It took six years with over 100 Congressional hearings and 10 opinion papers to draft the tax reform legislation now referred to as the “Tax Cuts and Jobs Act.” President Trump signed the legislation into law on December 22, 2017, authorizing a massive piece of legislation that will impact all taxpayers. Whether you are operating as a sole proprietor, Limited Liability Company, “S” corporation, or “C” corporation, the act will change how your tax liability is computed. This article briefly summarizes some of the significant changes to the law. While most of the changes are effective for tax years beginning after December 31, 2017, the changes are generally not permanent and set to expire after 2025.
Tax Rates Reduced
For companies operating as pass-through entities and sole proprietorships, the top tax rate is reduced from 39.6% to 37%. Additionally, the rates for most brackets have been lowered and the income range for the bracket has been increased. For companies operating as C corporations, a 21% flat rate replaces the graduated corporate rate structure that previously had a maximum rate of 35%.
Alternative Minimum Tax
The alternative minimum tax (AMT) system has been eliminated for C corporations. Individuals, including owners of pass-through entities, are still subject to AMT, although the exemption amounts have been increased, along with the phase-out of the exemption amounts. Between the increased exemption and phase-out, many taxpayers who were previously subject to the AMT will no longer be subject to this tax.
Small Taxpayer Exemption
The small taxpayer exemption increases the threshold for determining who must use the accrual method of accounting to $25 million. This change will benefit many companies, particularly those that have inventories that were previously required to use the accrual method of accounting. If a company chooses to change its accounting method, it may be required to file form 3115, Application for Change in Accounting Method, by the end of the company’s fiscal year. For some changes, there is a $9,500 fee due to the IRS with the form.
New Deduction on Qualified Business Income
The new 20% deduction has been described by many observers as “the new business deduction for pass-through income.” This new deduction does not apply to C corporations. However, many other entities with profitable trade or business activity will benefit from the deduction, with certain phase-outs. Thus, income from pass-through entities such as partnerships, LLCs, “S” corporations, sole proprietorships (schedule C), and rentals (schedule E) can qualify for the deduction.
Although the deduction is available to all trades or businesses, other than C Corporations, it has significant limitations on specified service businesses. Note that specifically excluded from the definition of service business are architectural and engineering firms, thus allowing these businesses to take full advantage of this new deduction. Other service businesses are limited with regards to the amount they can deduct once the individual’s taxable income exceeds $315,000 ($157,500 single / head of household).
The bill does include limitations to the deduction. The first limitation is that the deduction is calculated as the lesser of 20% of Qualified Business Income, or taxable income. Thus, a taxable loss cannot be created with this deduction.
The second limitation is that the deduction is generally limited to the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of qualified property. These limitations do not apply if the taxpayer’s taxable income is below the threshold of $315,000 (married filing joint) or $157,500 (others) but phase in as taxable income exceeds these amounts.
In summary, this new deduction is a great deduction for qualified businesses and can effectively lower the highest individual tax rate from 37% to 29.6% on trade or business income. However, the deduction is extremely complex and has limitations related to the type of business that is generating the income, the income level of the business owner, the W-2 wages paid by the business, and the amount of assets owned by the business.
The new law makes investing in capital equipment more lucrative from a tax standpoint. The first year depreciation benefit (Section 179) was significantly increased from $500K to $1 million with a phase out of this amount starting at $2.5 million rather than $2 million. Certain real property improvements will be able to claim Section 179 deductions, including nonresidential building components like roofs, HVAC, fire alarm systems and security systems.
Although this increase is significant, the increase in bonus depreciation or 100% expensing rules are even better for the next several years. Congress increased the bonus depreciation rate from 50% to 100% for most property (other than real property) placed in service after September 27, 2017 through December 31, 2022. After this date, the deductibility is phased down to allow for 20% bonus depreciation after December 31, 2026. Thus, some companies can actually benefit from this new law in 2017 for purchases made after September 27, 2017, and before their year-end. Another significant change is the expansion of the bonus depreciation, which will now apply to both new and used equipment, rather than just new equipment.
Business Interest Deduction
A new limitation was placed on all taxpayers that may limit the deduction for business interest. The new limit allows a business to deduct interest expense up to 30% of its “adjusted taxable income,” which (for this purpose) is net trade or business income adjusted for interest deductions, depreciation, amortization, depletion, and net operating losses. Any limited or unused interest expense can be carried forward. There is a small business exception where this rule does not apply to most businesses with average annual gross receipts of less than $25 million.
Taxpayers that would otherwise be subject to these new rules can elect out of these new limitation rules by making an irrevocable election to depreciate real property in the trade or business using the alternative depreciation method (ADS), which is generally a slower depreciation method and does not allow for bonus depreciation.
There are several other items in the new law that will affect companies. A few of the notable items are:
- Deductions for entertainment expenses are disallowed. The 50% limitation for meals was retained with some modifications.
- The deduction for state taxes and personal real estate taxes is limited to $10,000 per year.
- Deductions for employee transportation fringe benefits (e.g., parking, mass transit) are now limited to 50%.
- The 9% domestic production activities deduction (DPAD) is eliminated.
- Net operating losses will no longer be able to be carried back, will have an indefinite carryforward period, and usage will be limited to 80% of taxable income in future years.
- Certain business losses from active trade or business will be limited in their ability to offset other types of income such as interest or dividends if the loss is larger than $500K (married filing joint) or $250K (others). Limited losses can be carried forward.
- The exclusion from tax on lifetime gifts and certain transfer at death was doubled.
- Like kind exchange treatment (1031 exchanges) will be limited to real property exchanges.
As you can see, this is a massive new tax bill that will impact nearly every taxpayer. At BFBA, we are prepared to discuss your specific situation and how these changes may impact you and your business.