The recently enacted P.L. 115-97, known as the Tax Cuts and Jobs Act, will have a significant effect on tax planning for clients, but many CPAs are also investigating what it will mean to their own firms. Best to listen to the advice of American Pulitzer prize-winning reporter and best-selling author Charles Duhigg on the process; make sure you know what’s in the tax planning “box.”
Under the new rules, pass-throughs can now deduct up to 20% of qualified business income (QBI). That sounds like good news for the many CPA firms organized as partnerships or S corps, but the new 20% (QBI) deduction that applies to pass-throughs that are “specified” service businesses, including accounting firms, is limited.
At the same time, the corporate tax rate for C corps has dropped to a flat 21% from the highest marginal rate of 35% (with most corporations in the 35% bracket). As a result, we’ve received questions about whether it might be better for CPA firms to organize as C corps instead of pass-throughs, given the lower corporate tax rate. We advise using extreme caution for two reasons.
- Switching could possibly raise your taxes
Consider three simple scenarios, based on straightforward assumptions for a married individual, filing jointly and using the standard deduction. One set of scenarios presumes income of $500,000 and the other income of $1 million. In one scenario, 100% of income gets distributed by the C corporation, and no salary. The next scenario presumes that 70% of the C corporation income is distributed as salary to the owner and 30% is retained within the corporation and distributed as dividends. We used the 70/30 split because those numbers dominated the conversation during the tax reform debate over the last year as the correct amount of “reasonable compensation.” Note: This is not the AICPA position – we take a facts-and-circumstances approach to reasonable compensation – but it is simpler to use in the scenarios. The final scenario is a pass-through situation.
Here’s how the numbers would work out, based on the new tax rules:
As you can see, income on S corps or partnerships would have the lowest tax, even without the new pass-through deduction. If the flow-through owner fell within the $157,500/$315,000 taxable income exclusion from the “specified” business rule, even better.
Obviously, CPA firms will make very specific, careful calculations; again, these simple scenarios are for illustrative purposes.
- You could lose the benefit of the CPA brand
There are different practice structure options to consider when forming a CPA firm. Many firms choose to become an LLC (limited liability company), a PLLC (professional limited liability company), or even a PC (professional corporation). General business corporations and other business structures are limited by many state boards of accountancy. It is important, no matter what the specific choice, that all of the legal and board of accountancy formalities are followed in both the formation and administration of the entity.
Running afoul of board of accountancy rules could mean a loss of some meaningful advantages associated with the CPA brand. AICPA research has found that business decision makers consistently trust and respect CPAs. In fact, they rank CPAs as the most trusted financial adviser.
Here’s the bottom line: Huge uncertainties exist and there is a lack of formal guidance necessary to make informed decisions regarding entity structures. For instance, one of the main areas of concern with regard to QBI relates to the definition of “specified” service trade or business. And is it possible to spin off parts of a CPA firm that might qualify for the 20% deduction? Examples that come to mind are (1) real estate rental activities, or (2) billing and accounts management. We don’t know the answer.
Practitioners work diligently to determine what’s best for their firms and their clients, constantly considering the real or possible effects of new developments. When it comes to tax reform and CPA firm organization, we recommend carefully considering whether any switch would actually be beneficial from a tax standpoint, as well as the impact that it could have on the strong, trusted reputation that CPA firms enjoy in their communities. Charles Duhigg also said “[b]etween calculated risk and reckless decision-making lies the dividing line between profit and loss.” Make sure to fill in that uncertainty gap before making any decision.
Edward Karl, CPA, CGMA, Vice President- Taxation, Association of International Certified Professional Accountants
C corp courtesy of Shutterstock
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Originally published by AICPA.org