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TCJA brings new rules for pass-through income
Some practices can realize up to a 20% deduction.
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Pass-through entities such as partnerships, limited liability companies, S corporations and sole proprietorships have long been extremely popular entities for optometric practices. In fact, one form of pass-through entity, the S corporation, is currently the most-used business entity. Limited liability companies are coming on strong as the pass-through most frequently being chosen today.
Under last December’s Tax Cuts and Jobs Act (TCJA), individual tax rates, including the income of pass-through businesses and practice, have been lowered in seven tax brackets, with a top tax rate of 37%. In contrast, an incorporated practice will be taxed at a flat 21% tax rate.
To balance things out, lawmakers created a deduction of up to 20% for the qualified business income, or QBI, of pass-through entities. QBI is defined as net income from a practice without counting compensation and excluding investment income.
Although the deduction from pass-through income may be good news for some optometric professionals who will see the top effective federal tax rate on their practice income drop, it will not help all practices.
In addition to profits being taxed only once, only when passed onto their personal tax returns, many optometrists choose to operate their optometric practices as so-called “pass-through” entities because of the protection from personal liability. By electing to operate as a pass-through entity, an optometric practice can benefit from the legal advantages available to practices with a corporate structure as well as the tax advantages available to a sole practitioner.
The main attraction of pass-through entities has been the tax savings for both the practice and its principals. But a pass-through designation also allows a practice to have an independent life, separate from its principals. If a principal leaves the optometric practice or sells his or her shares, the pass-through entity can continue doing business relatively undisturbed. Maintaining the practice as a distinct, separate entity also creates a clear line between the principals and the practice, greatly improving the principal’s liability protection.
TCJA pass-through practices, businesses
Those optometry professionals operating pass-through entities are effectively taxed on earnings at their individual tax rates, much in the manner corporate owners are taxed on wages. Now, thanks to the TCJA, pass-through income can benefit from a unique 20% deduction.
The TCJA’s 20% deduction applies to the first $315,000 of income (half that for single taxpayers) earned by optometric practices operating as pass-through entities. For pass-through income amounts above the threshold, the new law also provides a deduction for up to 20%, but only for “business profits.”
Safeguarding profits
Because the TCJA places limits on who can qualify, that 20% deduction from pass-through income applies only to business profits, generally income that has been reduced by the amount of “reasonable compensation” paid the practice’s principal. That reasonable compensation has not been defined by our lawmakers yet.
Reasonable compensation, or so-called “wage income,” clearly does not qualify as pass-through income for the purposes of that 20% deduction. There are, however, still more, equally strong, safeguards to ensure that not all practice profits qualify as pass-through income.
Service businesses
Despite being limited to business profits, the deduction from pass-through income is good news for many optometrists. This benefit will not, however, help many service providers because of restrictions placed on “specified service trades and businesses.”
That is correct, under the TCJA, service businesses are not eligible for the 20% deduction. Businesses defined as service business include those in the fields of health care as well as “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”
With the 20% deduction phased out by the amounts of reasonable compensation paid to the practices’ principals, restrictions for practices labeled as service businesses, and with some optometrists facing potential tax rates as high as 29.6%, it is little wonder that many have begun considering switching to the basic “C” corporation for their practices.
Lost with pass-throughs
Those optometrists practicing or participating in pass-through entities lose things like fringe benefits, plus being required to pay themselves reasonable compensation and deal with the other restrictions. Then there is the elimination of a number of itemized, personal deductions to consider.
The vast majority of optometrists receiving pass-through income are no longer able to deduct state and local income taxes and are permitted to write off only $10,000 of their property taxes.
As a general rule, the losses from a pass-through entity cannot be claimed by S corporation shareholders, LLC members or partners in excess of the amount they have invested, their “basis” in the pass-through entity. In addition, not too surprisingly, there are several other tax issues pass-through practices and businesses must consider.
Partners, for example, are considered to be self-employed, not employees, and required to file a Schedule SE with their Form 1040 and pay self-employment taxes. Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare.
Partners are responsible for paying double what an employee would pay (because employers match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for half of the self-employment tax that can be deducted from taxable income.
While pass-through entities are generally not subject to federal income tax, they may be liable for and required to make estimated tax payments based on entity-level tax bill for previously unrecognized profits, built-in gains (BIG) taxes that resulted from an entity change. Other entity level taxes include a tax on passive income, voluntary and involuntary terminations, as well as a tax on profits accumulated rather than paid out.
Switching to corporate form
In the eyes of many experts, there is no longer a reason to operate any practice as an S corporation or other pass-through entity. However, converting from a pass-through entity to a regular C corporation can be a complicated process requiring quite a few adjustments.
In order to determine how best to structure a practice for tax purposes, it will be necessary to take into account other factors. A sale of assets by an S corporation that was formerly a C corporation during a “recognition period” is, for example, subject to the BIG tax.
The BIG tax is imposed on the incorporated optometric practice at the highest corporate tax rate, 21%, based on the appreciation in asset value from the date the incorporated practice switched to an S corporation. Shareholders may, of course, be subject to a second tax when sale proceeds are distributed.
This “double tax” created by imposing the BIG rules can be eliminated if the corporation holds and sells assets only after the 10-year recognition period has expired. Naturally, the longer the recognition period, the more difficult it is to avoid the double tax.
The annual tax return has long provided an opportunity to reconsider the options available to some optometry practices. Entities with more than one shareholder, partner or member can elect corporate status right on the tax returns. Thus, a partnership under state laws may elect to be taxed as a C corporation or S corporation for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified as corporations and may not elect to be treated as any other type of entity.
Changing business entities
Changing circumstances, revised tax laws and even the success of the optometric practice might prompt a reassessment of the entity used. Although many of the tax law’s provisions apply to all business entities, confusion need not be the name of the game when choosing among the various entities – or choosing to be treated as a regular C corporation.
Because some areas of the law specifically target each entity, choosing among the various entities can result in significant differences in federal income tax treatment. Remember, however, there is also more to choosing the right structure for an optometric practice than taxes. Not only will the decision to change the practice entity have an impact on how much is paid in taxes, it will also affect the amount of paperwork required for the practice, the personal liability faced by the principals and, especially important in today’s economy, the practice’s ability to raise money.
To switch or not to switch? Knowing how much income will qualify for the pass-through deduction is critical in determining whether it is advantageous to be a pass-through practice. Because every situation is different, the best approach when choosing a practice entity might be to ignore the possibility of further tax “reform.”
If earlier tax law changes are any indication, the IRS should issue guidelines to help the optometric practice switch entities without incurring a penalty. In the meantime, ensuring the practice qualifies for any or all of the new provisions should be a priority. To help in this decision-making process, professional advice is strongly recommended.
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- Mark E. Battersby has been reporting on news and developments in the tax and financial arenas for more than 25 years. He can be reached at MEBatt12@Earthlink.net.
Disclosure: Battersby has no relevant financial disclosures.