Crack and Pack: How Companies Are Mastering the New Tax Code

State of the Nation

Source:  MSN Money

Dallas attorney Garry Davis plans to break up his immigration-law practice. One firm will have all the lawyers. The other will record the profits.

It’s just one of many strategies businesses are exploring as they pore over the biggest rewrite of U.S. tax rules in decades. Mr. Davis’s approach, which some have dubbed “crack and pack,” seeks to get around a provision denying high-earning lawyers, doctors and other professionals a tax break available to plumbing contractors, restaurateurs and architects.

By separating the lawyers from other parts of the business, he hopes to lower the business’s overall tax bill while changing little in his day-to-day operations.

Long before most clarifying regulations have been issued, the new law has led to a burst of activity in tax circles as lawyers, accountants and businesses look for ways around some of the proposals meant to pinch them—and for ways to extend the reach of new tax breaks. For owners of closely held businesses, that can mean splitting operations apart, reclassifying them and re-categorizing their activities, all in an effort to get as much of their income taxed at the new low rates as possible.

The legislation contains more uncertainties than usual for a tax overhaul because of the speed of its drafting, which left little opportunity for the public and congressional scrutiny that often identifies confusion in bills. The recent omnibus spending bill shut down one loophole, involving farm products sold to cooperatives, while lawmakers and regulators say they are collecting feedback as they consider future changes.

In the meantime, tax experts are searching for moves business owners can make that will disrupt their businesses the least, while best qualifying for new tax breaks Congress has dangled. The private sector’s old game of cat-and-mouse with the Internal Revenue Service and Congress, in other words, is intensifying, and is likely to play out over years in regulations, audits, appeals and litigation.

For all but the largest publicly traded companies, much of the attention is focused on a new tax break for so-called pass-throughs, which make up a majority of U.S. businesses. In these, profits “pass through” to owners and are taxed at the individual level, instead of facing a corporate tax and then individual taxes, too, after money is distributed to owners.

Even with the corporate tax rate reduced by the new law, that two-layered structure means that it will still be attractive for many businesses to operate as pass-throughs. And the break given to them by the tax law effectively lowers the maximum individual income-tax rate for millions of business owners to 29.6% from 37%, the new top rate for wage income.

The break is fully available for the smallest businesses, but it contains guardrails meant to prevent some high-earning business owners such as Mr. Davis from claiming some or all of the benefit. Business owners who may bump up against these limitations are looking at steps that could permit them to claim or maximize these savings.

“People are hesitant to be the first to try some of this because the rules are so vague and you don’t know how it’s going to be interpreted,” said John Rizzo, an accountant in Rochester, N.Y., who has discussed the crack-and-pack strategy with several clients. “Some of these changes are hard to untangle.”

Another complication: The pass-through deduction expires at the end of 2025. Democrats might seek to reduce or eliminate the benefit and make other changes if they gain control of Congress and the White House before then. That means businesses are balancing the benefits of taking immediate advantage against the possibility it may not last.

Pass-through businesses, which include limited-liability companies, partnerships and what are called S corporations, now can deduct 20% of their business profits from their overall income. The break was created in part from political necessity, because pass-through owners are an important part of the Republican coalition and opposed cutting just the corporate tax rate.

The break can be claimed without restriction by owners with taxable income of $157,500 or less, or $315,000 for joint filers. Above those levels, it is phased out for lawyers, doctors and providers of certain other services.

Mr. Davis, the Dallas lawyer, figures he can still benefit from the break by splitting his law firm, Davis & Associates, into one entity holding four lawyers and another holding the 26-person administrative staff, who take information from new clients, put together immigration applications and handle other tasks. Profits in this part could be subject to lower taxes.

It isn’t clear how the IRS will look at such arrangements or how it will determine where profits are made. The agency hasn’t yet issued regulations in this area.

“It adds a layer of administration,” said Mr. Davis, whose firm is expected to have about $4 million in revenue this year. “We think we will be able to make it up as we grow.” The firm’s accountant is still working out the details.

Marvin Blum, a wealth planner in Fort Worth, Texas, is pitching a related strategy to his clients: Profit meant to be reinvested into a business is channeled into an entity that pays the new, lower 21% corporate tax rate, while profit that is meant to be distributed to owners in the near term goes into a pass-through entity that pays just the individual taxes. He calls it the “half and half.”

Joe Eppy, a Fort Lauderdale, Fla., insurance and financial-services adviser, is looking at creating a new corporation that would hold his real estate and certain other business revenue, would cover the cost of real-estate taxes, long-term care insurance and other benefits, and would pay the 21% corporate tax rate on any profit from the businesses in the new entity. “It will take some more time to fine-tune everything down to the last detail,” Mr. Eppy said.

Many of the workarounds are tailored to a specific business and its plans, such as how long the owners plan to hold the business and the effect of local taxes. That makes it hard to come up with the mass-market strategies that typically follow new tax laws.

Spinning off the real estate from a medical or legal practice into a separate leasing company, for instance, wouldn’t be likely to work in Florida, because the savings would largely be canceled by a 5.8% sales tax Florida imposes on lease payments, said Marvin Kirsner, a tax attorney in Boca Raton for Greenberg Traurig LLP.

Whether some strategies become popular could depend on how the IRS deals with fine points of the law, such as how health services are defined.

Cliff Holt owns four pharmacies in Utah that get more than 90% of their revenue from selling medicines, nutritional supplements, gifts and other retail products. The pharmacies also provide flu shots and vaccinations—which could be considered health services—and two of the 80 employees are registered nurses. Mr. Holt said he doesn’t want to miss out on the 20% deduction simply because he provides some health services, nor does he want to stop giving flu shots.

His tax adviser, Tom Wheelwright of WealthAbility LLC in Tempe, Ariz, is hoping the IRS will allow businesses structured as pass-throughs to claim the deduction even if a small amount of their revenue comes from health or other excluded services.

“If it’s all or none,” Mr. Wheelwright said, “the logical solution is to create two companies.” Mr. Wheelwright recently split his own CPA business from his education business, in part to take advantage of the new 20% deduction.

Accountants are finding ways around another tripwire: For high earners regardless of industry the tax break is limited to 50% of wages paid or a combination of wages paid and assets, pinching business owners with few or no employees.

Philip London and Mark Feldstein, accountants at Wiss & Co. in New York City, said they have cut a client’s projected annual federal, state and local tax bill by $145,000 with a relatively simple shift. The two-owner marketing and events company will elect to be taxed as an S corporation instead of as a partnership.

The new arrangement doesn’t fundamentally change the business, which earns estimated profits of $3 million annually. But the switch frees the owners from certain limits on partnerships and lets them pay themselves $500,000 each in wages, the accountants said. Those wages then let them qualify for the 20% deduction.

Other business owners are likely to redefine the type of work they do to better fit the law’s requirements. Karen Brosi, an accountant in Palo Alto, Calif., is telling high earners who consult on engineering projects to indicate on tax returns that they are “engineers”—a group not subject to the income limits for service businesses—rather than “consultants,” who are. The work is “all about engineering, code writing and systems engineering,” she said.

Advisers also are looking at ways to get taxable income below the $157,500 threshold so the restrictions don’t apply. That could simply mean stepping up charitable contributions or retirement-plan contributions, or taking other steps that reduce taxable income.

A more complicated option is to give shares of the business to family members, each of whom files a tax return that falls below the income threshold. Giving shares is easier now that the tax bill has raised the lifetime gift and estate tax exemption, tax advisers say.

Some business owners say potential tax savings aren’t worth the fuss. Larry Helms, president of C-Tech Controls Inc. in Hendersonville, Tenn., considered splitting his 37-person technology company in two to get around the wage limitations, but gave up on the idea after learning it would shave his tax bill by just 2% or 3%.

“There is a cost of doing that,” said Mr. Helms, whose firm provides building automation and controls, “and the tax incentive just wasn’t that great.”

 

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