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Possible Outcome of Tax Reform on Tax Treatment of Single Member Service-Oriented Pass Through Entities

Executive Summary

Prior to the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), many single member, service-oriented passthrough entities (SMSOPE) saw the same tax treatment, regardless of their corporate structure. In other words, the IRS treated single member service-oriented LLCs in a similar manner as single member service-oriented S-corporations, despite the latter's preferential tax treatment of dividends. Under TCJA, this treatment does not appear likely to change, despite the introduction of a 20% qualified business income deduction. In fact, TCJA gives the IRS a possible incentive to go after SMSOPEs more than in the past!

If you’re a solo practitioner, or are thinking about going out on your own, this should be helpful to you as a starting point for tax planning. And even if you’re an existing advisor with an established practice, you may still want to make yourself aware of the possible future tax implication, as it may be months, or even years, before the IRS and tax courts provide clear guidance on this thorny subject.

WHY S-CORPORATIONS DIDN'T WORK FOR MANY SMSOPEs IN THE PAST

Although most financial planners are familiar with SMSOPE tax treatment prior to TCJA, it's worth mentioning a few points as a baseline.

First, there was a compelling reason many SMSOPEs formed S-corporations. Since there is zero difference in tax treatment between a sole proprietor and establishing an LLC, many SMSOPE owners considered this primarily a choice between establishing an LLC (which may or may not provide some liability benefits, depending on state law) and establishing an S-corporation. The incentive behind establishing an S-corporation was that an owner could classify part of his or her earnings as dividends. Doing so would avoid the 15.3% self-employment tax (both sides of the employer/employee FICA & Medicare responsibility) on those earnings.

Second, the IRS established a long history of scrutinizing S-corporation tax returns and recharacterizing those dividends as wages. This would then allow the IRS to impose penalties and interest on the unpaid self-employment tax. In order to recharacterize dividends as wages, the IRS relied upon the definition of what's known as 'reasonable compensation.' Although the IRS recognized that there was no Internal Revenue Code or Revenue Regulation definition of reasonable compensation, Fact Sheet 2008-25 outlines how the IRS defines reasonable compensation. The IRS website cites court decisions which support the IRS' position on S Corporation Compensation, specifically:

  • Authority to reclassify (Joly vs. Commissioner, 211 F.3d 1269 (6th Cir., 2000))
  • Reinforced employment status of shareholders (Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001))
  • Reasonable reimbursement for services performed (David E. Watson, PC vs. U.S., 668 F.3d 1008 (8th Cir. 2012))

Third, the IRS has established a further definition of reasonable compensation on its website, which goes beyond Fact Sheet 2008-25. Specifically, the IRS asserts:

The key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation. As such, we need to look to the source of the S corporation's gross receipts.

The three major sources are:

  1. Services of shareholder,
  2. Services of non-shareholder employees, or
  3. Capital and equipment

If the gross receipts and profits come from items 2 and 3, then that should not be associated with the shareholder-employee's personal services and it is reasonable that the shareholder would receive distributions along with compensations.

On the other hand, if most of the gross receipts and profits are associated with the shareholder's personal services, then most of the profit distribution should be allocated as compensation.

In addition to the shareholder-employee direct generation of gross receipts, the shareholder-employee should also be compensated for administrative work performed for the other income producing employees or assets. For example, a manager may not directly produce gross receipts, but he assists the other employees or assets which are producing the day-to-day gross receipts.

In other words, the IRS' position asserts that the owner of a SMSOPE with no employees, no contractors, and no capital equipment should be treated as if 100% of their income consists of wages. While the IRS doesn't cite any court precedent in establishing this position, it can be assumed that establishing a counter position and taking it to court would be cost-prohibitive for most SMSOPE owners. Certainly, the legal fees would outweigh the costs of simply paying self-employment taxes on the disputed income in the first place!

Fourth, the IRS' incentive to go after self-employment taxes decreased dramatically after wages reach the Social Security threshold. For disputed wages incomes up to the threshold, the IRS stood to gain a 'return' by reclassifying them. This amounts to a 14.13% return (15.3% X 92.35%), since SMSOPEs can deduct half of the self-employment tax. Although the Medicare tax on self-employment income is unlimited, there is a definite diminishing return. After wages surpass the Social Security threshold, the Medicare portion of FICA represents only 2.82% (2.9% X 97.1%). For taxpayers who have dutifully paid themselves wages equal to or greater than the Social Security threshold, this represented a disincentive for the IRS. After all, there were plenty of other recharacterizations to go after!

Impact of TCJA on pass through entities

TCJA's most apparent impact, with regards to pass through entities, appears to be the partial deductibility of their income on the owners' tax returns. This new deduction applies to what is called "qualified business income," or QBI. Since this QBI deduction is more complicated than originally thought, it's important to understand it in more detail.

First, the rules limit the deduction to the lesser of 20% of the entity's passthrough income or 50% of the total wages paid by the business to its employees.

Second, this limit only applies to taxpayers whose taxable income exceeds a threshold of $157,500 for individuals or $315,000 for joint filers.

Third, the deduction is limited, or even eliminated, for taxpayers who exceed the taxable income threshold and who are in specified service businesses. TCJA specifically excludes engineers and architects, but virtually includes every other service-oriented occupation, to include financial planning. While the deduction is reduced pro-rata under the "phase-in rule," there is no deduction for specified service business owners whose taxable income exceeds $207,500 for single filers and $415,000 for joint filers.

Fourth, and most notable, is the definition of QBI. Specifically, QBI does not include:

  • Capital gains
  • Dividends
  • Interest income
  • Business income earned outside the United States
  • Guaranteed payments to partners in partnerships or LLC members
  • Reasonable compensation paid to S corporation shareholders

Most important, however, is the IRS' definition of 'reasonable compensation' when it eventually interprets TCJA.

In fact, this begs the reader to ask two questions on this subject:

  1. What impact could TCJA have on the IRS' tax treatment of SMSOPE owners of S-corporations?
  2. What, if any impact, will carry foward to SMSOPEs who are NOT S-corporations?

HOW THE IRS INTERPRETATION OF TCJA MIGHT IMPACT SINGLE MEMBER S-CORPORATION OWNERS

It's understandable that TCJA represents ample incentive for the IRS to reevaluate its definition of 'reasonable compensation,' when it comes to S-corporation employee/owners. After all, it's already done most of the legwork and posted its position on its website. And the IRS' position has largely been supported in Tax Court and the Court of Appeals. The only two questions are:

  1. Why TCJA might inspire the IRS to make a change.
  2. How the IRS might make this change.

The 'Why' part to this question is pretty straightforward. After all, the IRS has revenue at stake. Finding a way to keep that revenue from disappearing through Section 199A would greatly benefit the IRS.

The 'How' part is a little more problematic. For that, we'd have to look at two parts of TCJA, as written: Section 199A(c)(4), and 199A(d)(3).

While Section 199A(c) defines Qualified Business Income, Section 199A(c)(4) discusses the treatment of reasonable compensation and guaranteed payments. Specifically, it states that QBI does not include:

“Reasonable compensation paid to the taxpayer by any qualified trade or business of taxpayer for services rendered with respect to the trade or business."

Section 199A(d)(3) outlines exceptions for specified service businesses based upon income (which all financial planners would qualify as specified service businesses). Specifically, Section 199A(d)(3)(A)(i) states that

“If, for any taxable year, the taxable income of any taxpayer is less than the sum of the threshold plus $50,000 ($100,000 for a joint return), then any specified service trade or business of the taxpayer shall not fail to be treated as a qualified trade or business due to paragraph (1)(A).”

In other words, Section 199(c)(4) excludes reasonable compensation paid to the taxpayer of a qualified trade or business, then Section 199(d)(3) states that if you are a specified service trade or business (like financial planners), then you can be treated as a qualified trade or business, provided you meet the income threshold. But since you are treated as a qualified trade or business, that means QBI specifically excludes reasonable compensation for any work you do in that trade or business.

Moving the Bar

This effectively gives the IRS an incentive to further scrutinize any income above the Social Security threshold. In fact, this could be interpreted as 'moving the bar' with respect to incentive for the IRS to more aggressively recharacterize reasonable compensation. Taken literally, this new 'bar' is now the taxable income phaseout for SMSOPE owners. After the phaseout, the IRS is limited to the Medicare portion of an S-corporation's self-employment tax liability.

This isn't so difficult to imagine, for two reasons. First, the Internal Revenue Code and Treasury Regulations have given virtually zero guidance on the definition of 'reasonable compensation' for S-corporation owners. In TCJA, the only reference to reasonable compensation clarifies it with respect to qualified trades and businesses:

"Qualified business income shall not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business."

Then, TCJA nicely ties up any loopholes by classifying SMSOPEs who would otherwise be eligible for the pass-through deduction as qualified trades and businesses.

In other words, there is no new clarification on the role of reasonable compensation with respect to S-corporation owners. Since the only definition of reasonable compensation for S-corporation owners was created by the IRS, it stands that the IRS will rely upon this definition in the future. In fact, the IRS has already created the expectation for a more aggressive enforcement within its definition of reasonable compensation by its classification of sources of income.

If the IRS adheres to its already established position on allocating income to various sources, AND the IRS determines that for a particular SMSOPE, most of this income comes from the services of the shareholder, then it can be expected that the IRS could adopt a more aggressive policy of ensuring a proportional amount of this income is classified as reasonable compensation. Adopting this position could possibly eliminate any tax break a single member S-corporation owner could expect under TCJA!

In fact, this begs another question: "Could the IRS extend its definition of reasonable compensation for non-S-corporation entities, such as LLCs and sole proprietorships?"

Let's imagine Scenario #1 occurs: the IRS adopts a more aggressive enforcement of reasonable compensation. In fact, its enforcement is so aggressive that for any single-member S-corporation, 100% of income attributable to services of shareholder is now classified as reasonable compensation.

For single-member S-corporations, this essentially nullifies not only any benefit of classifying income as dividends (even the amount above the Social Security threshold), but eliminates the deductibility of any pass-through income that TCJA would have otherwise provided. Under the current circumstances, this would not only eliminate any perceived tax benefit from having an S-corporation (as a single member), but it would also ensure that S-corporations stand out as a potential tax liability, as opposed to a tax saving opportunity.

However, the argument could be made that this would not happen. When you consider the potential windfall from this possible aggressive treatment of reasonable compensation, what's to prevent the IRS from extending this tax treatment to all SMSOPEs, not just S-corporations?

HOW THE IRS INTERPRETATION OF TCJA MIGHT IMPACT SINGLE MEMBER ENTITIES OTHER THAN S-CORPORATION OWNERS

Assuming Scenario #1 is in place, and the IRS adopts the most aggressive stance possible when it comes to classifying reasonable compensation for S-corporations. What would keep the IRS from extending this treatment to all SMSOPEs? In a word, nothing!

After all, it's already been established that the only authoritative source on the definition of reasonable compensation comes from the IRS itself! As a matter of fact, there's really no obstacle that precludes the IRS from extending this definition to include all SMSOPEs, specifically LLCs and sole proprietorships. After all, the case could be made for applying the IRS definition of sources of income (which includes services of shareholder, services of non-shareholder employees, and capital & equipment) to all pass-through entities.

And what incentive is there for the IRS to not do this? In order to figure this out, it's important to look at what's at stake. According to the most recent IRS data for S-corporation tax returns, there were 4.26 million S-corporation tax returns filed for tax year 2013. Of those, 2.7 million returns were for single shareholder corporations. Within those returns, approximately $273 million was allocated to wages and salary and $111 allocated to officer compensation (essentially treated in an identical manner to wages), while less than $1.5 million was distributed to shareholders as dividends. In other words, the intent of the IRS policy seems to be very effective in its application.

Compare this to the total windfall that the IRS stands to gain by a more liberal use of the reasonable compensation definition. While it's difficult to directly compare the IRS data for S-corporations and other pass-through entities, we can draw an approximate proxy by using Schedule C income, which represents sole proprietors. Using the most recent Schedule C data from 2015, there were approximately 25.2 million non-farm income tax returns containing Schedule C data. 17.4 million of those returns represented businesses with a positive net income. In other words, the potential pool of pass-through entities that the IRS can figuratively tap into goes up by a factor of 6. And that's just for sole proprietors.

When you factor in LLCs, its safe to assume that the IRS' most important question is not "How do we apply this aggressive definition of reasonable compensation," but "How do we find the time?"

Conclusion

While this seems to be an extreme application of TCJA (not to mention a gross perversion of the tax reform's intent), it might be a bit early to jump to conclusions. After all, TCJA has all of the tax experts jumping to early conclusions. Even the IRS has stated that it would need an extra billion over the next two years to implement TCJA. And that was before the government shutdown that promises to halt any progress in the short term. In the long term, the shutdown only the timeline, which might give taxpayers enough time to establish their own positions regarding TCJA.

Ironically, this funding shortfall might give the IRS an added incentive to find ways to increase revenue. If that's the case, this more aggressive position regarding compensation for owners of SMSOPEs might be the exact ticket to do so. This would seem to fit Congress' intent to exclude service-oriented business from the tax benefits that TCJA provides, even if that is interpreted by the wider US population to include all pass-through entities.

So what do you think? How do you see the Tax Cuts and Jobs Act playing out? Do you plan to change your tax structure in anticipation of the IRS' potential policy changes? Do you see new loophole opportunities emerging? What questions do you still have? Drop us an e-mail.

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