Welcome to the last 7 days before Christmas. I hope you find time to read my blog and many others in the next few days whilst you run about finding last minute gifts. Or, if you are like me, an adrenaline junky who thrives on shopping in the last 14 hours – relax and go with the flow, until the 23rd – then let the coffee flow!
All evidence points to the Tax Cut and Jobs Act of 2017 becoming law this week. Based upon the volume of questions we are already receiving, many people are already trying to plan how to take advantage of the upcoming changes. But before you go down this path, it may be worthwhile to stop, take a deep breath and think strategically.
Converting to a Pass-Through Entity
The most talked about issue – besides the significant drop in tax rates for corporations – is the preferential treatment for pass-through entities, LLC’s, S Corporations, sole proprietorships and partnerships. Some are already thinking of changing their business structure to take advantage of the potential tax savings. My advice, slow down and think about it.
In some situations converting could cost you more than you save in taxes. For instance, are you thinking of having to borrow money in 2018? If so, converting to a flow though entity may cause you to either have to provide more documentation, incur higher loan costs or even outright denial of loans. Lenders are notoriously hard on owners of pass-through entities so the conversion might toss cold water on some of your planning.
Let’s say you are currently a C Corporation and are thinking that you want to take advantage of the upcoming tax situation and convert to an LLC. If you are currently taking wages and maximizing your retirement plan contribution, this “little change” in your tax structure could cause troubles with contributions and the Company match. This is because LLC’s and C Corporations have different technical rules about how “wages” are calculated and who ultimately takes the deduction for the match. A switch to an LLC could cause a termination of your old plan and require you to set up a new one.
Are You Really Saving Taxes?
Let’s say you are currently working for your C Corporation and paying yourself $100,000 a year in salary. This puts you in the 25% personal tax bracket. Let’s also say your Company earns $50,000 in taxable income. Will converting offer any tax advantage?
Probably not. At $100,000, you are currently in the 25% effective tax bracket personally. With this tax law change, you are likely still in the 25% effective tax bracket personally. If you convert, then your Company would no longer owe taxes, because it passes that taxable income to you, but you would owe taxes at about 25% – which is 4 points higher than what you would have paid in C Corporation taxes (everything else being equal). Think bigger picture – have your accountant prepare different cash flow models showing what happens to your income and taxes at various levels under the different tax structures. Don’t assume that it will automatically be beneficial.
Thinking of Buying a House?
Now that there are caps and limitations on state and local tax deductions as well as the deductibility of mortgage interest, it may be a little while before lenders figure out how to determine your qualification. In theory, most borrowers should not be negatively impacted by the changes in the tax act; the problem is that there is no longer a direct impact between a mortgage interest deduction and tax reduction. There is a sweet spot for most tax payers where interest deduction can have an impact but knowing what that looks like will take time and effort to put into the forms. Remember that the days of seeing a tax reduction from having a mortgage for the vast majority of us is gone so plan accordingly.
I will be writing more about the new tax law as we go forward and some things to consider for you and your business. In the meantime, don’t fixate on these changes, this is why you hire professionals. You worry about your business, we will worry about how changes will impact your finances.
Have a great Monday.