Offering preliminary analysis on the potential impacts of the Tax Cuts and Jobs Act of 2017 on the advisory business, experts with the Wagner Law Group warn right off the bat that the Internal Revenue Service (IRS) still has to put forth its own interpretative regulations and technical corrections.
Even so, there are some potential loopholes emerging in the legislation that financial advisers and brokers would be wise to learn about. Even if these loopholes are closed by IRS or the Congress in the coming months, they still show the ways broad policy changes can result in unexpected challenges and opportunities. One such loophole “relates to broker/dealers, the new pass-through rules, and whether establishment of an independent contractor arrangement brings justifiable tax benefits.”
Wagner Law Group attorneys observe that, under the Tax Act, a deduction is available for 20% of qualified business income (QBI) from a pass-through entity. These include partnerships, sole proprietorships, limited liability corporations (LLCs) and S corporations. Related to this, a phased out deduction is available to “specified service businesses,” which includes brokerage businesses and advisory businesses, only if the taxpayer’s taxable income is $415,000 or less for married filing jointly or $207,500 or less for single filers. Wagner attorneys further highlight how the full deduction is available to specified service businesses if the taxpayer’s income is $315,000 or less for married filing jointly or $157,500 or less for single filers.
“The provision may prompt registered representatives to approach their employers with questions about restructuring their tax status,” the Wagner attorneys warn. “The reason being that for many registered representatives, their federal income tax position will be improved if they are independent contractors rather than employees of a broker/dealer firm. The 20% deduction of QBI means that a self-employed individual will be taxed at a lower rate than an employee performing substantially the same work with a broker/dealer firm.”
The Wagner attorneys speculate the following situation could occur with some frequency: “An individual registered representative who is presently an employee of a broker/dealer firm will give his or her proverbial two-weeks’ notice, and establish him- or herself as a sole proprietor performing substantially the same services that he or she was previously performing as an employee of the broker/dealer firm. In order to take advantage of this loophole, the threshold question is whether the registered representative can establish him- or herself as a bona fide independent contractor.”
This won’t necessarily be easy to accomplish, the attorneys warn, as the Internal Revenue Service has traditionally employed a 20-factor test to evaluate whether a worker is an employee or an independent contractor, with a focus on financial control, behavioral control, and the manner in which the relationship is treated by the parties.
“But assuming that the taxpayer can establish himself- or herself as a bona fide independent contractor, the Internal Revenue Code as amended by the Tax Act has certain anti-abuse provisions in place to deter taxpayers from converting wage income into QBI,” the attorneys notes. “For example, QBI may not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Therefore, if a number of registered representatives joined together to form a partnership or LLC, the amount of QBI cannot include any guaranteed payment for services rendered by the registered representatives with respect to brokerage services.”
One way to navigate this hurdle would be to restructure compensation so that it did not constitute guaranteed payments, the attorneys suggest.
“Also, because the services performed by a registered representative are treated as specified services, the deduction is subject to the dollar phase out: beginning at $157,500 for single taxpayers, and being fully phased out at $207,500, and $315,000 for married taxpayers, being fully phased out at $415,000,” the attorneys explain. “Therefore, certain registered representatives will be unable to take advantage of the lower pass-through rates.”
The Wagner Law Group attorneys urge firms and employees to think very carefully about attempting to reorganize compensation in this way, and not just because the loophole here could easily be closed by follow-up regulation or technical amendment.
“Even if an employee could benefit by converting his or her status from employee to independent contractor, there would be trade-offs in losing employee status,” they say. “For example, as an independent contractor, the individual would be responsible for the tax on self-employment income and the computation and payment of estimated taxes. The individual may also lose the benefit of workers’ compensation and unemployment compensation protection as well as the protection under certain federal statutes that provide protections to employees.”
At the other end of the spectrum, they even speculate some pass-through entities unable to take advantage of the new rates will be motivated to incorporate because of the lower 21% corporate rate.
“Even for S corporations to which the pass-through rate would apply, for taxpayers at the highest rates, the tax for S corporations is still approximately nine points higher than for corporations, although there are countervailing considerations for corporations desiring to pay dividends,” they conclude.