JULY 2018

The Vision BUSINESS SOLUTIONS

FOR ARCHITECTURE AND ENGINEERING PROFESSIONALS

In a recent article by Ed Horton, Tax Cuts and Jobs Act: Effect on the Architecture and Engineering Industry, we highlighted various provisions that will significantly affect architectural and engineering firms, and their owners. This article will delve into how the changes from the Tax Cuts and Jobs Act (TCJA) may affect the selection of the firm’s operating entity structure.

The federal corporate tax rate, now at a flat 21%, has attracted a lot of attention of business owners. This is a significant rate decrease from the previous top corporate rate of 35%; while many corporations paid taxes on their income using graduated tax rates, qualified personal service corporations were taxed at a flat 35%. The top individual tax rate decreases from 39.6% to 37%.

Pass-through entities, which includes partnerships, LLC’s, sole proprietorships and S-corporations, benefit from a new Qualified Business Income (QBI) deduction. This can be up to a 20% deduction on QBI. Many personal service businesses are excluded from being able to use this deduction. However, architects and engineers can take advantage of the QBI deduction. QBI does not include reasonable compensation to an S-corporation owner or guaranteed payments, as reasonable compensation, to partners and LLC members. The QBI deduction is scheduled to expire after 2025.

Even though the above rates, make the corporate structure an attractive option, there are a number of factors that need to be addressed when picking an operating entity. The choice of an entity presents its own tax opportunities and challenges to address a business’ unique needs and goals. Let’s review some differentiating aspects of various entity choices – and start with rates.

First, the above tax rates are just the federal rates, most states tax C-corporations, and many have corporate rates higher than the individual rates. Second, unless there’s a reason to reinvest profits, most A&E firms want to distribute the profits to the owners. There is a double taxation issue when it comes to profits in C-corporations - putting state taxes aside, there is the corporate-level tax of 21% and then there is an individual tax rate of 23.8% on the dividends paid.

After the cumulative effect of the taxes, an owner would net $361,188 on $600,000 earned in a C-corporation and ultimately distributed. The same $600,000 in an S-corporation distributed to the owner would net to $422,400. For this, I have simplified the tax computation by using the highest individual tax rate of 37% (without the benefit of the lower brackets) and have assumed the taxpayer can benefit from the full 20% QBI deduction, resulting in real rate of 29.6%. So, now the S-corporation looks to be a good entity choice. But still the ultimate decision between an S-corporation and a C-corporation goes beyond the rates. Some of the C-corporation benefits include (1) no restrictions on the number of owners or multiple classes of stock, (2) under certain circumstances, fringe benefits for the employee-owner can be deducted and (3) there is the potential for double taxation on a sale of a business by an S-corporation.

One of the significant differences between the S-corporation and the other pass-through entities (partnerships, LLC’s and sole proprietorships) is how the flow-through profits are taxed. Both are subject to federal and state taxes but for “the other pass-through entities”, the profits are also subject to self-employment (SE) taxes. SE taxes are at 15.3% on up to $128,400 of earned income in 2018. After that it’s 2.9% increasing to 3.8% when SE income is in excess of $200,000 ($250,000 for joint returns). This continues to bolster the case for practicing as an S-corporation.

All states have differing firm registration requirements. Generally, all the owners of a partnership have to be licensed architects or engineers. New York has established a Design Professional Corporation (DPC) which can be partially owned by non-licensed architects and engineers, as long as their ownership is below 25%. Connecticut, New Jersey, and Pennsylvania have to have at least 2/3 of the stock owned by licensed individuals. The corporate format does provide the opportunity to offer ownership to key employees who are not licensed. These corporations can also elect to be taxed as S-corporations.

Entity Selection under Tax Reform By Gilbert Watkins, CPA, Partner

JULY 2018

While the comparative advantages seem to stack up for the S-corporation, it still is not for everyone. Here are a handful of reasons, not a comprehensive list, one may choose an entity taxed as a partnership (this also includes LLC’s taxed as partnerships):

• Ownership of an S-corporation is limited to 100 members and some owners cannot qualify as S-corporation shareholders

• Partnerships can have different classes of ownership; all of the S-corporation’s stock must have the same economic rights

• Unlike partnerships, income allocation does not necessarily have to correspond with equity ownership

• Partners can generally increase their basis for partnership liabilities which may allow them to deduct business flow-through losses on their individual returns. S-corporation owners can only increase their basis with loans they make directly to the corporation.

• An individual can receive a “profits interest” in a partnership for services performed with a tax consequence. This would be taxable if an individual receives an ownership share in exchange for the services.

The choice of an entity, one of the more important decisions to be made right after deciding to start a business or consider a structure change, is not an easy selection. The decision needs to follow your firm’s facts and circumstances so it will meet your financial and operational goals to maximize the benefits to the owners.