By Martin E. Prendergast
Gray, Gray & Gray, LLP
The Tax Cuts and Jobs Act of 2017 included several provisions lowering tax rates for both C Corps and many pass-through entities such as S Corps, LLCs, partnerships, and sole proprietors. C Corps received a drop in their corporate tax rate from 35% to 21%. Pass-through entities (with the exception of “Specified Service Businesses”) received a 20% deduction on “qualified business income” (QBI).
As you can imagine, the definition of a Specified Service Business and the definition of “qualified business income” are the key to determining whether or not your architectural or engineering firm will qualify for the 20% deduction.
Qualified business income includes domestic income from a trade or business. Employee income, capital gains, interest, and dividend income are excluded from this deduction.
Specified Service Businesses are defined as those in which the principal asset is the reputation or skill of one or more of its owners. This includes most occupations that provide a personal service, such as consultants, lawyers, accountants, investment brokers, performing artists, doctors, and professional athletes.
There is one very important exception to this list: architects and engineers.
Despite the fact that the principals’ skill and reputation are at the heart of an architectural or engineering practice, this segment was granted an exception and will be allowed to take the 20% deduction on qualified business income.
One reason the architectural and engineering profession may have been granted this beneficial treatment is the loss of the domestic production activities deduction (DPAD). The DPAD was a 9% tax deduction offered as an incentive designed to reward companies that manufacture or produce their goods in the U.S. Architectural and engineering firms performing services on domestic construction projects qualified for the DPAD deduction; however, the DPAD expired at the end of 2017 and was not renewed. The exception made for the 20% deduction was Congress’ way of continuing the incentive for architects and engineers.
What does all this mean for your architectural or engineering firm? If you are organized as a C Corp, your tax rate should drop from 35% to 21%, beginning with the 2018 tax year. Please keep in mind that any C Corp distributions will continue to be taxed as dividends at the individual level at rates as high as 23.8% (which includes the 3.8% surcharge to help fund the Affordable Care Act). All of these factors should be considered when determining your true C Corp effective tax rate.
If you are a pass-through entity, there is some additional planning required. Your income is being taxed at the personal income tax rates, which have also been altered under the new tax law with the maximum rate now at 37%. In addition, the 20% deduction (under Section 199A of the tax law) can now be applied towards qualified business income (QBI). The deduction reduces the top effective rate on QBI income to 29.6% (which is 80% of the top 37% rate).
The 20% deduction for pass-through income is a complex issue with several twists and turns. The good news is that if you are the owner or partner of an architectural or engineering firm, you may be eligible to take advantage of a beneficial 20% deduction in your income starting in 2018. But before you start planning how to spend the money, make sure you know which part of your income will be eligible for the deduction and how much it will be.
Martin Prendergast is a Manager in the Architecture, Engineering & Design practice group at Gray, Gray & Gray Certified Public Accountants and Advisors in Canton, Mass. He can be contacted at (781) 407-0300 or at firstname.lastname@example.org