Businesses to confront thorny tax decisions
Tax professionals everywhere can breathe easy. The tax code is no simpler than it was last week.
“Accountants and tax lawyers rejoice, it’s Christmas from Congress!” said tax lawyer John Ransom, chair of the corporate practice for Jackson Walker’s Houston office. “Forget any simplification. It’s going to wring people’s brains out certainly for the next couple of months.”
Many businesspeople are excited about what they expect will be a big windfall next year from lower tax rates. Some are expanding employee benefits and paying bonuses.
Business owners, though, will sober up once they speak with their tax advisers.
The tax code passed by the Republican-controlled Congress, which President Donald Trump signed Friday, will require businesspeople to make some important strategic decisions for their companies’ future, while forcing them to make a bet on our nation’s political future.
The most important decision is how a business wants to pay its taxes. The IRS deadline for making that decision is March 15, so no pressure.
Most privately owned American businesses are classified as flow-through or pass-through, which means the company’s profits go to the owners, and they pay the taxes on their personal returns. These are mostly partnerships and socalled S-corporations.
These differ from C-corporations, where the company is an independent legal entity paying its own taxes. Investors who own stock in the company pay taxes only on the dividends and any profit they receive from selling the stock.
Before the tax bill, the
“I’m having to read some of this stuff a third and fourth time.” John Ransom, Jackson’s Walker’s Houston office
wealthiest Americans benefiting from pass-through income paid the top rate of 39.6 percent in taxes. That was not significantly different from the 35 percent tax rate paid by corporations, especially since flow-through income was not taxed twice like it is at C-corps.
The new tax bill, however, slashes the corporate tax rate to 21 percent, potentially taxing flow-through businesses at a much higher rate. To balance the rates out, Congress changed the law on flow-through income, but in so doing, created an extremely complicated new system that even Ransom, a veteran of the 1976 and 1986 tax code rewrites, finds difficult to understand.
“I’m having to read some of this stuff a third and fourth time,” he told me.
The new bill allows owners of flow-through businesses to deduct 20 percent of qualified business income from their taxes, within some complicated limitations. Determining what counts as qualified business income, as well as understanding the limitations, is the hard part.
For example, money collected by accounting and legal partnerships for providing services is not qualified business income. But if you own part of a business that makes and sells oil field equipment, those profits are qualified.
In most cases, though, some of a business owner’s income will be qualified for the deduction and some won’t. Some businesses will want to change how they compensate people who own part of the business.
Since there is little guidance from Congress, private accountants and attorneys will make their best guesses until the IRS starts writing regulations to eliminate what auditors will undoubtedly consider abuses of the new system, Ransom said.
“At best it can cut your rate from 39.6 percent to 29.6 percent,” he added. “But these C-corp guys are getting 21 percent, which is almost another 10 percent drop in tax drag on earnings.”
Those extra earning will entice some flow-through business owners to become C-corps. But switching to a C-corp also has drawbacks.
Remember, the income is taxed twice, first at the corporate level and then at the shareholder level. And selling a C-corporation that has appreciated assets can generate a huge tax bill, potentially wiping out profits from the sale.
The IRS also frowns on C-corps trying to become flowthrough businesses, making the process difficult and costly, Ransom said. And don’t forget the political risk.
Every Democrat in Congress voted against the bill and will campaign against it. A Democratic-controlled Congress with a Democratic Congress could reverse everything.
Ransom advises quickly making decisions about how long you want to own your business, whether you plan to buy any assets that can appreciate, and carefully consider your other sources of income. Then meet with a tax attorney to run the numbers.
Also, don’t fall for hucksters offering tax advice that sounds too good to be true, he warned. Congress is already working on a tax code correction bill to fix the errors in the new bill, and that will close glaring loopholes.
GOP leaders are correct when they say no one has seen a tax overhaul quite like this one. It will take months to understand exactly what it all means. But with a March 15 deadline on deciding whether to become a C-corp, there is no time to waste. Chris Tomlinson is the Chronicle’s business columnist. chris.tomlinson@chron.com twitter.com/cltomlinson www.houstonchronicle.com/author/ chris-tomlinson