Tax reform bill has some hidden gotchas
The tax reform legislation that Congress approved Wednesday has a number of complexities that
could prove problematic for tax professionals and their clients.
“S corporations are now going to be required to pay FICA and Medicare tax on the profits,
whether they distribute the profits or not,” said Edward Mendlowitz, a partner with
WithumSmith+Brown. “If an S corp has profits, they’ll be required to declare the profits as
salary. Under existing law you didn’t pay the FICA and Medicare tax on the profits. You only
paid in the amounts that were declared as salary. This is a big change.”
It might be a good idea for many S corporations to become C corporations where the profits that
are not distributed as salary would be taxed at the 21 percent rate. “Under the new law, if we
make it a corporation, then the earnings that are not distributed as salary would be taxed at 21
percent and not subject to FICA and Medicare tax at all,” said Mendlowitz. “The downside is if
the money is distributed as a dividend to stockholders, it could be subject to another 15 percent
dividend tax. Just as an FYI, it would be 15 percent under the remaining 79 percent that the
corporation has left over after paying the corporate tax, and 15 percent tax on the remaining 79
percent would be subject to another 12 percent tax when distributed as a dividend. That means
the effective tax is 33 percent, which is still less than the individual tax plus the FICA tax and
Medicare tax on the earnings.”
Bill Smith, managing director of CBIZ MHM’s National Tax Office, thinks businesses may want
to use the existing expensing rules by the end of the year. “One issue is for businesses to take
advantage of the full expensing by buying and placing tangible assets in service by Dec. 31 to
take advantage of the higher entity and pass-through effective rates this year (the provision
applies for assets after Sept. 27),” he said.
He and Mendlowitz cautioned against an earlier recommendation of paying 2018 state income
taxes in 2017, pointing out that the conference committee has now killed that option.
Smith advises modeling this year’s taxes based upon the deductions that are disappearing next
year. “You may want to do the opposite of the traditional idea of deferring income to a lower tax
rate year, if you have enough deductions to reduce your high tax rate year,” he said.
The American Institute of CPAs expressed disappointment that the tax reform bill didn’t provide
the same favorable tax treatment for accounting firms as it does for other pass-through
businesses and for C corporations. “While the tax reform legislation contains several provisions
that should be welcomed by CPAs and their clients, the AICPA is very disappointed by
lawmakers’ decision to exclude CPAs from the measure’s treatment of pass-through entities,”
said AICPA president and CEO Barry Melancon in a statement. “Congress should have provided
parity for pass-throughs, regardless of their line of business, in order to achieve a fairer, simpler,
and more competitive tax code. The AICPA pointedly and repeatedly made the case that all
professional service firms–including accounting firms–should have received the new deduction.
The professional services sector, a critical element of America’s economic success, has been
ignored.”
Melancon pointed out that it’s not easy for CPA firms to simply reorganize themselves as C
corporations. “Accounting firms play an important role in the nation’s growth and job creation
and legislators erred in excluding them,” he said. “Those who suggest that CPA firms can adjust
to the change by reforming as C corporations do not understand that the nature of state licensing
regulations make such a transition impractical, if not impossible.”
Jon Traub, managing principal of tax policy at Deloitte Tax LLP, acknowledged the bill may
have unintended consequences. “The scope of what Congress was able to achieve cannot be
over-emphasized and will have major ramifications,” he said in a statement. “Congress approved
tax reform in record time; however we will not see its full impact for some time, as Treasury
implements it and companies react to it. With a bill of this size and complexity, there will be
unintended consequences that will need to be worked out on both the regulatory and policy
levels. The Treasury Department will be very busy in 2018 and beyond, helping provide
certainty to taxpayers, soliciting comments and drafting guidance. Companies will have to
carefully consider the impact of the law in their own context.”
Accountants should start on earnings and profits studies early if their companies might be subject
to the new deemed repatriation rules for multinational companies, Smith recommended.
“Determine if there is any benefit to actual repatriation prior to year-end, given your foreign tax
credit situation,” said Smith.
Corporations are getting more benefits from the new tax reform bill than professional services
businesses such as accounting firms.
“The new law seems to disregard service businesses like professional firms that need to retain
any funds in the company to be used to grow the company, so all that income would be subject to
the Medicare tax,” said Mendlowitz. “Meanwhile, the C corp, to the extent that money is used to
buy additional equipment, at least is only paying tax at the 21 percent level.”
Some service businesses may decide to reconstitute themselves as C corporations, but that opens
up new complications. Some accountants may find themselves using some familiar old tax
strategies once again. “If for some reason there’s a resurgence of using C corporations, some of
the old rules that have been pushed aside or neglected, such as the sale or disposition of stock in
a corporation at a loss, would be resurrected,” said Mendlowitz. “Also tax-free incorporations
under section 351, or investment in small business corporations under section 1202, would start
to be used more. Assuming the C corporation route makes more sense, the pass-through entities
like LLCs can elect to be taxed as a corporation on Form 8832, so you don’t have to be a C
corporation to be taxed as a C corporation.”
Some service businesses may balk at the different treatment they will now receive under the tax
reform bill.
“They’re making a major change, a big change,” said Mendlowitz. “They actually discriminated
against different types of businesses. They separated heavily capital intensive businesses from
service businesses.”
Nevertheless many service businesses employ working capital to invest in areas such as artificial
intelligence technology. “My firm has a very large investment in artificial intelligence,” said
Mendlowitz of Withum. “They’re ignoring that service businesses are doing that. They’re
ignoring that service businesses are growing. Those growing businesses need capital in the
business just to fund growth. A service business needs to buy real estate. If you’re an accounting
firm or an architecture firm you have to spend a lot of money building offices. These are issues
that are going to be coming. We want to look at ways to help our clients as much as possible.”
The legislation is likely to require a technical corrections bill to fix drafting errors and loopholes,
along with extensive regulations to work out the details of what's in the law.
“After the dust settles and Congressional Republicans celebrate their hard-won victory, their
attention will likely soon turn to the inevitable legislative work of fine-tuning and perfecting the
new tax framework,” said John Gimigliano, partner-in- charge of Federal Tax Legislative and
Regulatory Services at KPMG, in a statement. “As we’ve seen with other major tax legislation, it
can often take years to issue all the regulations and revisions related to a bill, and there’s no
reason to think this one will be any different.”
States will also face dilemmas with how to set tax policy as the tax reform bill limits deductions
for state and local income taxes, sales taxes, and property taxes to $10,000. Scott Peterson, vice
president of U.S. tax policy at the tax software company Avalara, used to be director of sales tax
for South Dakota, where the only income tax applies to banks. “Every time Congress changed
their corporate income tax, the state would have to hire an economist and a CPA to look at how
that would affect the income reported by banks in South Dakota to see does this increase revenue
to the state, or does it decrease revenue to the state,” he recalled. “Regardless of whether there
was a positive or a negative, the state legislature would have to decide do we want to collect less
revenue or do we want to collect more revenue. It’s always a decision the state makes.”
The impact of the tax reform bill is likely to be far-reaching for the coffers of many state and
local governments around the country. “Just about everything that’s part of the darn federal
corporate and personal income tax has changed somewhat," said Peterson. "There’s going to be
an immense amount of work required by state legislatures and state economists to try to
understand how those things flow down to their taxes and whether or not they want that outcome
or not. If you’re a legislature and you’ve got to make all these changes to your personal and
corporate income tax, you might throw your sales tax into the mix just to see maybe there’s
something you can’t do to resolve an issue in your personal or corporate income tax, but you
can’t do it in your sales tax. I’m expecting to see lots of conversations because it truly is an
immense undertaking that these states are going to have to go through just to understand what the
effect is. Often, I remember we had to hire outside people to do the analysis because we did not
have the data to know whether even relatively minor changes to the federal corporate income tax
would affect the income tax on banks. In this case, every business is going to be affected.”
If anything, the tax reform bill will encourage businesses to consult with their accountants for
advice on all the new changes. “There are a lot of moving parts, so it has never been a more
important time to get with their accountants and model out scenarios of options this year versus
next year,” said Smith.