Christine Benz: Hi, I'm Christine Benz for Morningstar. The recently enacted tax laws have some potential implications for financial advisory businesses. Joining me via Skype to discuss some of them is Michael Kitces. He is a financial planning expert.
Michael, thank you so much for being here.
Michael Kitces: My pleasure. Thank you.
Benz: One thing that we are hoping to get your take on--and I know you focus a lot on the community of financial advisors, on the business of providing financial advice--is the implications of the recently enacted tax laws for financial advisors. Let's talk about some of the effects that you see taking effect over the next several years.
Kitces: The big issue that's cropping up for financial advisors in the new tax law is this new deduction for so-called pass-through businesses. It's actually a little bit of a narrow name because it's really any business that's not a traditional C corporation. That includes both partnerships, LLCs, and S corps that are pass-through businesses and even just a good old-fashioned Schedule C sole proprietor is eligible for this deduction as well. What it simply says is, when you get this pass-through business income, you can then deduct 20% of it straight back off your tax return. You effectively only pay taxes on 80% of the business income that you generate.
It becomes a very appealing deduction with the caveat that there is a big limit. The limit is, so-called specified service businessesk which are essentially personal services businesses like doctors, lawyers, accountants, and unfortunately, for us, financial advisors, have a cap on this, where once your income goes over certain thresholds, this 20% deduction phases out and you go back from being taxed on 80% of your income to being taxed on 100% of your income. A very appealing deduction but a limited one. Because of that I think we are going to see a lot of focus and activity on how to qualify for the deduction, who qualifies for the deduction, and how to try to manage your income to stay below the line to get the deduction as advisors.
Benz: We had been hearing initially when the tax laws were proposed and then when they were enacted that there would be this mad scramble for a lot of people who had businesses to sort of recharacterize themselves as pass-throughs. You think from a practical standpoint for advisors that's just not going to work because they are service businesses.
Kitces: For advisors that are looking at this, there's kind of two considerations. First is, are you a pass-through business in the first place? If you already are, if you are an advisor that gets paid through Schedule C, you have your own LLC or partnership or S corporation, you are a partner to the business, you are already going to be eligible for this. The only question is, whether you phase it back out because your income is too high. The income threshold is, $157,500 for individuals, $315,000 for married couples, it's where the new 32% bracket kicks in. Once you are over that line, you start phasing out the deduction and after $50,000 or $100,000 of income, you lose it entirely.
If you've got a pass-through-qualifying entity in the first place or you are a sole proprietor Schedule C, you will be eligible, but you may phase it out, and it just becomes a question of whether your income is over the line. Recognize that income means all the income on your tax return, not just your business income. Your portfolio income, your rental real estate, your spouse's income. Everything that shows up on your tax return in the aggregate can put you over this line, which unfortunately means a lot of advisors may not get the deduction simply because we happen to be in a relatively higher-earning profession. A lot of long-term, experienced, successful advisors get over these income lines or at least they do when all the household income comes together.
The second group is those who don't actually qualify because they are not structured as a pass-through business entity or a Schedule C independent contractor, they are an employee. This includes employees in RIAs; this includes employees at captive broker/dealers where you actually have an employee relationship and seven independent contractor relationships. For people on that situation, this deduction simply isn't on the table. This is the group that I think is going to be starting to take a hard look at do I actually still want to be an employee or do I want to try to recharacterize my relationship with the firm to become an independent contractor so that I can get the deduction. Not helpful if your income is already so high that you are over the line, but plenty of employee advisors that earn $50,000, $75,000, $100,000, $150,000 and their household income may be over the line, and they can get this 20% deduction by restructuring themselves away from an employee relationship into an independent contractor one, or if necessary, even changing firms just to move from an employee-based firm into an independent contractor or partner-based firm.
Benz: You think we'll see some action on that front. I want to ask you about, you mentioned registered investment advisors or RIAs. Are there any specific implications for them from the new tax laws that we've seen?
Kitces: The rules get very messy for RIAs for a couple of reasons. Smaller RIAs that are under the income limits simply get to enjoy the deduction. It's pretty straightforward. Those who are very high income and over the line, just won't get it at all. Larger RIAs end up in a slightly different and a little bit more of an odd bucket, because the new deduction is calculated based on 20% of your business income but phasing it out is based on the personal income on your tax return, which means I can have a series of partners at an RIA where some of them get the deduction and the other ones don't. In particular, founders will tend to struggle for the deduction because a large, successful firm probably has enough income to put them over the phase out line, but all of their next-generation junior partners may get the deduction because their household income is under the line, because they are not quite earning as much, and they are not founders. Larger RIAs start getting some distortions because some partners will get the deduction and others will not. For especially large RIAs, the fact that they don't get the deduction at all, I think it's going to make some start to take a hard look at whether they even want to recharacterize the nature of the business and convert themselves to a C corporation instead, because C corporations have this new rate themselves under the reform of just 21%, while our individual tax brackets cap out a 37% with no deduction.
Benz: C corps qualify for the corporate tax rate?
Kitces: Right. C corp, if I convert my advisory firm into a C corp, I get the corporate tax rate. Now, the problem is, as the business owner I still can actually get my profits out without at least taking a dividend distribution. Dividends are taxable. The corporation will pay 21%, but then I could pay as much as 23.8% top qualified dividend rate plus the Medicare surtax and the total taxes of the two may actually add up to more than just staying as a pass-through entity.
But I control the timing. Pass-through businesses are always taxable immediately. If I'm a founder of a large RIA, I'm paying 37% under the new law. As a C corp, I pay 21% now and I don't pay taxes on the rest of it. I actually take the money out or until I sell the business. And for large, highly profitable RIAs, that's a lot of very valuable cash flow that they might decide, hey, I love to not pay taxes on a huge portion of this or pay at a much lower rate, and then reinvest it for hiring, growth, acquisitions. At some point, I may have a capital gains rate when I sell my firm, but I can get 21% rates instead of 37% rates for three or five or 10 years of reinvesting to make my firm more valuable and then sell it for a much bigger number down the road. I think we are going to see some large growth-minded RIAs start taking a hard look at the implicit tax deferral of only paying a 21% corporate rate now and dealing with their dividend or capital gains rates down the road if they are not planning to take the money out anyways.
Benz: Certainly, a lot of food for thought here for financial advisors. Thank you so much for being here to share your perspective.
Kitces: My pleasure. Happy to be in service.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.