On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (“The Act”) was signed into law. Its focus is to provide tax benefits for corporations, individual taxpayers, and their families.
Despite the Tax Act’s complexities, it would appear to be beneficial for both corporations and pass-through entities. And, should provide eligible business owners with additional tax relief.
Before I continue, let me start by saying I am neither an accountant or attorney. However, I have spent a great deal of time working with privately held business owners, accountants, and their attorneys to implement strategies focused on reducing income and estate taxes.
Corporate Income Tax Rate (C corporations)
Beginning in 2018, The Act permanently lowers the income tax rate on C corporations to 21-percent. In doing so, it eliminates the prior corporate income tax rates of 15%, 25%, 34%, and 35%.
The Act also repealed the corporate alternative minimum tax (AMT) for entities with gross revenue more than $7.5 million.
According to the Brookings Institute, only 5-percent of corporations are C corporations. While this percentage may seem small, the permanent repeal to a flat rate of 21-percent may encourage more individuals to consider a C corporation.
It is important to note owners of a C corporation are not eligible to deduct qualified business income.
Planning Opportunities for C corporations:
Providing you are in a higher individual income tax bracket then your corporation, the permanent repeal to a 21-percent flat tax rate can provide several advantages.
The following is a short list of a few options:
Stock Redemption Buy-Sell Agreement
For C corporations with more than one owner (or an owner considering their own buy out), a stock redemption buy-sell agreement with a permanent life insurance policy owned by the corporation can provide many benefits.
Deferred Compensation for Key Employee
Deferred compensation for privately held businesses has always been challenging. The reason has been contributions to deferred compensation plans are made net of taxes. For C corporations in a higher tax bracket it rarely made sense because there were little tax benefits. With a significantly lower 21-percent tax rate deferred compensation plans make a lot of sense.
Long-Term Care Insurance
Premiums paid by a C corporation for eligible, traditional long-term care insurance policies are 100% deductible to a C corporation. If you are a concerned about having and paying for a long-term care event this is a great way to reduce or eliminate that risk.
Corporate Split Dollar
Endorsement Split Dollar is one of the best ways for owners to receive a benefit. It allows for a corporation to pay life insurance premiums on a policy benefitting the owner(s) or key employees. The company owns the policy and endorses a portion or all the death benefit to the participant.
Any owner of a C corporation considering a permanent life insurance policy should evaluate this option. It can provide life insurance coverage (at a lower net cost), and provide supplemental retirement income later in life.
Pass-Through Entities Business Deduction
Sole proprietorships, most LLCs, partnerships, and S corporations are taxed as a pass-through entity. A pass-through entity is taxed at the owner(s) individual tax rate, and will continue to be taxed the same way.
However, with a slight reduction for most individual tax rates, The Act introduced one major change. The Act gives owners of pass-through entities a 20-percent deduction for “qualified business income”.
The 20-percent deduction combined with the new maximum individual 37-percent tax rate, would reduce the maximum effective tax rate on qualified business income to 29.6-percent.
However, not all owners of pass-through entities are eligible for the qualified business income deduction. Individuals not eligible for the qualified business income deduction primarily include service related entities.
Note: If you make less than $157,500 individually or $315,000 jointly you will still be eligible for the deduction.
These include (but are not be limited too) the following fields:
- Health care professionals
- Financial Services
- Investment Management
- Performing Artists
- Individuals performing services as an employee
While the qualified business income, and its correlating code section IRC Section 199A, are beyond the scope of this post (and my intelligence) we have included the following to The New Pass-Through Deduction Explained provided by nationally renowned law firm Loeb & Loeb LLP.
As with any new code section, there are going to be many questions and technical details to be worked out. It is important to work with a tax advisor who understands all its nuances.
Lastly, the deduction of qualified business income provision is scheduled to expire December 31, 2025.
Planning Opportunities for Pass-Through Entities
The planning opportunities that exist for pass-through entities are much different than with C corporations. This is because the owner of a pass-through is the one receiving the tax benefits (provided you’re eligible).
What’s important here is how you use the deduction for qualified business income. A lot of times we talk about a three-legged stool for retirement. Each leg of the stool represents how retirement income will be received; (1) ordinary income, (2) capital gains, and (3) tax-free.
Without getting into a lot of details about how each of these works, and the funding vehicles for them, this is a great time for owners of pass-through entities to fund their tax-free accumulation. But, the window is short.
For high-income earners this may be the first and only time you will be taxed at less than 30-percent. It makes sense to consider taking some of those tax savings and using strategies providing tax-free income. You only have until 2025 to make this happen.
Full Disclosure: The most effective tax-free income tool available is life insurance. This is a life insurance blog. Many of the following recommendations will be based on using a life insurance policy. There are a lot of bad policies out there. Provided you receive the proper guidance this could be an opportunity worth considering.
Here are a few thoughts:
Life Insurance Retirement Plan (LIRP)
Life Insurance Retirement Plan (LIRP) is a concept that has been around for as long as I can remember. There are many people opposed to this strategy, and I completely understand why. Most people have a friend, or have heard or read a story about someone who was absolutely taken advantage of when using this strategy. I can’t argue this or defend the advisors who have done this.
When structured correctly a life insurance retirement plan can provide significant tax-free income. However, this is a long-term strategy (like a 401(k)). By taking advantage of the lower tax rate to accrue tax free benefits from a life insurance policy provides a great tax arbitrage opportunity for high-incoming earners of pass-through entities.
While real estate is not my area expertise, it would seem to me that the additional income would free up capital to purchase real estate or investment properties. This may include the building or warehouse you are currently running your business out of. Maybe there is a property you have been considering purchasing, but just haven’t had the capital to do so.
The additional benefit of doing this is it would seem rental income would receive the 20-percent of net income deduction. At least through 2025. Now, might be the perfect time to take advantage of this opportunity.
Restricted Property Trust
A Restricted Property Trust is a strategy used by successful business owners to reduce income taxes and grow assets. Any pass-through entity can establish a plan, except for sole proprietors. The benefits of a Restricted Property Trust are the corporation receives a 100-percent corporate deduction on all contributions. The business owner recognizes 30-percent of the total contribution on their individual tax return. Contributions must be made for a minimum of 5-years. The Restricted Property Trust owns a whole life insurance policy.
Once the owner has completed funding the trust, the policy is distributed to them. At that time a small tax is owed and paid from the policy. From there, the owner can take tax-free distributions from the policy.
A business owner would have to earn a minimum of 8-percent (oftentimes more) on after tax income to equal similar results to a Restricted Property Trust. All of this is accomplished by using a very conservative funding vehicle.
A Restricted Property Trust is also beneficial for those individuals in the service industry who are trying to reduce their income below the $157,500 individually (or $315,000 jointly) threshold to be eligible for the deduction of qualified business income.
On the surface, it would appear to me, the Tax Cuts and Jobs Act of 2017 will be a benefit to many companies, both large and small. From an individual and family perspective (which we did not cover), it would seem less advantageous. It is especially disadvantageous for individuals in states with high state income taxes.
Over the next 18-months, there are going to be a lot of questions and attempts to understand and interpret how the deduction on qualified business income works, and is applicable. As always, we recommend working with a professional who understands this area.
This article was written for informational purposes. The material cannot be used by any taxpayer to avoid IRS penalty. It was written to support the marketing of the transactions of the subjects covered. Those interested in the information, transactions, or topics discussed should receive advice based on their specific situation from independent professional advisors.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. Partnering with a specialized team of advisors, he is able to help business owners significantly reduce taxes, protect assets, and create tax-favorable income.
He compliments his extensive knowledge of tax strategies and products with an in-depth understanding of the different tax and legal structures for which they are used.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. He has partnered with a unique team of professional advisors specializing in helping business owners significantly reduce taxes, protect assets, and create tax-favorable income.
Jason compliments his extensive knowledge of tax solutions and products with an in-depth understanding of the different tax and legal structures for which