Update: Changes in the US Federal Tax Law 2018 (Part 2 – Impact on Entity Choice)
In Part 1 we discussed the impact of recently passed tax bill, formerly known as the Tax Cuts and Jobs Act (the “Act”), on certain types of investment funds including hedge funds and venture capital funds. Here we discuss how modifications to tax rates applicable to corporations and certain businesses operating as “passthroughs” should cause certain businesses to restructure.
As mentioned in Part 1, the highest corporate tax rate has been reduced from 35% to 21% starting with the 2018 tax year. In addition, the corporate alternative minimum tax has been repealed. This in tandem with certain other provisions of the Internal Revenue Code could make corporate form much more appealing, particularly for startup companies.
The Act also provides for a maximum 20% deduction for noncorporate owners of pass-through entities on the qualified business income they earn from the entity. The deduction does not apply to entities in specified service businesses including health, law, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of its employees or owners, or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.
The pass-through deduction available for an individual owner with respect to each eligible pass-through business is capped at the greater of (i) 50% of the individual’s share of the W-2 wages paid by the business to employees and (ii) 25% of such W-2 wages plus 2.5% of the unadjusted cost basis of the business’s “qualified property” (generally depreciable assets used in the business). This cap does not apply to taxpayers below certain income thresholds ($315,000 for married couples), nor are such taxpayers subject to the qualified business limitation.
Additionally, there are special rules for REIT dividends but not for income from other real estate investments. Finally, an individual’s total pass-through deduction is capped at 20% of the excess of the taxpayer’s taxable income for the year over the taxpayer’s net capital gain for the year.