New rules for taxing pass-through income

Pass-through business entities, aggregate producers and businesses operating as partnerships, limited liability companies (LLCs), S corporations and sole proprietorships have long been popular.

In fact, one form of pass-through business entity, S corporations, are currently the most-used business entity. LLCs are the pass-through entity most frequently chosen today.

Unfortunately, thanks to the recently enacted “reforms” under the Tax Cuts & Jobs Act (TCJA), the owners of many small businesses operating as pass-through entities will face personal tax rates as high as 29.6 percent – far above the new 21 percent corporate tax rate. It’s little wonder that many have begun considering a switch to the basic C corporation for their construction materials company.

Passing through businesses

In addition to profits being taxed only once, not at the business level but rather only when passed onto the owner’s tax returns, many aggregate producers choose to operate as so-called “pass-through” business entities because of the protection from personal liability.

As mentioned, under the recently passed TCJA, the tax rate for incorporated crushed stone, sand and gravel businesses was reduced from the previous 35 percent rate to 21 percent for the 2018 tax year and thereafter. Pass-through entities will now enjoy a 20 percent deduction.

Pass-throughs

A business electing to incorporate as an S corporation or choosing to be treated as another type of pass-through entity has its business income taxed only once, similar to the manner in which sole proprietorships and partnerships are taxed. By electing to operate as a pass-through entity, a crushed stone, sand and gravel operation can benefit from the legal advantages available to businesses with a corporate structure, as well as the tax advantages available to partnerships.

One of the best features of a pass-through entity, such as an S corporation, was the tax savings for both the aggregate business and its shareholders. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S corporation shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a distribution, which was taxed at a lower rate.

An S corporation designation allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the aggregate business, or sells his or her shares, the S corporation can continue to operate relatively undisturbed. Similar rules now also apply to partnerships. Maintaining the business as a distinct, separate entity defines clear lines between the shareholders and the business that improve the protection of the shareholders.

An LLC is, on the other hand, a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with producers in partnerships or sole proprietorships, LLC members report business profits or losses on their personal income tax returns; the LLC itself is not subject to income taxes.

However, while pass-through entities are generally not subject to federal income tax, they may be liable for and required to make estimated tax payments based on a number of entity-level taxes such as built-in gains; last-in, first-out recapture; passive income tax; voluntary and involuntary terminations; and the accumulated earnings tax.

Those other taxes

As a general rule, shareholders or partners cannot claim a pass-through entity’s losses in excess of the amount they have invested, their “basis.” Not too surprisingly, there are several tax issues pass-through businesses must consider.

Partners, for example, are considered to be self-employed, not employees, and are required to file a Schedule SE with their Form 1040 and pay self-employment taxes. Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare.

Partners are responsible for paying double of what a normal employee would pay (because employers normally match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for one-half of the self-employment tax that can be deducted from taxable income.

TCJA pass-through businesses

As previously mentioned, pass-through businesses pass their income to their owners who pay tax at their individual rate. The TCJA created a 20 percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by crushed stone, sand and gravel operations operating as pass-through businesses.

All pass-through businesses under the income thresholds, regardless of whether they’re considered “service” professionals or not, can take advantage of the 20 percent deduction. However, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income.

For pass-through income above the threshold, the new law also provides a deduction for up to 20 percent – but only for business profits. In other words, that 20 percent deduction applies only to business income that has been reduced by the amount of “reasonable compensation” paid to the owner. Our lawmakers have not yet defined that so-called reasonable compensation.

Those operating a pass-through aggregate business such as an S corporation lose things like fringe benefits, plus being required to pay themselves reasonable compensation and deal with the other restrictions. Then, there is the elimination of a number of itemized, personal deductions.

Currently, the vast majority of pass-through business owners will no longer be able to deduct state and local income taxes, and will be permitted to write off only $10,000 of their property taxes. A regular C corporation faces no similar deduction restrictions.

Pass-through asset sales

A sale of assets by an S corporation that was formerly a C corporation during the “recognition period” is subject to a built-in-gains tax. A built-in-gains tax is imposed on the incorporated business at the highest corporate tax rate, based on the appreciation in asset value that existed on the date the corporation became an S corporation. The shareholders may then be subject to a second tax on distribution of the sale proceeds.

This “double tax” created by imposition of the built-in gain rules can be eliminated if the corporation holds and sells assets only after the 10-year recognition period expires. Naturally, the longer the recognition period is, the tougher that is to do.

Under the former rules, distributions made by an S corporation converting to a regular C corporation during the post-termination transition period can be tax-free to shareholders. Distributed funds from those accumulated adjustment accounts can also reduce the adjusted basis of the stock.

Under the new rules in the TCJA, adjustment of a terminated S corporation (even if only changing accounting methods) is taken into account ratably during a six-year period beginning with the year of change.

Decisions, decisions

The annual tax return provides an opportunity to reconsider the options available to the aggregate business. Entities with more than one shareholder or member can elect corporate status on their annual tax returns. Thus, an entity that is a partnership under state laws may elect to be taxed as a C corporation, or S corporation, for federal taxes by using Form 8832 (Entity Classification Election).

Unfortunately, under those so-called “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified corporations and may not elect to be treated as any other type of entity.

Changing business entities

In the eyes of many experts, there is no longer a reason to operate a crushed stone, sand or gravel business as an S corporation or another pass-through entity. Still, converting from a pass-through entity to a regular C corporation can be a complicated process requiring quite a few adjustments.

Changing tax laws such as the TCJA, changing circumstances and even the success of the aggregate business might prompt a reassessment of the entity used for a business. Best of all, the annual tax return is not the only option when it comes to selecting the most economical tax entity.

Although many of the tax law’s provisions apply to all business entities, some areas of the law specifically target each entity. Admittedly, choosing among the various types of entities can result in significant differences in federal income tax treatment, but there is more to choosing the right structure for a quarry operation than taxes.

Not only will the decision to change the aggregate business’ entity have an impact on how much is paid in taxes, it will also affect the amount of paperwork required for the business, the personal liability faced by the principals and, especially important in today’s economy, the operation’s ability to raise money.

To switch or not to switch

Since the situation of every producer is different, there is no one answer that will produce the lowest possible tax bill. While no decision should be based on taxes alone, choosing a new entity for an aggregate business should include the TCJA.

To help with this decision, pro or con, professional advice is strongly recommended.

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Mark E. Battersby is a freelance writer who has specialized in taxes and finance for the past 25 years.