We are coming to terms with US tax reform in the shape of the Tax Cuts and Jobs Act, the most substantive change in US tax legislation since 1986. The broad intent was to reduce taxes for both individuals and corporations, yet the American abroad may not achieve this.
In a series of articles by BDO’s London-based private client US tax advisory team, the firm considers the recent US Tax reform through the eyes of the American abroad. In this fifth instalment, tax partner Mark Walters looks at the impact of US tax reform on professional practices and the partners in them.
Professional practices and their partners
The December 2017 legislation includes several provisions which affect professional services firms and their partners. Here, we consider how the most important changes will affect international professional practices.
Qualified Business Income Deduction
The Republican Party’s 2015 ‘blueprint’ for tax reform was clear that reducing business taxes was key to its tax reform agenda. The final legislation included a significant reduction in the headline corporation tax rate, from 35 percent to 21 percent, but also included a significant tax break for members of certain pass through entities through the Qualified Business Income (‘QBI’) deduction.
Members of pass through entities such as partnerships – including Limited Partnerships and LLPs, LLCS, S-corporations and sole proprietorships – are now able to deduct the lesser of their QBI, or 20 percent of their income. Taxpayers who receive only QBI are, therefore, able to reduce their new top tax rate from 37 percent to 29.6 percent.
QBI is essentially any US source trading income other than income from a ‘specified service’ – defined as law, health, accounting, performing arts, consulting, athletics and financial services. However, partners in a ‘specified service’ business can still claim the QBI deduction if their income is below $315,000 for joint filers or $207,500 for single filers. The deduction is also limited to a percentage of wages paid to US resident employees. Most partners in professional practice firms will not be able to claim the QBI deduction, although engineers and architects are not ‘specified’, so such partners may benefit.
Structuring (or restructuring) US operations
Cutting the headline US corporation tax rate has moved the goalposts for entity selection for business expanding into the US. The use of pass through entities has historically been commonplace: most small businesses are established as pass through entities to avoid the additional layer of corporation tax at 35 percent. While the majority of small businesses will still be better off as pass through entities, the new 21 percent corporation tax rate may tip the balance for some.
Traditionally, professional practice businesses have structured themselves as partnerships - often for regulatory as well as tax reasons. However, those without a regulatory restriction may now consider using a corporation for their US operations, particularly where the QBI deduction is not available and there is significant reinvestment of profits.
New foreign tax credit ‘basket’
The corporate tax reforms aimed at US multinationals created two new foreign tax credit baskets. However, the new ‘foreign branch income’ basket applies to individuals as well as large multi-national corporations. It is broadly defined as covering any income from a non-US business, including partnerships operating outside the US. For example, a US citizen partner in a non-US professional firm may find that their income now falls under ‘foreign branch income’ - leading to problems if the partner cannot use carry forward credits from prior years from a different basket. No such guidance or transitional rules have yet been published to prevent any inequitable results.
Sales of US partnership interests
Is a sale of a US partnership or LLC interest by a taxpayer who is not US-resident subject to US tax? The IRS has long argued it was on a ‘look through’ approach (i.e. gains on selling the underlying US assets should be taxed). The IRS lost a significant case on this point in 2017 so, unsurprisingly, the tax reforms seek to enforce the IRS’ view. In fact, it went even further by including requirements for those purchasing such interest from non-residents to withhold and pay over tax on the transaction. Again, the IRS has yet to release any guidance on these new rules.
The legislation was drafted hurriedly without consideration of the many complexities. For example, how to determine what proportion of the business’ assets are US situs, or how US double tax treaties affect the net tax liability.
Impact on international firms and partners
Most international firms will have US citizen partners based outside the US. These partners are unlikely to benefit greatly from the QBI deduction, so if they are subject to tax in their country of residence, great care is needed to ensure that their foreign tax credit position is not harmed by the new rules.
However, firms looking to expand into the US may now find that a corporation is the better choice than a flow through partnership or LLC. The comparison will certainly be more nuanced than it has been and great care should be taken with transactions until the current tax uncertainties are resolved.
BDO’s private client US tax advisory team, based in London, comprises dual qualified US UK tax professionals experienced in the international taxation for ‘US-connected’ clients:
- US citizens living abroad
- Foreign nationals moving to US or with investments in the US
- Businesses looking to expand into or out of the US
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