Under the tax plan agreed upon by the House and Senate this week, pass-through businesses such as LLCs or S-corporations would see a 20% deduction on their income, but for some individuals and businesses, the rate reduction could cause some reorganization and creative maneuvering as they wrap their heads around what will make the most financial sense moving forward.
The key to whether a business will see the benefits of the lower pass-through rate lies in how it is organized. For example, employees in brokerages and LLC law firms could either see big benefits from the new pass-through rate, or be left out in the cold.
Independent brokerages that are set up as partnerships or work as independent contractors affiliated with a firm are viewed as pass-through owners, and could qualify for the 20% rate. Brokers at firms that are owned by larger organizations such as banks are viewed as employees and are not eligible for the pass-through rate.
“The tax law shouldn’t pick one business model over another.”
—Equity Dealers of America CEO Christopher A. Iacovella
This means that independent brokers could end up paying far less in taxes annually than employee brokers under the new tax structure—a situation that could spur employees to leave and set up their own independent brokerage firms, or to jump ship and join a different firm to lower their tax bills.
“The tax law shouldn’t pick one business model over another,” Christopher A. Iacovella, CEO of Equity Dealers of America told Chief Executive.
In a letter to Congressional leaders this week urging them to change language in the bill to create a more level playing field for brokers classified as employees, Iacovella said “unequal treatment that incentivizes employee financial advisors to convert to the independent contractor model could reduce the tax liability of both firms and employee financial advisors and result in significantly less tax revenue for the government.”
Meanwhile, LLC law firm employees also could benefit from the law’s pass-through provision—an area highlighted in a report released this month authored by 13 attorneys and tax experts focused on potential loopholes in the new tax regulations.
By simply naming LLC law firm associates as partners in the LLC, they would qualify for the lower pass-through rate that they wouldn’t as associates. The problem here is such a policy could encourage businesses to either mischaracterize or rearrange its relationships to be classified as independent contractors, as opposed to employees, resulting in a loss of tax revenue.
“If Congress does not intend to write in such a massive loophole into the bill, it should act now to clarify—and not hope the IRS will staunch what could be a major bleed in revenue and a giveaway disproportionately benefiting those with high incomes,” the report reads.
Pass-through businesses also could consider a switch from S-corporation classification to C-corporation classification (or vice versa) depending on how they are structured, to take maximum advantage of lower rates.
“In some cases, it will be more advantageous to take advantage of pass-through rates; in other cases, a C-corporation shelter would be preferable,” according to the report. “Importantly, it will be the taxpayer’s choice, and, either way, the result is that the taxpayer will avoid tax at the top individual rate—and will instead enjoy a lower, preferential rate, whether via a C-corporation or pass-through.”
As Congress hammers out the final details of the plan leading up to a possible vote next week, qualifying pass-through businesses will certainly be closely monitoring the specifics and weighing their next moves if the bill becomes law.