Update Dec. 22, 2017: The “Tax Cut and Jobs Act” (Act) is law, and as expected, the Conference Agreement (CA) adopted the Senate Amendment on the QBI deduction on pass-throughs. It reduced the rate to 20% from 23%. To meet the House part-way, it lowered the taxable income threshold to $157,500 single and $315,000 married, for the “specified service activity” (SSA) and wages limitations. The CA retained the Senate’s phase-out ranges above the threshold of $50,000 single and $100,000 married. If an individual’s taxable income is over $207,500 single or $415,000 married, he or she won’t get a pass-through deduction on an SSA. But, they might get a deduction on a non-SSA, subject to the wages limitations. The CA added an alternative to the 50% wage limitation: 25% of wages plus 2.5% of “unadjusted basis, immediately after acquisition, of all qualified property.” The House bill had a capital percentage, so contrary to media reports, a capital factor did not come from out of the blue. In the CA on pages 28 – 37, there are examples for how the phase-out range works. The CA raised the C-Corp flat tax rate to 21%, and it adopted the House commencement date in 2018.
The Senate passed their “Tax Cuts And Jobs Act” bill on Dec. 2, after making last-minute concessions to holdout Republican senators. One significant change was increasing the pass-through deduction to 23% from 17.4%. Many service businesses, including traders, may qualify for the deduction if their taxable income is under an upper-income threshold. Conferencing the Senate and House bills should commence next week and that may be difficult for this provision since the House 25% pass-through rate is entirely different from the Senate 23% pass-through deduction. I hope the Senate provision prevails and the House accepts it. In this article, I’m offering preliminary advice — stay tuned for updates if and when Congress passes final legislation.
I envision most TTS traders continuing to use an S-Corp for 2018 to unlock employee-benefit plan deductions – it’s the cake. They may qualify for the 23% pass-through deduction if their taxable income is under the upper-income threshold, which would be icing on the cake. A high-income trader living in a corporate-tax-free state, who does not expect to qualify for the pass-through deduction, should consider a C-Corp when the 20% flat tax rate applies. The Senate bill delays the 20% corporate rate by one-year to 2019, whereas, the House bill commences its 20% corporate rate in 2018.
Form a single-member LLC and select entity type afterward
Traders planning to be eligible for trader tax status (TTS) in 2018, who want an entity, can form a single-member LLC this month and remain a “disregarded entity” for 2017, so there is no 2017 LLC tax return. On Jan. 1, 2018, admit a spouse for a partnership tax return, and/or file an S-Corp election by March 15, 2018, or choose to be taxed as a C-Corp. That plan provides time to make the best assessment of your tax situation and planning, and it facilitates account openings in time for trading on Jan. 1. If you commence trading in 2018 in an individual account, and later switch to a partnership, S-Corp or C-Corp, it will complicate 2018 tax compliance.
The C-Corp 20% rate
In the Senate’s bill, C-Corps benefit from a 20% flat tax rate vs. individual rates up to 38.5%, plus 3.8% Obamacare net investment tax (NIT). (The House bill’s top individual tax rate is 39.6%.) The maximum difference could be a whopping 22.3% in federal tax rates. Several tax pundits have suggested that many pass-through entities would likely switch to a C-Corp.
The 20% corporate flat tax rate is not as good as it seems at first look. The average individual tax rate is 30% for high-income taxpayers just entering the top tax bracket, and with the inclusion of the 3.8% NIT, the actual difference is 14%. Double taxation on the federal level can wipe out that savings with a 15% or 20% capital gains tax on “qualified dividends” plus 3.8% NIT. Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity. Forty-four states have a corporate income tax, and states treat qualified dividends as ordinary income. There are also potential 20% accumulated earnings taxes and 20% personal holding company tax penalties. Look before you leap into a C-Corp and consult a trader tax expert.
Pass-through tax cuts
The Senate bill provisions for pass-through entities have many limitations, especially for service businesses. The definition of a “specified service activity” includes trading. Qualified business income (QBI) includes Section 475 ordinary income, and it excludes capital gains from investments. It is questionable whether QBI excludes business-related capital gains for a TTS futures or securities trader, not electing Section 475 ordinary income. That answer may not be apparent until the IRS issues regulations. In the Senate bill, a pass-through service business owner is eligible for the 23% deduction on QBI, providing his or her taxable income is under the threshold of $500,000 married and $250,000 other taxpayers. It phases-out up to $600,000 married and $300,000 other taxpayers. Non-service businesses do not have the income threshold. (See Senate’s Five Haircuts On The Tax Deduction For Pass-Through Entities and Section 475 Traders May Be Eligible For Pass-Through Tax Cuts.)
The House bill also restricts specified service activities, including trading. It allows active owners of service businesses to use the 11% pass-through tax rate vs. the 12% ordinary bracket for 2018, on the first $75,000 of business income, for taxable income under $150,000 married and $75,000 other taxpayers. There is a phase-out range up to $225,000 married and $112,500 other taxpayers. Active owners of a service business can qualify for the maximum 25% pass-through tax rate if the business has an “alternative capital percentage” of 10% from a significant investment in business equipment (and perhaps “internal-use software”). Many traders won’t achieve a 10% alternative capital percentage, so they may not get any of the 25% rate benefit under the House bill.
C-Corp double taxation with qualified dividends
A C-Corp pays taxes first on the entity level, and the owners owe taxes a second time on the individual level on dividends and capital gains. The House bill has a 20% flat tax rate on C-Corps and a 25% flat tax rate on “personal service corporations.” The Senate just has one 20% flat tax rate.
When C-Corps make a cash or property distribution to owners, it’s a taxable dividend if there are “earnings and profits” (E&P). If the individual holds the stock for 60 days, it’s a “qualified dividend,” subject to lower long-term capital gains rates of 0%, 15%, and 20%. A high-income trader will likely pay the 15%, or 20% rates, plus Obamacare 3.8% NIT on unearned income over the modified AGI threshold. This dividends tax and NIT may offset the 14% difference in individual vs. corporate tax rates.
Accumulated earnings tax
If the C-Corp does not pay dividends from E&P, the IRS can assess a 20% “accumulated earnings tax” (AET) if the C-Corp E&P exceeds a threshold and company management cannot justify a business need for retaining E&P. The IRS is trying to incentivize C-Corps to pay dividends to owners. The IRS AET threshold is $250,000, or $150,000 for a personal service corporation.
As stated in Section 533 – Evidence of purpose to avoid income tax:
“(a) Unreasonable accumulation determinative of purpose
For purposes of section 532 (Corporations subject to accumulated earnings tax), the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.
“(b) Holding or investment company
The fact that any corporation is a mere holding or investment company shall be prima facie evidence of the purpose to avoid the income tax with respect to shareholders.”
If the IRS treats a TTS trading company as an “investment company,” then it may assess 20% AET on all E&P and therefore undermine the C-Corp strategy for traders. But I don’t think a TTS trading company is an investment company. Perhaps, a TTS trading C-Corp can demonstrate it has a business need for E&P above the threshold.
Officer compensation avoids double taxation
Historically, C-Corps paid higher officer compensation to avoid the 35% C-Corp tax rate. But now, C-Corps may want the 20% C-Corp tax rate over the individual tax rates of 35%, and 38.5% on wage income instead.
State double taxation can ruin the C-Corp strategy
If you live in a high tax state for corporate and individual taxes, the C-Corp may be the wrong choice of entity. According to Tax Foundation, “Forty-four states levy a corporate income tax. Rates range from 3 percent in North Carolina to 12 percent in Iowa.” (See the Tax Foundation map, State Corporate Income Tax Rates and Brackets for 2017.)
States don’t use lower capital gains rates; they treat qualified dividends as ordinary income. The Senate and House bills repeal state and local income tax deductions for individuals.
A C-Corp is a wrong choice for a trader entity in California with an 8.84% corporate tax rate, but it could be the right choice for a high-income trader in Texas without corporate taxes. The Texas 0.75% franchise tax applies to all types of companies with limited liability, including LLCs, and C-Corps, and the “No Tax Due Threshold” is $1.11 million. Most traders won’t trigger the Texas franchise tax.
Don’t try to avoid filing a C-Corp tax return in your resident state. You are entitled to form your entity in a tax-free state, like Delaware, but your home state probably requires registration of a “foreign entity,” if it operates in your state. Setting up a mail forwarding service in a tax-free state does not achieve nexus, whereas, conducting a trading business from your resident state does.
1. No lower 60/40 capital gains tax rates on Section 1256 contracts.
2. Ordinary losses do not pass-through to the owner’s tax return, missing an opportunity for immediate tax savings against other income. The Senate bill has an excess business loss limitation of $250,000 single, and $500,000 married, and it repeals the NOL carryback. (See How The Senate Tax Bill Disallows Excess Business Losses In Pass-Throughs.)
3. A C-Corp investment company without trader tax status may not deduct investment expenses.
4. If you liquidate a C-Corp to realize the capital loss and ordinary loss trapped inside it, you might qualify for Section 1244 ordinary loss treatment up to $50,000 single, or $100,000 married, with the remainder of the loss treated as a capital loss. That means you could be stuck with a capital loss carryover. Per Section 1244, “a corporation shall be treated as a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000.”
S-Corps work well for TTS traders
For 2017 and subsequent years, TTS traders can arrange to deduct health insurance and retirement plan contributions in an S-Corp. The 2017 maximum Solo 401(k) retirement plan deduction is $54,000 or $60,000 if age 50 or older. For 2018, the IRS raised the limit by $1,000. Health insurance premiums for a family could easily be $20,000 per year. Sole proprietor traders and spousal-partnership traders cannot have these employee-benefit deductions.
The Senate and House bills bring potential additional benefits for TTS traders, starting in 2018. As a specified service activity, a TTS trader may qualify for the Senate’s pass-through deduction or the House’s pass-through tax rates.
There is no double-taxation with an S-Corp, except for minor S-Corp taxes in a few states: California has a 1.5% franchise tax, Illinois has a 1.5% replacement tax, and New York City treats S-Corps like a C-Corp. In those jurisdictions, high-income TTS traders use a dual entity solution: A trading partnership and S-Corp or C-Corp management company to limit S-Corp entity-level taxation.
If there are business losses from business expenses and Section 475 trading losses, using a pass-through structure will offset other income, and possibly generate a net operating loss (NOL) carry forward. (The Senate and House bills repeal NOL carrybacks.)
If the TTS trader does not need employee-benefit plan deductions, they may trade in an LLC filing a partnership return or a general partnership. A partnership return qualifies for pass-through tax cuts. Sole proprietor traders may have difficulty claiming tax cuts since it deducts business expenses on Schedule C and reports trading gains on other tax forms.
When should a TTS trader consider a C-Corp?
If you are a high-income trader in a corporate-tax-free state and don’t qualify for pass-through tax cuts, the C-Corp’s 20% rate may be attractive. But, the Senate bill delayed the 20% rate until 2019. The House commences its 20% corporate rate in 2018. (See the Nancy White example below.)
There will be opportunities for tax advisers to conceive other ideas based on final legislation and its anti-abuse provisions. For example, a trading company is a “specified service activity” with limits on pass-through tax cuts, but a second entity set-up to receive royalties for licensing trading systems may not be.
S-Corp example for a middle-income trader
Joe Smith is single, and he operates a TTS trading S-Corp in 2017 to maximize employee benefit deductions.
For 2018, the S-Corp net income is $200,000, including Section 475 ordinary income, and after it deducted business expenses and officer compensation. The S-Corp officer compensation is $25,000, including reimbursement of health insurance of $6,500, and a Solo 401(k) “elective deferral” of $18,500 (2018 maximum). Joe’s taxable income is $170,000 ($206,500 gross income, less a $6,500 health insurance AGI deduction, less $30,000 itemized deductions).
Taxable income is under the Senate bill’s $250,000 single threshold for a “specified service activity” so Joe is entitled to the lower of a 23% deduction on qualified business income (QBI), or 23% deduction on modified taxable income. The QBI deduction is $39,100 (23% of $170,000 modified taxable income). Taxable income after the pass-through deduction is $130,900.
Joe’s 2018 federal income tax is $25,956. Joe’s marginal tax bracket is 24%, and his average tax rate is 20%. A C-Corp has the same 20% rate, but Joe qualifies for a $39,100 pass-through deduction, whereas with a C-Corp, he does not.
If Joe used a C-Corp, then net income is $200,000 after deducting health insurance expenses and officer compensation of $18,500 for Joe’s Solo 401(k) elective deferral. A C-Corp can deduct the $6,500 health insurance premiums as a business expense. So far, Joe’s taxable income is zero, unless he executes additional officer compensation above the elective deferral and/or he pays a qualified dividend, before year-end. Joe wants to utilize the $12,000 standard deduction and the 0% capital gains bracket up to $38,700 single, so he pays a qualified dividend of $50,700. His individual tax bill is still zero on the federal level. Joe may take officer compensation, but that incurs 12.4% social security taxes up to the social security base amount of $128,400 (2018 limit) and 2.9% Medicare tax is unlimited. Traders don’t owe payroll or SE taxes on trading gains, so this additional social security tax is unwarranted and costly.
If Joe does not pay additional wages to reduce net income of $200,000, the C-Corp taxes are $40,000, assuming the new corporate rate applies in 2018. That’s $14,044 more tax than using the S-Corp entity strategy. Even before considering state taxes, it’s wise for Joe to use an S-Corp.
A C-Corp might be right for a highly profitable trader in a tax-free state
(Assume the low C-Corp tax rate applies for 2018). Nancy White, a resident of Texas, consistently makes well over $500,000 net income per year trading securities with Section 475 ordinary income. She has officer compensation of $146,000 to maximize her Solo 401(k) retirement plan contribution of $55,000 (under age 50).
With an S-Corp, her 2018 gross income is $646,000 ($500,000 K-1 income and $146,000 wages), she takes a $25,000 itemized deduction, which makes her taxable income $621,000. Nancy is over the $250,000 taxable income threshold, so she does not qualify for the Senate bill’s 23% deduction on pass-through business income. Her 2018 federal income tax is $197,325 using Senate rates. Her marginal tax bracket is the top 38.5% rate, and her average tax rate is 32% — 12% above the C-Corp flat rate of 20%. She also owes 3.8% NIT on the unearned net income of $500,000 K-1 income over the modified AGI threshold of $200,000. NIT is $11,400. Nancy’s total federal tax liability using an S-Corp is $208,725.
With a C-Corp, her individual tax return gross income is $146,000 from wages, and Nancy takes a $25,000 itemized deduction, which lowers her taxable income to $121,000. Her individual federal income tax is $23,580, which is 19.5% of taxable income. Nancy does not owe NIT in this case. (This assumes she has no qualified dividends from the C-Corp.)
The federal corporate tax is $100,000 ($500,000 times 20%). Total federal tax is $123,580.
The C-Corp structure delivers 2018 federal tax savings of $85,145 vs. the S-Corp. There is no corporate or individual income tax in Texas, so the savings with the C-Corp can be significant. It further depends on if Nancy pays qualified dividends or has an IRS 20% AET assessment.
If Nancy needs distributions for living expenses, she has two choices:
1. Pay additional wages, which only are subject to Medicare tax of 2.9%, which reduces C-Corp net income at a 20% rate, and subjects her to more individual tax at 24% and 32% marginal rates.
2. Pay qualified dividends taxed at 15%, plus some 3.8% NIT, which does not reduce C-Corp taxes. Her overall savings will decline, but it’s still substantially positive vs. the S-Corp. For example, a qualified dividend of $300,000 would cause $45,000 of capital gains taxes and $9,348 of NIT. Net federal tax savings from using the C-Corp vs. the S-Corp would be $30,797.
If Nancy moves to California, the C-Corp is not a good idea because California has an 8.84% corporate tax rate and with double taxation, the C-Corp savings disappears. Just like many other states, California treats all income as ordinary income; it does not distinguish qualified dividends or long-term capital gains. California’s corporate tax is $44,200 ($500,000 times 8.84% rate), plus individual taxes on $300,000 qualified dividends is approximately $28,000. A C-Corp in California would lead to $41,403 higher federal and state taxes vs. using a dual entity solution, where a trading partnership and S-Corp management company are used to avoid the state’s 1.5% franchise tax on S-Corps.
Webinar Dec. 6: How To Setup The Best Trading Entity For Tax Cuts.
Darren Neuschwander CPA contributed to this blog post.