The Tax Cuts and Jobs Act (TCJA) permanently lowers the federal income tax rate for C corporations to a flat 21%, starting in 2018. But manufacturers that operate as sole proprietorships and “pass-through” entities aren’t eligible for this reduced tax rate. Instead, they may be eligible for a “qualified business income” (QBI) deduction for 2018 through 2025. Will this special tax break bridge the disparity between the rates for C corporations and pass-through entities?
Why are pass-through entities popular in manufacturing?
Many small and midsize manufacturers have set up shop as sole proprietorships or one of the following types of pass-through entities:
- Limited liability companies (LLCs) that are treated as sole proprietorships or partnerships for tax purposes, and
- S corporations.
These business structures allow a business to avoid double taxation. That is, income from C corporations is taxed when it’s earned, and again when a C corporation pays dividends or shares are sold. By comparison, income from sole proprietorships and pass-through entities is reported on an owner’s personal tax return and taxed just once at the owner level at standard rates.
How are rates changing under the TCJA?
C corporations are still subject to double taxation under the new tax law. But the TCJA substantially lowers the income tax rate and eliminates the alternative minimum tax (AMT) for C corporations, starting in 2018.
However, individual income tax rate cuts are less significant and only temporary (from 2018 through 2025) under the new tax law. In addition, individual AMT still exists under the TCJA, although the exemption amount and phaseout thresholds have been temporarily increased, so fewer individuals will owe AMT for 2018 through 2025 than under prior law.
The new law also creates a new QBI deduction for sole proprietorships and pass-through entities. The rules for this special deduction are complex, and the IRS plans to issue additional guidance to explain how it works.
For tax years beginning after December 3, 2017, the QBI deduction will be available to noncorporate owners of qualified businesses, including individuals, estates and trusts. For manufacturers, the deduction generally will equal 20% of QBI, subject to certain restrictions.
On an individual owner’s tax return, this deduction is essentially treated the same as an allowable itemized deduction — but the taxpayer doesn’t need to itemize to claim the QBI deduction.
QBI is defined as the noncorporate owner’s share of items of taxable income, gain, deductions and loss from a qualified business, without making AMT adjustments. QBI doesn’t include investment-related items (such as capital gains and losses, dividends, and interest income), reasonable owners’ compensation and guaranteed payments from a pass-through business to its owners.
The QBI deduction and applicable limitations are determined at the owner level. Each owner must track his or her share of qualified items of income, gain, deductions and loss from the qualified business, as well as his or her share of W-2 wages paid by the entity.
What are the restrictions?
There are no additional restrictions on the QBI deduction unless an unmarried owner’s taxable income exceeds $157,500 or $315,000 for a married joint filer. Above those income levels, the following restrictions are phased in over a $50,000 taxable income range for unmarried filers or over a $100,000 taxable income range for married joint filers.
Service business limitation. This targets professional services providers, such as doctors, athletes and investment advisors. It doesn’t generally affect manufacturers, unless a principal asset of the business is the reputation or skill of one or more of its employees.
W-2 wage limitation. This limits the QBI deduction to the greater of the noncorporate owner’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.
Taxable income limitation. Your QBI deduction can’t exceed 20% of taxable income calculated before the deduction and without counting long-term capital gains and dividends.
Some manufacturers that are set up as sole proprietorships and pass-through entities now wonder: Should we operate as a C corporation to take advantage of the permanently reduced corporate income tax rate and avoid the complicated QBI rules?
The answer depends on your specific personal and business circumstances. There are still some advantages to being taxed at the individual, rather than corporate, level.
For example, the income of C corporations is still subject to the threat of double taxation under the new law. And the flat 21% C corporation rate may be higher than the effective tax rate paid by individual owners, depending on their circumstances. In addition, the QBI deduction for some qualified entities might be limited based on the entity’s wages and tangible property.
This is a complex decision, and Congress could scale back or reverse some TCJA provisions in the future. Set up a meeting with your tax advisor to discuss whether your current business structure still makes sense under the new law.
These are just the basics. The rules for calculating the QBI deduction are more complicated if you own interests in several qualified businesses or your business reports a tax loss. Contact us for more details.