By Martin E. Prendergast
Gray, Gray & Gray, LLP
One of the biggest changes to emerge from the Tax Cuts and Jobs Act of 2017 was a significant drop in the corporate tax rate, from 35% to 21%. However, this new tax rate only applies to businesses structured as C Corp entities. Does this mean that architectural and engineering firms that are currently S Corps, LLCs, or partnerships should rush to elect C Corp status?
There are many reasons NOT to make the switch. In fact, most architectural and engineering firms that are firmly established as a “pass through” entity are likely to enjoy tax relief as deep – or deeper – than their C Corp compatriots. Here are three important reasons to consider:
- Starting in 2018, owners and members of many (but not all) pass through entities, including S Corps, partnerships, LLCs, and sole proprietorships, will get a 20% deduction on qualified business income. The good news is that architectural and engineering firms are the recipient of a special exemption that allows them to take full advantage of the deduction.
- The standard deduction for taxpayers has essentially doubled, to $24,000 for married couples filing jointly, and $12,000 for single taxpayers. This more generous standard deduction will continue to offset income “passing through” to S-Corp shareholder’s personal tax returns.
- C Corps will continue to face double taxation on dividends, one at the corporate level and one at the shareholder level. Dividends are taxed at the qualified dividend rates generally at 15% to 20% depending on shareholder income levels. In addition, the 3.8% surtax to help pay for the Affordable Care Act also still applies. Both taxes dilute the savings realized from the decreased tax rate for C Corps, while S Corps are not subject to this second layer of taxation.
The new 20% deduction was intended as a conciliation for pass through entities by equalizing the big tax cut C Corps are getting. Unfortunately, there is a complex formula for figuring out who can take the 20% deduction and which type of income it can be applied to.
To begin with, the 20% deduction cannot be taken by “specified service businesses” where the skills and reputation of the owner(s) is essential to the success of the business. This list includes law firms, accounting firms, consultants, professional athletes and performers, musicians, and more. However, it does not include architects and engineers, a category which received a special exemption that allows the 20% deduction to be taken. This is a significant win for the A&E arena!
The 20% deduction cannot be applied across the board on all income. The deduction can only be taken on qualified business income, which is calculated using a complicated formula that considers W-2 wages within the business, the acquisition of qualified property, and whether or not the owners receive guaranteed payments (which cannot be included as qualified business income).
As a result, it may make sense to make internal changes in 2018 to take full advantage of the new tax law. For example, a partnership may want to rework their compensation structure to reduce guaranteed payments; S-Corp owners may want to increase their wage base and limit distributions to further tap into the deduction; and all entity types might consider converting 1099 contractors to W-2 employees. This would all be done to boost the amount of qualified business income to which the 20% deduction can be applied. While these and other strategies will play a major role in tax planning this fall, it is less likely that a conversion of your entity will be necessary, or recommended, to enjoy tax savings similar to those C Corporations have been awarded.
The new tax law is filled with provisions and adjustments, with more details emerging regularly. It is essential that you consult with your qualified tax advisor as early as possible to begin to unravel what the changes to the tax law mean to your business, and how you can take advantage of the opportunities it presents.
If you have a question about the new tax rates (corporate or personal) and how they might affect your corporate or individual tax return, please contact us at (781) 407-0300.
Martin Prendergast is a Manager in the Architecture, Engineering & Design practice group at Gray, Gray & Gray Certified Public Accountants and Advisors in Canton, Mass. He can be contacted at (781) 407-0300 or at mprendergast@gggcpas.com