Tax Reform Act – A Game Changer For Pass-Through Entities?

Last year’s tax reform significantly modified individual and business tax rates.

Major changes for individuals (set to expire December 31, 2025) include a reduction in rates, the roughly doubling of the standard deduction, and the removal of personal exemptions.
On the business side, the corporate rate fell (with no expiration date) from 35 percent to 21 percent – the largest reduction in U.S. corporate tax rate history.

Importantly, the tax reform made major changes for pass-through entities, whose income is taxed at the owner’s individual rate, such as S corporations, partnerships, and most limited liability companies.

These entities now have a “Qualified Business Income” (QBI) deduction.

The QBI deduction allows a pass-through entity to deduct 20 percent of trade or business income earned in connection with a domestic business, which, in practice, reduces the effective rate paid by individuals.

Congress included this deduction to give pass-through entities a total tax break in line with the corporate rate reduction.

The QBI deduction is likely to be a major factor in an existing or potential business owner’s consideration of whether his or her business should be run through a pass-through entity.

First, despite tax reform, traditional C corporations still face double taxation on distributed dividends. A company will be taxed at 21 percent, and taxed again at the individual’s rate once distributed.

Even so, tax reform made C corporations more attractive for companies reinvesting business income in the company. Without its distribution, the income is only taxed once, at 21 percent.
An owner’s structuring a business this way should seriously address exit planning, so that tax benefits accrued during the individual’s ownership are not lost on a sale or other transfer.

Second, the QBI deduction is complicated, with limitations and phase outs, and clarifying regulations have not been written.

Still, an applicable QBI deduction will reduce pass-through income tax rates across the board.

Even where the resulting tax rate is higher than the C corporation rate, a pass-through entity is not subject to double taxation.

In most circumstances, pass-through entities will continue to be a logical entity choice for many businesses from a tax perspective.

If you are considering which entity is most appropriate for your new or existing business, contact your FOS corporate or tax attorney.