The relationship between individual taxpayers and their businesses continue to offer opportunity for effective tax savings, including the use in certain circumstances of C corporation structures to arbitrage tax rates, allow for greater deductions and potentially offer savings on an exit. However, much tax planning continues to focus on accessing these benefits before they sunset (absent future extensions of TCJA legislation) in 2025.
For business owners who have structured their businesses as a flow-through entity (i.e., partnership, disregarded LLC, S Corp), the following should be considered in any year-end tax planning:
- Net Investment Income Tax
For passive investments in pass-through entities, consideration should be given to net investment income tax (“NIIT”) which is imposed at 3.8% on such income. While many taxpayers view this tax as primarily imposed on passive income like dividends, interest and capital gains, it can also impact income from rental properties, mutual fund distributions or royalty and annuity income. As relates to business investments, if the activity of the owner of such investment is considered to be passive (vs. active), the NIIT can also apply on income that flows through to such owner where their adjusted gross income exceeds a certain threshold ($250,000 for MFJ, $125,000 for MFS and $200,000 for all others; thresholds which are not indexed for inflation). Where investments or business interests are held by trusts, the tax is also applied at the same rates but at much lower adjusted gross income thresholds (approximately $13,450). Careful management of your adjusted gross income threshold may minimize your exposure to the NIIT.
- Excess Business Losses
The Inflation Reduction Act of 2022 (“IRA”) extended the limitation on excess business losses for noncorporate taxpayers from 2026 to 2028. Taxpayers except corporations are limited on the amount of trade or business deductions that can offset nonbusiness income. For 2022, the limitation is $540,000 for married filing jointly. The CARES Act had suspended these limitations for 2018, 2019 and 2020; however, this limit is now back in effect and planning to mitigate its effect if your business is in a loss position should be undertaken.
- Possible C Corporation Conversions
The use of a C corporation structure for business may, if qualifications are met, produce significant currently tax savings as C corporations earning are tax at a 21% U.S. income tax rate versus the maximum 37% U.S. tax. Additionally, upon a sale Section 1202 allows for up to $10 million of gain from the sale of qualified small business stock to be exempt from taxation. A detailed analysis on whether to utilize such benefits is beyond the scope of this newsletter, but DUGGAN BERTSCH attorneys are familiar with this analysis and can assist you in determining if converting your pass-through business to a C corporation is in your best interest.