Tax Reform Watch: Planning for Deductions, Contributions and C Corps– December 01, 2017 by Tracy Monroe

On November 16, 2017, the House of Representatives passed their version of a tax reform bill, and, as of this post, we are waiting on the final vote today that will more than likely pass the Senate bill. The conference committee that comes next faces a significant amount of work to reconcile the differences between the two and to present one unified bill for the President to sign. While both bills have effective dates of January 1, 2018, or beyond for most provisions, there is an opportunity now to start planning for provisions that will likely make the final cut.
 
Both bills reduce the amount and type of itemized deductions that can be claimed. State and local tax deductions, miscellaneous itemized deductions and medical expenses are all likely to be non-deductible after the end of 2017. We have been recommending that taxpayers consider prepaying these amounts by year-end if they do not otherwise lose the benefit of the deduction through the operation of the alternative minimum tax (AMT).
 
Another likely outcome of tax reform is that more people will claim the standard deduction instead of itemizing. As a result, taxpayers should consider whether they should increase their 2017 charitable contributions or establish a donor-advised fund to facilitate prepaying several years of charitable gifts and claiming the standard deduction in the future. Donating appreciated securities is a tax-efficient manner through which to fund charitable deductions.
 
Another aspect of tax reform we are starting to plan for now is how the new regime relates to pass-through entities and if C Corporations will become more attractive. Each bill has a different perspective as to how to provide tax relief to businesses operating as flow throughs. In the House bill, a 25% tax rate will apply to passive owners of flow-through businesses, while active owners of flow-throughs will need to do some additional analysis. Income related to personal service businesses will be subject to ordinary income rates, while income from other flow-through activities will be considered 70% active and 30% passive. Only the passive portion qualifies for the lower rate in the bill’s safe harbor. There is also a formula approach to split the income, but first impression is that the 30% safe harbor will apply to most business owners. The Senate bill provides for a 17.4% deduction instead of a special tax rate but contains the same complexity of only having passive income qualify for the deduction.
 
It appears the effective tax rate for active flow-through business owners in the highest tax bracket is about 34.72% under the House bill and 36.5% in the Senate bill. On the other hand, both bills call for a new tax rate of 20% for C Corporations, begging an interesting question about which structure is “best.” While the 20% corporate rate is enticing, it’s important to note that flow-through owners would need to make a very well thought out and strategic decision as to whether changing their entity structure to a C Corporation makes sense. Businesses will need to evaluate and analyze a number of factors to determine if there is a real benefit to making the switch, including strategies to minimize the impact of the double tax and how to change their structure. One option may be to adopt a hybrid structure. Under this approach, assets that would generate capital gain income (intangibles) are held in a flow-through entity, while operations are conducted in a C Corporation to enjoy the lower tax rate on operating income. Certain situations may provide the opportunity to change status effective back to January 1, 2018, within the first 75 days of 2018. 
 
As we wait for a final bill, we will continue to monitor the situation and study the proposals to develop potential strategies in light of this monumental shift in our tax system. It appears increasingly likely that tax reform will be achieved, with a bill passing both the House and the Senate in the near future. 
 
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Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.