In December 2017, new tax laws (called the Tax Cuts and Jobs Act) were enacted and became the biggest tax reform since 1986. These new tax laws heavily impact many individual taxpayers and businesses, including those in the entertainment industry. Two elements of the new tax act that especially affect entertainment and media companies are the deductions for loan-out companies and the choice of entity type.
New QBI Deduction
As discussed in our previous Media Clips blog, loan-out companies are very common in the entertainment industry. Many entertainment professionals set up an S-corporation or a limited liability company to protect themselves from liability and benefit from tax deductions that normally would not be deductible on an individual income tax return. Under the new law, the maximum federal tax deduction for pass-through entities is the lesser of either:
- 20 percent of the taxpayer’s qualified business income (“QBI”)
- The greater of 50 percent of the W-2 wages or 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of all qualified property
For this purpose, the computation of QBI excludes salaries and guaranteed payments, which means in a loan-out company the salary that the shareholder-employee pays her or his self is backed out from the net income, allowing for a higher threshold to calculate the 20-percent QBI deduction.
That sounds like good news to the taxpayers, doesn’t it?
Unfortunately, if we take a closer look at who qualifies for the new QBI deduction, we will notice that a majority of the loan-out companies in the entertainment industry will not benefit.
The QBI deduction disqualifies any “specified service trade or business,” subject to a taxable income threshold exception. Performing arts — including both front-of-camera and behind-the-camera — and athletics are some of the fields specified in this rule since the principal asset of the business is the reputation or skill of one or more employees or owners.
In order to take the full 20-percent deduction, the taxable income of the individual owner must not exceed $157,500 for a single filer or $315,000 for joint filers. For individuals with taxable incomes higher than these thresholds, there is a deduction phase-out until no deduction is permitted over $207,500 for a single filer or $415,000 for joint filers.
The thresholds are relatively low for talents in the entertainment industry, and it is likely that most taxpayers with existing loan-out companies will not be able to take the full deduction.
Loss of Various Deductions
If we won’t benefit from the new QBI deduction at the entity level, can we choose to deduct some business expenses as the individual’s itemized deductions?
Starting in tax year 2018, miscellaneous itemized deductions subject to a 2-percent adjusted gross income floor – such as unreimbursed employee business expenses and investment expenses – will be disallowed. That means, if the individual pays for union fees and agency fees out of pocket, these will not be deductible expenses anymore.
Another deduction that has been eliminated is the 50-percent entertainment deduction. Previously, businesses were allowed a 50-percent deduction on meals and entertainment expenses directly related to or associated with the active conduct of the taxpayer’s trade or business. Beginning in 2018, no entertainment expenses will be deductible, but the 50-percent of meals deduction is likely retained.
So far we have looked at how the changes impact pass-through loan-out entities and individual taxpayers, and it appears these taxpayers are at a loss. This is because the 20 percent QBI deduction generally does not apply to loan-outs and the loss of previously available deductions at the individual level. Let’s take a look at the changes that affect C-corporation loan-out companies.
Lower Corporate Tax Rate and Lower Dividends Received Deduction
The United States is no longer on the list of countries with the highest corporate tax rate. The corporate tax liability is computed at a flat 21-percent rate instead of a progressive tax system with a 35-percent maximum rate.
However, we should bear in mind that double taxation still applies to a C-corporation and its shareholders and the dividends received deduction for C-corporations has also been reduced from 80 percent to 65 percent and 70 percent to 50 percent despite the fact that the tax rate itself decreased. When a shareholder receives dividends from the C-corporation or liquidates assets, the income will be taxed a second time at the shareholder level.
Ultimately, the aggregate effective tax rate at the individual owner’s level depends on each person’s unique financial situation. However, it would not be wise to switch your loan-out entity type from a pass-through to a C-corporation without consulting with your tax advisor.
In conclusion, pass-through loan-out companies will no longer bring as many tax benefits as they used to. But, it is still a viable practice if the purpose is to protect the owner’s personal assets and shield them from liabilities, as the loan-out company is considered a separate legal entity.
Please note that impacts on businesses with international activities are beyond the scope of this blog. If you believe your business has international complications that arise from the new tax laws, we suggest that you reach out to our team for professional advice.