting of the original owners themselves, who become concerned solely with preservation of the day-to-day. The big picture, enterprise-level concerns become neglected, eroding the value built up within a business. Management succession planning requires patience, discernment and generous training, but it’s part of what’s necessary to make any private business an ongoing success.
Planning for future ownership. No private business owner remains one forever. She may pass away, retire or sell or otherwise transfer the business. Businesses are often transferred from one generation to the next within a family, but unless attention is paid to the management (as discussed above), the value being passed on may erode rather than grow. A business owner always should have an exit plan, whether its the successful transition of the business to the owner’s children and grandchildren or an outright sale. Advance planning is always beneficial.2
Under the Act, many successful private business owners will be tempted to make transfers of interests in their businesses using the increased gift and GST tax exemptions. With valuation discounts for interests in family businesses still available, there’s potential to transfer large amounts of value to lower generations through a sequence of transfers of partial interests in a business. For example, with an $11.2 million exemption, a client may transfer interests with a pro rata value of $16 million if subject to a 30 percent discount.
But, advisors should caution clients to run the numbers before completing any gifts. Under the Act, the step-up of income tax basis still applies to property transferred at death and doesn’t apply to lifetime gifts. As a result, the transfer of low basis assets, as interests in private businesses often are, won’t make sense for tax purposes in many cases, potentially even for those clients with assets well in excess of the exemptions.
Any gifts of interests of a business also should be coordinated with the plan for management of the business, because the desire to save estate taxes always has to be balanced against the impact those gifts would have on the control and management of the company itself. Trusts are frequently used to hold these interests because they can allow for certain benefits of the gifts for family members while at the same time allowing for control and voting of the gifted shares. It’s especially important to pay attention to the terms of these trusts that may hold the gifts, whether of limited period or in perpetuity. The Act has impacted the taxation of trusts, as well as businesses and individuals. Ideally, any transfer of ownership is part of an overall plan that accounts for the impact on the current owners, the business itself and the new owners receiving the gifts. And, when it’s not possible to align those interests, it’s usually time to discuss whether the sale of the business is preferable to trying to force a transition that isn’t likely to work.
For those clients who have an exit plan that involves a sale, the Act has changed the analysis to a degree. For clients in states with high income tax levels, a sale likely will have a greater tax cost with the deduction for the state income tax paid on the capital gains limited to $10,000. This may lead certain taxpayers to retire to a low or no income tax state before completing a sale of a business that’s structured not to generate source income in the high income tax state.
For clients who won’t retire, the increase of the estate tax exemption creates an incentive to postpone a sale until after death to realize a step-up in basis and thereby avoid capital gains. For sales during lifetime, strategies to postpone or offset capital gains, such as a transfer to a charitable remainder trust or direct cash charitable gifts (now subject to a 60 percent limit of adjusted gross income for gifts to a public charity), remain available.
New Concerns
It’s fitting that a change in law that’s bestowed significant potential tax savings on businesses has also bestowed a whole new set of concerns for business owners. As we know, businesses aren’t static, and as advisors, the changes present an opportunity to highlight the need for planning in relation to both the Act itself and the ever-evolving concerns around identifying, structuring, managing and owning a business that were present before the Act and will be present long after its temporary provisions expire.
Endnotes
1. We refer to the legislation under Public Law No. 115-97 by the short title included in the bill introduced and passed by the House of Representatives, while recognizing that the short title wasn’t included in the enrolled bill.
2. Business owners may want to consider hiring a consultant for this stage. See Paulina Mejia, “Questions to Ask Before Hiring a Family Business Consultant,” Trusts & Estates (March 2017), at p. 48.