When the Tax Cut and Jobs Act of 2017 was signed into law on December 22nd , the most significant change to the US tax code in more than thirty years, I expected a collective rejoicing among home care owners who stand to benefit. Instead, confusion prevailed.
It is clear that home care companies organized as “C” corporations will be benefactors of the corporate tax rate reduction from 35% to 21%. Less clear is how home care companies organized as “S” corporations, LLCs, sole proprietors and partnerships will be affected by the new 20% tax deduction on Qualified Business Income that flows through to the owner’s personal tax returns.
Since pass-thru entities make up most of the approximately 20,000 US home care providers, I will endeavor to eliminate the confusion and provide clarity. As I do, if you have any noisemakers left over from your New Year’s Eve party kits, you may want to keep one handy while I report some good news.
My disclaimer though is that I’m not a Certified Public Accountant. However, my team and I work closely with them in executing home care acquisition transactions across the US. My personal interpretation of the new law will need to be verified and validated by a CPA.
As our ownership succession planning clients know, the final return on their home care investment is the sum total of the after tax income achieved during ownership and the net capital gain earned upon the sale of the business. Although the nuances of the law are subject to further interpretation and clarification, my opinion is this. The vast majority of home care owners stand to substantially benefit from the new law in the form of lower tax rates and higher business valuations.
Specified Service Businesses: The confusion began when it was widely reported that certain service companies would not be eligible for the tax cuts. The law defines a Specified Service Business as health, law, consulting, athletics, financial services, brokerage services or any business where the principal asset is the reputation of one or more of its employees or owners. The underlined portion of this definition certainly appears to apply to home care providers. But even if it eventually becomes interpreted as such, most home care providers would not be excluded. Rather, they would be limited on a means tested basis. Only a minority wouldn’t benefit at all.
Qualified Business Income (QBI): The 20% tax deduction applies to the net income of S corporations, LLCs, sole proprietors and partnerships. If such entities are categorized as Specified Service Businesses, the full tax deduction is limited to those owners with taxable income of less than $315,000 if married filing jointly or $157,500 for single filers. The deduction does not apply to reasonable W-2 wages that S Corporations or partnership owners pay themselves as compensation for running their companies.
If the home care industry is caught by the Specified Service Business net, it would only impact owners with taxable incomes that exceed these thresholds. Otherwise, the tax deduction is limited to 50% of the home care company’s W-2 payroll. Given the labor intensive nature of the home care industry in which provider payrolls average more than 65% of revenue, the tax deduction would in essence be limitless if home care providers as currently interpreted fall outside of the Specified Service Business designation.
Example: To illustrate how it works, I pulled the 2017 tax returns of one of our sale clients formerly operating in the great Hawkeye State. The key figures are as follows.
Total Income (Line 6): $2,000,000
Compensation of Officer (Line 7): $72,000
Salaries and Wages (Line 8) $1,228,000
Ordinary Business Income (Line 21) $200,000
The $272,000 of compensation and ordinary business income this former home care owner earned was subject to a 33% tax rate based on 2017 household adjusted gross income of $300,000. Therefore, the home care owner compensation and business income net of the $89,760 tax bill was $182,240.
Under the identical scenario in 2018, the $89,760 tax obligation would be reduced to $55,680 for a reduced tax bill of more than $34,000. That’s because the W-2 compensation in 2018 is taxed at the lower rate of 24% and the business income at a 19.2% rate net of the 20% tax deduction (24% tax bracket minus 4.8 = 19.2%).
With a reduced tax bill of $34,000, the owner could either increase his ordinary business income by 17%, reinvest it back in the business or a combination of the two. Increased caregiver wages to top performers is certainly one way to invest the tax savings. But keep in mind, most caregivers just got a big tax cut in the form of the doubling of the standard deduction to $24,000 and an increase in the child tax credit to $2,000. That’s because the law was designed to benefit those at the lower end of the tax scale and job creators. So in this scenario, it’s a net win for the owner and her caregivers.
If the tax savings is applied to her business income, the value of her business using an after tax targeted rate of return of 15% would have increased from approximately $900,000 at the 33% tax rate to $1,077,000 at the 19.2% tax rate. That’s a valuation increase of 20%! And if this particular home care company stays outside of the Specified Service Provider designation, the cap on the deduction would be $650,000 (half of the company’s W-2 payroll.) So as the company grows, the deduction grows with it.
But before you blow too hard into that noisemaker, keep in mind there are some offsets to the tax savings such as the $10,000 cap on deductions for state income and property taxes. That means in high tax states like California and New York, the effective state tax rate on compensation and business income is going up. But the overall effect on the home care industry is a net positive.
The call to action is this. Now is the time to meet with your CPA to determine the following.
1. Am I organized in the most tax efficient manner possible?
2. Are my W-2 wages for services performed fair and reasonable?
3. Am I subject to deduction limitations?
4. Am I one of the many benefactors under the new tax law?
Since the Tax Cut and Jobs Act was designed to benefit business owners, job producers, and investors, the primary enablers of a growing economy, I expect corporate managers and executives who aspire to acquire and run their own business to take a closer look. They now have a considerable tax incentive to do so.