The Tax Cuts and Jobs Act Is a Mixed Bag for S Corporation Shareholders
The Tax Cuts and Jobs Act (the “Act”) has passed both houses of Congress and only awaits President Trump’s signature to become law. President Trump may wait until January to sign the bill into law, but when he does, the Act will have a substantial impact on S corporation shareholders. Among other things, the Act: lowers the top tax rates for most individual taxpayers; substantially lowers the tax rate for ordinary corporations from 35% to 21%; and only permits state and local taxes, including property and income taxes, to be deducted up to $10,000. But the Act will also directly affect S corporations and other pass-through entities such as partnerships and limited liability companies.
Unlike ordinary corporations, which are taxed both at the corporate level and at the individual level when after-tax distributions are made to shareholders, tax on S corporations’ income is paid only at the individual level, when the S corporations’ profits are passed through directly to the corporations’ shareholders. Under the Act, most taxpayers with pass-through income would be able to deduct 20% of that income, effectively lowering the tax rate they pay. But there are some important limits on the deduction.
First, the deduction applies only to a “qualified trade or business,” which does not include (1) “the trade or business of performing services as an employee,” or (2) any service trade or business the principal asset of which is the reputation or skill or one or more of its employees, such as in the medical, legal, and accounting fields. The first part of the exclusion is aimed at preventing every employee from forming an LLC just to take advantage of the 20% pass-through deduction. The service trade or business the exclusion does not apply to any service professional whose taxable income for any taxable year is less than $207,500 for a single filer, or $415,000 for a married couple filing a joint return, so professionals earning under those thresholds would still be entitled to the deduction from their income, subject to the limit discussed in the next paragraph. Coupled with the new $10,000 limit on the deduction for state and local taxes, this exclusion will likely result in a net tax increase for working professionals earning in excess of those thresholds in high-tax states like California, New York, and New Jersey, which is why 11 of the 12 Republican Representatives who voted against the Act were from those states.
Second, a limit to the 20% deduction is phased in for taxpayers once they reach the threshold amounts of $157,500 for a single filer or $315,000 for married couples filing jointly. Importantly, however, the formula for determining eligibility for the full 20% deduction beyond those thresholds includes a capital element: the greater of 50% of employee wages paid, or 25% of employee wages paid plus 2.5% of the unadjusted basis of all qualified property immediately after purchase. Various tax experts have opined that the second part of this formula benefits businesses, such as commercial real estate, “where there aren’t a lot of workers, but there is a lot of valuable property around.”
Third, unlike the lower tax rate for ordinary corporations, which is permanent, the deduction for S corporations will not apply to tax years beginning after December 31, 2025. Republicans have vowed that the Act’s other tax cuts will be extended after their termination dates, but there is no guarantee at this time.
In sum, the Act is somewhat of a mixed bag for S corporation shareholders. Shareholders of S corporations operating businesses will benefit substantially from both the new 20% deduction up to the threshold amounts of $157,500 for a single filer and $315,000 for married couples filing jointly and the lower top tax rates for most taxpayers. On the other hand, high-earning service professionals, including doctors, lawyers, and accountants, in high-tax states may well pay more taxes under the Act.
 Waiting until January could postpone until 2019 spending cuts to Medicare and other programs that are required under federal law if legislation is approved that is projected to add to the deficit, as is the case with the Act. See Damian Paletta & Jeff Stein, GOP Tax Bill Passes Congress, The Washington Post, Dec. 20, 2017.
 See id. (to be codified at 26 U.S.C. § 199A(d)(1), (2)(A) (incorporating definition of “specified trade or business” in 26 U.S.C. § 1202(e)(3)(A)). The definition also includes the fields of financial and brokerage services, the performing arts, consulting, and athletics, but engineers and architects were carved out of the definition for purposes of the new pass-through deduction.
 See id. (to be codified at 26 U.S.C. § 199A(d)(3)(A)(i), (e)(2)).
 See Laura Saunders, What the Tax Plan Means for Doctors, Lawyers and Professional Service Firms, The Wall Street Journal, Dec. 19, 2017. The loss of the 20% deduction will be somewhat offset for single working professionals earning more than $500,000 and married couples filing jointly earning $600,000 or more, since they will get the benefit of the decrease in the top tax rate from 39.6% to 37.0% under the Act. See H.R. 1, 115th Cong. § 11001(a) (to be codified at 26 U.S.C. § 1(j)). But single working professionals earning between $207,500 and $416,700 will get the worst of both worlds, because they cannot take advantage of the new 20% deduction and will actually see their top tax rate go up from 33% to 35%. Id.
 See H.R. 1, 115th Cong. § 11011(a) (to be codified at 26 U.S.C. § 199A(b)(3)(B), (e)(2)).
 See id. (to be codified at 26 U.S.C. § 199A(b)(2)(B), (3)(B)).
 Amanda Becker, Tax Bill’s ‘Pass-Through’ Rule Will Aid Wealthy, Not Workers: Critics, Reuters, Dec. 20, 2017 (quoting Steven Rosenthal, a senior fellow at the Tax Policy Center); see also id. (this formula expands “the ability of highly paid owners in certain industries – and particularly those heavy in property but light in employees, like real estate – to qualify for the pass-through deduction” (quoting an assessment of H.R. 1 by 13 tax experts)).
 See H.R. 1, 115th Cong. § 11011(a) (to be codified at 26 U.S.C. § 199A(i)). The lower top tax rates for most individual taxpayers are set to terminate at that time as well. See id. § 11001(a).