Planning for the new Section 199A deduction

As indicated in our January newsletter when we first reported on the Tax Cuts and Jobs Act (the Act), the new Section 199A deduction for pass-through tax entities (almost any for-profit entity that is not a C corporation) is the most important provision in the new law for small and closely held businesses.

Business owners may want to take advantage of this deduction as soon as possible. Who doesn’t want a 20 percent tax deduction? Tax advisors, CPAs and attorneys alike are equally anxious to counsel clients on how to maximize use of the deduction. And this deduction presents a great opportunity for advisors to add value to their clients.

In a perfect world, there would be one-size-fits-all advice that could apply to all businesses, which makes the planning simpler to implement. Thus far, we are not aware of any “simple planning.” The new tax section is filled with limitations and nuances that complicates the deduction process. Further complicating matters is that the deduction ends after Dec. 31, 2025. So any planning to take advantage of the deduction for tax purposes, including a possible conversion from a C corporation to a pass-through entity, must take into account that the deduction is not permanent. In addition, some entities may do the reverse and convert from a pass-through tax entity to a C corporation.

Recently, for example, KKR & Co. LP, a large publicly traded private equity firm (how’s that for an oxymoron) announced that it would become the second alternative asset manager to change its tax status to a C corporation (Ares Management LP was the first). KKR’s share value increased by over three percent after the announcement. This is in part because under the Act the tax rate for C corporations was reduced to a flat 21 percent. So for those entities, the C corporation structure is apparently a better alternative than a flow-through entity (the owners of which may not be eligible for the Section 199A deduction). Given this, more large entities may follow suit.

In the meantime, the advisors of closely held businesses currently structured as pass-through entities for tax purposes are anxiously waiting on the IRS’ guidance regarding this provision (which is anticipated to be issued this summer) and proper counsel could then be provided to business owners. The following are basic strategies that appear to be currently acceptable:

• Implement processes to reduce income (naturally, this is somewhat counterintuitive) to keep taxable income below the thresholds where income limitations kick in;
• Restructure and/or create a new operating company to transform the income from a “specified service business” (to which the deduction may not apply) into non-specified service business income (to which the deduction may apply) – although recent unofficial comments from an IRS spokesperson questions whether this will be viable; and
• Hire more W-2 employees or convert 1099 contractors to W-2 employees to increase the amount available for the deduction.

We will keep you informed as new strategies emerge or as the IRS’ guidance is issued, which is currently anticipated to be issued in July.

Feel free to contact one of Chuhak & Tecson’s Corporate Transactions & Business Law attorneys for further counsel.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Mitchell D. Weinstein, Principal