When at parties, I typically try to avoid bringing up what I do for a living. Nothing makes people’s eyes glaze over faster than the words Certified Public Accountant. When I do get cornered into stating my profession, a common follow-up is “what are you going to do once Congress passes tax reform where everyone can do their taxes on a post card?”
By now most of you are aware that Congress has passed its most significant tax reform in a generation – the Tax Cuts and Jobs Act (TCJA). With it was Congress’ attempt to simplify the tax code and reduce the tax burden for both corporate and individual taxpayers.
So, was Congress successful in passing a tax reform substantial enough that my fellow CPA colleagues and I are soon to be out of a job? To find out, let’s walk through three aspects of the TCJA which are of particular interest to small business owners: the new QBI deduction for pass-through entities, entity structuring under the new code, and the reformed standard deduction and child tax credit.
The Qualified Business Income (QBI) Deduction for Pass-Through Entities. Ah yes, the QBI deduction. One of the most controversial and rapidly-changing elements of the new TCJA rules. There were a lot of 11th hour (practically 13th hour) changes and additions to this provision. Effectively, pass-through businesses will receive a deduction of 20% of their reported net income for the year, in a move to help equalize pass-through businesses (such as S-Corporations) with the new 21% corporate tax rate. For specified service businesses (such as dental practices) the pass-through deduction is subject to a phase-out for taxable income above $315,000 for married taxpayers or $157,500 for individuals. Remember, taxable income is the total aggregate of income and deductions on your 1040 tax return and not the more common (and higher) adjusted gross income from the tax return. This means married couples with taxable income in excess of $415,000 will effectively not qualify for this deduction as it relates to their practice income.
For example, say you’re a self-employed dentist operating your practice as an S-Corp, with $240,000 of salary and $160,000 of K-1 (pass-through) income. This gives you a total income of $400,000 which at first glance appears to be nearly at the full phase-out level. But let’s say your combined deductions total to $90,000. Remember, because the pass-through deduction is calculated on taxable income and not adjusted gross income from the tax return, the number you would use for the pass-through deduction eligibility test is $310,000 ($400,000 – $90,000). In this case you would be eligible for a QBI deduction of $32,000 ($160,000 x 20%). It is possible that this deduction would be subject to the 50% W-2 limitation or other limitations in similar examples.
Entity Structuring Under the New Tax Code. It’s important to understand that the $315,000 phase-out provision only applies to specified service businesses, such as dental practices. How does the IRS know your business is a specified service business? One tool the IRS uses to track this is the NAICS code you’re required to report on your tax return (621210 is “Offices of Dentists” for example). The IRS uses this information to statistically group similar businesses together to look for outliers to audit.
Discrimination against specified service businesses has long been a part of the tax code even before the TCJA. The logic is that businesses whose income is primarily earned off the skills of the owner (such as dentists, doctors, attorneys, CPAs, etc) have too great an ability to manipulate their salary for tax evasive purposes compared to, say, the minority owner/manager of a regional manufacturing company. The manufacturing company’s income is much less driven by the actions of that single manager and therefore he is much less able to manipulate his tax situation compared to his specified service business neighbor. There is a more apparent “bright line” between the regional manager’s salary he earns as a manager and his ownership distributions.
Similarly, because real estate is not subject to the specified service phase-out there can be a real advantage for owners of commercial property. They will typically get a deduction of 20% from their net earnings from commercial real estate activity. There is a limitation to the QBI deduction of 50% of W-2 wages, which would have prevented a large majority of small business real estate owners from taking much of a deduction. However, a last-minute addition to the TCJA now allows for an alternative calculation of 25% of W-2 wages plus 2.5% of the unadjusted basis in depreciable property. So, if you own a $1 million building in a single-owner LLC your pass-through deduction would be the lesser of $25,000 or 20% of your net income for the year.
It might be tempting for those dentists who are above the $415,000 taxable income line (and therefore phased out of the pass-through deduction) to convert to a C-Corporation to take advantage of the 21% corporate tax rate. However, when you consider the dividend tax rate incurred to bring the business earnings home, it brings the effective tax rate equal to or higher than the pass-through entity rate in most examples, once you factor in this double taxation. For example, a taxpayer taking home $415,000 per year would pay 18.8% capital gains rate on business earnings he brought home from the C-Corp as dividends. The end result is his effective tax rate would be a weighted-average 35.9%, which is going to be a higher effective tax rate than most pass-through owners would have incurred in the first place. There are nuances to this beyond the scope of this article, but the takeaway is Congress knew what it was doing here and specifically designed the TCJA rules to avoid this loophole.
The New Standard Deduction and Child Tax Credit. Under the TCJA there are some significant changes to the way your standard deduction and personal exemptions work. Under the new law the standard deduction has nearly doubled from $12,700 to $24,000 for married couples and from $6,350 to $12,000 for individuals (2018 figure). However, the TCJA also eliminated the personal exemption worth $4,050 per taxpayer ($8,100 for married couples). This means that married couples who were previously eligible for $20,800 in combined standard deduction and exemptions are now eligible for just the $24,000 – an increase of only $3,200. Slightly less generous than it originally appears.
The upshot of this is Congress has essentially made it harder to itemize your deductions. Previously, married couples only needed to pass the $12,700 hurdle rate to itemize their deductions (while automatically getting the $8,100 in personal exemptions). Now they must pass the $24,000 hurdle rate to justify itemizing their deductions. This means a large majority of taxpayers will no longer itemize as the previous trifecta of common itemized deductions: state/sales/property taxes (capped at $10,000), mortgage interest (capped at prorated portion of $750,000 of loan balance), and charitable donations are less and less likely to add up to greater than the $24,000 standard deduction for married couples. It will be interesting to see how this provision affects charitable giving, as a large swath of Americans will effectively no longer deduct their donations to 501(c)(3) charitable entities, due to the fact they will no longer be itemizing their donations to receive the deduction.
Finally, the TCJA has expanded the Child Tax Credit from its previous $1,000 per qualifying child (under age 17) to $2,000 per child. It also increases the income phase-out from $110,000 to $415,000 for married couples. The new law also includes a $500 credit for other dependents they claim on their return (live-in family members, children over 17, etc). The IRS eligibility test rules still apply.
How might this affect a common taxpayer? A married family of four previously would have been eligible for four personal exemptions (worth a combined $16,200) plus their $12,700 standard deduction for total deductions of $28,900. Under the TCJA they will only be able deduct the new $24,000 standard deduction, meaning their overall taxable income will be higher by $4,900. However, assuming their children qualify for the tax credit, they will offset this loss with a combined $4,000 in tax credits. Assuming the 24% tax bracket, their $4,900 increase in taxable income will result in $1,176 of additional tax which is more than wiped out by the expanded tax credit. The new provisions here are slightly more favorable to this family than the previous tax code and could possibly be more so for a family that has more than two children.
So, there you have it: some of the most relevant tax issues under the Tax Cuts and Jobs Act for dental practices and similar small businesses. Has Congress succeeded in their stated goal to finally simplify the tax code? In my opinion, probably not. In fact, with the addition of the never-before-seen QBI deduction in some ways it’s arguably more complex. It turns out as long as we have Members of Congress who use the tax code to provide benefits for their constituents in the hopes of re-election we may never have a truly simplified tax code.
The good news is from the lower tax rates, to the expanded child tax credit, almost everyone in America should see some level of benefit in 2018. Please consider my summary here to be a helpful starting point when considering your tax strategy. But your situation may be complex and may differ significantly from my examples herein. I counsel you to reach out to your own tax advisor as you consider implementing new strategies under the Tax Cuts and Jobs Act.