Published in NH Business Review (8/16/2018)
New tax law contains some pitfalls that should require switching your tax regimen.
The Tax Cuts and Jobs Act of 2017 contains an amazing new provision of the Internal Revenue Code called Section 199A. Section 199A provides tens of millions of owners of pass-through businesses, including at least 5 million shareholders of S corporations, with federal income tax deductions of up to 20 percent from their shares of the net income of their business. These 5 million S corporation shareholders include many thousands of New Hampshire business owners.
But under Section 199A, there’s a major problem with Subchapter S for most S corporation shareholders, and the only way they can avoid this problem is to change their federal tax regimen from Subchapter S to sole proprietorship taxation (if they are the only owner of their business) or to partnership taxation (if their business has two or more owners).
It’s impossible to explain the above problem without using a little taxese, But here’s my best shot at explaining it in plain English:
• The income of most unmarried S corporation shareholders is less than $157,500, and that of most married S corporation shareholders is less than $315,000. If you’re in either of these situations, then your Section 199A deduction will be 20 percent of your net business income.
• However, federal tax authority requires S corporations whose shareholders are also employees of their corporations to pay these shareholder-employees W-2 wages that constitute “reasonable compensation.” The reason for this rule is to prevent these shareholders from underpaying their FICA taxes by paying themselves too little compensation,
• However, the reasonable compensation your S corporation pays you in W-2 wages will also reduce your S corporation’s net income, and thus your Section 199A deduction. And this reduction could cost you, over time, Section 199A federal income tax deductions of tens of thousands of dollars.
• However, under the relevant federal tax authorities, sole proprietors and the partners of partnerships (e.g., members of multi-member LLCs taxable as partnerships) aren’t allowed to pay themselves W-2 wages; but in addition, they’re not required to pay themselves any compensation, whether in the form of salaries (called “guaranteed payments” in partnership tax jargon) or otherwise.
• Furthermore, New Hampshire lets you deduct reasonable compensation from your sole proprietorship or your partnership for New Hampshire business profits tax purposes. Thus, you can legally pay yourself New Hampshire compensation, and thus reduce your BPT liability, yet not pay it for federal purposes and thus increase your Section 199A deduction.
If you’re a New Hampshire S corporation shareholder in either of the above situations, you need to talk with your accountant about making the federal tax regimen conversion I’ve noted above — namely, a conversion to a sole proprietor or partnership regimen.
It’s true that if you do so, the fact that you won’t be paying yourself any compensation will decrease your deductions for BPT purposes and thus will increase your BPT. However, if you do the math, you’ll find that the increase in your Section 199A deduction will significantly outweigh any BPT increase you incur.
It’s also true that if you change your federal tax regimen to sole proprietorship or partnership taxation, this risks your increasing your liability for the New Hampshire 5 percent interest and dividends tax and your self-employment and Medicare tax liability. However, my guess is that even with these increases, you’ll still come out ahead because of your Section 199A deduction.’
Furthermore, if your business is a multi-member LLC taxable as a partnership, you can protect yourself from the I&D Tax by including a proper “consent” provision in your operating agreement.
There’s also a legal way to reduce your SET and Medicare tax liabilities if you’re a partner in a partnership — namely, by including in your partnership agreement (which will probably be an operating agreement in the case of a multi-member LLC) provisions that comply with the guidelines of a little known but powerful IRS proposed regulation called the “Prop. Reg. § 1.1402(a)-2.
Finally, if you own a single-owner business and if you know of a compatible partner — the best option is almost always a spouse or other close relative — you can reduce your SET and Medicare Tax liabilities by converting your sole proprietorship to a partnership and taking advantage of the Prop. Reg.
John Cunningham, principal of the Law Offices of John M. Cunningham PLLC, is of counsel to the law firm of McLane Middleton. He wishes to express his gratitude to Kenneth Gelinas, CPA, for his assistance in the writing of this article