Everyone is an Owner: The Reclassification of Businesses
Some experts are predicting that the recent tax legislation will create a ton of new business creation and activity – just not the kind that lawmakers originally intended. These people are predicting a surge in efforts for reclassification and the organization of cover companies by employees so they can have their salaries recognized as business income, significantly lowering their tax burden as a result.
A central tenant of the tax bill is that it reduces both corporate and pass-through business tax rates. Corporate profits are now taxed at only 21 percent, and owners of pass-through companies will get to take a 20 percent deduction. While these same experts predict it will take some time to adapt, they believe that as lawyers and accountants delve into the new rules, they will find ways to minimize taxes for their clients using the new tax structure.
Below is a brief synopsis of the different strategies. As always, remember that each situation is unique and you should consult your tax professional before implementing any of these strategies – this is definitely not a DIY type of situation!
Partnership Game Changers
Some believe that people will transform themselves into self-employed contractors or partnerships, thus turning their wages into pass-through profits and entitling them to the 20 percent deduction.
The IRS lays out pretty strict guidelines on who can be classified as an independent contractor, with a bias toward workers being treated as W-2 employees – so this isn’t a simple path. The most likely candidates are individuals in certain professions, such as law firms. One example given is that associates (partners would already receive the pass-through treatment) could create an LLC and then be hired by the firm. There are provisions that prevent guaranteed payments from qualifying for the deduction; however, many feel these regulations are weakly written and might only apply to S corporations.
Split the Difference
Another strategy professional service pass-through can use is to split their companies into parts. One part would perform the services portion of the business, while the other would own the real estate and/or any productive revenue streams. Separating the service portion of the business would allow the other segments to qualify for profit deductions where they would not otherwise if they were co-mingled.
Initially, many believed the easiest way to arbitrage the new tax rate structure would be to organize a corporation.
Currently, however, most entrepreneurs avoid forming corporations due to double taxation (profits are taxed at both the corporate level and then again as dividend distributions). The reduced corporate rate of 21 percent combined with the top dividend rate of 20 percent means that even taxpayers in the top brackets will do better not incorporating; however, opportunities for interest earning investments are still available.
Change often means opportunity when it comes to tax law. The new tax law substantially shakes up business taxation, and as professionals sort through the finer details, new strategies will emerge for some taxpayers.
Thomas Jones is the lead tax partner at McConnell & Jones. With more than 40 years of experience in tax and accounting services, Mr. Jones is responsible for providing a complete range of financial services that promote long-term business success to entrepreneurs and small business owners such as tax planning and small business structuring.