Under the new tax laws, the rules for pass-through entities have made the climate a bit more favorable for these types of corporations. It’s also a bit more complex. Pass through entities include sole proprietorships, partnerships, certain LLCs, and S-corporations. Knowing which type is best for your situation depends on several factors.
New Income Deduction for Pass-Through Entities
Under the previous rules, net taxable income from pass-through entities was “passed through” to the owners and taxed at their rates. For tax years beginning in 2018, the new law creates a deduction based on a non-corporate owner’s qualified business income (QBI) that is available to eligible individuals, estates and trusts. This new deduction will typically equal 20% of the QBI, but there are restrictions at higher income levels. The deduction will not be used to calculate the non-corporate owner’s AGI, but it will reduce taxable income, making it effectively the same as an itemized deduction.
The following restrictions will also apply whenever an individual’s taxable income is greater than $157,500 ($315,000 for married joint filing) and will be phased in over a $50,000 range ($100,000 range for married joint filing):
W2 Wage Limitation
This limitation applies to all pass-through entities that are not sole proprietorships. The QBI deduction cannot exceed either the non-corporate owner’s share of 50% of the total W2 wages paid to employees, or the sum of 25% of W2 wages plus 2.5% of the cost of qualified property — whichever is greater. “Qualified property” is defined as depreciable, tangible property owned by the pass-through entity as of the end of the tax year that is used for the production of qualified business income.
Service Business Limitation
The QBI deduction is generally not available for income from certain service businesses, including most professional practices.
Distributions after Converting from S to C Corporations
In most cases, distributions by a C corporation to its shareholders are treated as taxable dividends. A “post-termination transition period” to shareholders of a corporation that changes from S corporation status to C corporation status, allows any distributions by the corporation to its shareholders to first be applied to reduce the basis of the shareholder’s stock until it reaches the accumulated adjustments account (AAA) balance that was generated during the company’s time as an S corporation. The distributions of AAA amounts are tax-free to recipient shareholders. The new law modifies the post-termination transition period relief rule to discourage corporations from converting S corporations to C corporations to take advantage of the new lower tax rate for C corporations. Under the new law – for C corporations that operated as S corporations prior to December 22, 2017, change their S corporation status during a two-year period following that date, and have the same owners throughout – distributions will be treated as paid pro-rata from AAA and E&P and therefore treated as a taxable dividend rather than a tax-free distribution.
Tax Rule Changes for Pass-Through Entities
New Rule for ESBT Beneficiaries
Trusts typically cannot be S corporation shareholders. However, an exception allows electing small business trusts (ESBTs) to be such. Under prior law, an ESBT could not have a current beneficiary who was a nonresident alien individual. Beginning in 2018, this rule is eliminated.
“Technical Termination Rule” Repealed for Partnerships and LLCs
Previously, a partnership (or an LLC that’s treated as a partnership for tax purposes) is considered to terminate for tax purposes, if a sale or exchange of 50% or more of the entity’s capital and profit interests occurs within a 12-month period. This can result in the filing of two short-period tax returns for that year and restart depreciation periods for the entity’s assets, while also terminating favorable tax elections made by the entity. For tax years beginning in 2018, this rule has been eliminated.
Substantial Built-in Loss Rule Expanded
A built-in loss occurs when the fair market value of assets is less than their tax basis. In general, partnerships – and LLCs acting as partnerships for tax purposes – must reduce the tax basis of their assets when ownership of an entity with a built-in loss of more than $250,000 is transferred. The result is often lower depreciation and amortization deductions. The new law adds language that expands the definition of built-in loss in 2018 to include situations when, immediately after the transfer of an interest, the recipient of the transferred interest would be allocated a net loss in excess of $250,000, upon a hypothetical taxable sale of all of the entity’s assets for proceeds equal to fair market value.
Loss Limitation Reductions for Charitable Donations and Foreign Taxes
Under previous rules, a partner (or an LLC member that’s treated as a partner for tax purposes) cannot deduct losses greater than the tax basis in the partnership or LLC interest. Now, for tax years beginning in 2018, an owner’s share of a partnership’s (or LLC’s) deductible charitable donations, and paid or accrued foreign taxes, will reduce the owner’s basis in the interest. The result may be a reduction of deductible losses. However, for charitable donations of property with a fair market value that is higher than the tax basis, the owner’s tax basis is reduced only by their share of the basis of the donated appreciated property — not the excess appreciated value.