Professor Bradley Borden: How the New Tax Act Creates Complexity and Inequity for Small Businesses
By Professor Bradley T. Borden
The 2017 Tax Cuts and Jobs Act changes the choice-of-entity analysis for business owners, including attorneys. The choice of entity for business owners may vary depending upon the type of business and the amount of the business’s income. An examination of how the new law affects different types of businesses shows the new act complicates the choice-of-entity analysis and treats similarly situated businesses differently.
Two aspects of the new law create complexity and inequity: the 21 percent corporate tax rate and the 20 percent deduction for qualified business income (QBI). The corporate tax rate applies to a corporation’s taxable income, but corporate dividends are also subject to tax, at a rate ranging from 0 to 20 percent. By contrast, the taxable income of an individual is subject to a rate schedule with rates ranging from 10 to 37 percent. The top rate applies only to taxable income over $600,000, so few individuals are subject to the top tax rate.
The new act also creates a deduction for QBI, which applies to income from a qualified trade or business (QTB). The QBI deduction is 20 percent of QBI, subject to limits based upon the W-2 wages and assets of the QTB. Many LLCs, partnerships, S corporations, and sole proprietorships will qualify for at least some portion of the QBI deduction. Specified service trades or businesses (SSTBs) generally do not qualify for the QBI deduction. SSTBs include professional services businesses, such as those in the fields of law, accounting, healthcare, athletics, consulting, financial services, and performing arts. The full QBI deduction applies to the income of an SSTB only if the income is less than $315,000 for married couples. The deduction phases out entirely if a married couple’s taxable income exceeds $415,000.
The new law fosters inequity by taxing similar income differently. Consider the different amounts of tax owed on a married couple’s $500,000 of taxable income ($800,000 of gross income and $300,000 of W-2 wages) under the following scenarios. To simplify the analysis, the discussion does not consider employment taxes or other tax rules, such as personal deductions and alternative minimum tax, which could otherwise apply.
• Couple withdraws 100 percent of earnings from a corporation. A corporation will pay tax of 21 percent on the $500,000. That corporate-level tax will be $105,000, leaving the corporation $395,000 to distribute, which will be subject to the tax on dividends. The total tax paid on the $500,000 will be $152,670, and the effective tax rate will be 30.53 percent ($152,670 ÷ $500,000).
• Couple has QBI in pass-through entity. If the $500,000 is QBI of an LLC, partnership, or S corporation and the income qualifies for the 20 percent QBI deduction, the couple may deduct $100,000 ($500,000 × 20 percent) from the income. After that deduction, the couple’s tax liability using the graduated rate structure would be $91,379, and their effective tax rate would be 18.28 percent based upon the $500,000 taxable income.
• Couple withdraws 25 percent of earnings from a corporation. Some business owners (typically those with income of more than $500,000) may choose to withdraw only a portion of earnings.
If the couple withdraws only 25 percent of a corporation’s after-tax income and reinvests the remainder in the business, only a portion of the business taxable income will be subject to the two layers of tax. The total tax on the $500,000 of corporate income in such a situation will be $108,233 ($105,000 + $3,233), resulting in a 21.65 percent effective tax rate.
• Couple has an SSTB in a pass-through. If the couple’s income comes from an SSTB, no portion of the QBI deduction will be available to them. They would thus owe $126,379 of taxes under the graduated rate structure, and their effective tax rate would be 25.28 percent.
The table above summarizes the effective tax rate that would apply to income of a corporation, a QTB, and an SSTB, all else being equal. Other factors, such as the tax consequences of owning property and employment taxes, may affect the choice-of-entity analysis, but this simple analysis illustrates how the new law taxes the same income differently depending upon its type and location. The amount of taxable income also may affect the choice of entity. For instance, as the ordinary income from a business increases, more of it will be subject to the 37 percent rate. That difference further emphasizes the complexity the new act adds, but does not obscure the inequities it creates.
For a more detailed analysis of these scenarios, see “Choice-of-Entity Decisions Under the New Tax Act,” available at papers.ssrn.com/abstract=3119829.
Bradley T. Borden is professor of law at Brooklyn Law School. His research, scholarship, and teaching focus on taxation of real property transactions and flow-through entities. His work has been published in several law reviews and leading national tax journals, and he is the author or coauthor of several books, including Federal Taxation of Corporations and Corporate Transactions (Aspen Casebook, 2017), with Professor Steven Dean; Federal Income Taxation (Foundation Press, seventh ed., 2017), with Daniel L. Simmons et al.; and Limited Liability Entities: A State by State Guide to LLCs, LLPs, and LPs (Wolters Kluwer Law & Business, 2012). His work has been cited by the U.S. Court of Appeals for the Fifth and Ninth Circuits, the U.S. Court of Federal Claims, and state judicial bodies. He is frequently quoted in the media, including the New York Times, the Los Angeles Times, and the National Law Journal.