As 2017 drew to a close, President Trump signed his promised tax reform into law. Dubbed the "Tax Cuts and Jobs Act," (TCJA) it was the most significant and thorough reform to U.S. tax law in more than three decades. Since it took effect on January 1, 2018, a number of winners and losers have emerged under the TCJA. Unfortunately for many professionals, professional service company owners lose out under the TCJA, especially relative to many other small business owners.
You may have heard that pass-through entities (PTEs), like limited liability companies (LLCs), sole proprietorships, partnerships and S corporations, will benefit under the law. Pass-through entities are so named because their income "passes through" to their owners, and is then taxed at the owners' individual rates. It is true that owners of PTEs can claim a 20% deduction on what the TCJA calls "qualified business income," or QBI. Ordinary business income is considered QBI; things like profit from the sale of a small business are not.
However, professional service companies receive less favorable treatment under the TCJA than other small businesses that are PTEs. Let's take a look at the specifics, and what professional service business owners can do to get the most benefit from the tax law.
Under the TCJA, a professional service company is "any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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 or owners." Also included in the definition of professional services companies is "any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities."
That language covers a lot of ground and a lot of businesses, including your dentist, your kids' dance teacher, your insurance agent, and your accountant, among many other businesses with whom you interact each day. (Interestingly, architects and engineers are excluded from being treated as most professional service companies.) And, of course, if you own a professional service company, the TCJA will affect your bottom line, too.
Here's how the TCJA affects the taxes of professional service companies. The income generated by professional services companies are not considered QBI under the new tax law, unless the taxable income of the owner is below a certain amount. Professional service business owners who have income of $157,500 to $207,500 as an individual, or $315,000 to $415,000 as a married couple are likely eligible to take the deduction. As income rises, the deduction begins to phase out, until individuals with income exceeding the highest amounts in those ranges are not eligible for the deduction.
When the income of a professional service company owner exceeds the $207,500 limit for an individual or the $415,000 limit for a married couple, whichever applies, the deduction to which they are entitled is limited by the so-called W-2 wage limitation. This means that the business owner can only claim a deduction which is the lesser of either:
As a practical matter, for most professional services companies, the amount that would apply is the 50% of W2 wages figure.
If you are reading this as a professional service company owner, you may be thinking that it's just best to convert your PTE into a C Corporation and benefit from the lower corporate tax rates created by the TCJA. This might be a viable option, but take a deep breath and speak with your accountant and attorney (both professional service company owners themselves, most likely) first. They will help you consider the big picture, including the financial and non-financial costs of converting your business entity. These include the risk of "double taxation" and the costs of filing fees, not to mention the risk that corporate tax law could become less favorable in the future. Working with a professional who is familiar with the new tax law can help you perform a cost-benefit analysis as to whether you should change your business entity or make other changes to maximize your tax benefit.
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