This article explains key tax changes in the recently passed tax bill (“Tax Cuts and Jobs Act”) significantly impacting small business owners. Each section describes the particular tax provision in a concise manner together with some analysis and planning opportunities. As the related regulations have not yet been issued, the planning opportunities may change. We will keep you updated as the regulations and clarifications are issued.
Unless stated otherwise, the new tax provision goes into effect January 1, 2018.
For a broader summary of tax changes, please view our helpful comparison chart.
Pass-through Entity Income Deduction
Taxpayers earning qualified business income (QBI) from passthrough entities (e.g. partnerships, S corporations, single member LLC’s, sole proprietorships) will be eligible for a 20% deduction against the QBI starting in 2018. The QBI must be effectively connected with the conduct of a trade or business in the US. The deduction is subject to limitations including:
- The deduction cannot exceed the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.
- Certain investment income is excluded from QBI – interest, dividend, capital gains, annuities. Note: Rental income seems to be eligible if connected to a business.
- QBI does not include guaranteed payments or reasonable compensation paid to the owner.
- Specified businesses (e.g. service businesses such as accounting, law, medicine, consulting, athletics and investment management services) are not eligible for the deduction.
Individual taxpayers with taxable income less than $157,500 ($315,000 filing joint) are not bound by limitations on wages (A above) and specified business income (D above). The benefit phases out over the next $50,000 ($100,000 for joint filers) until the deduction is eliminated entirely once taxable income exceeds $207,500 ($415,000 for joint filers).
The new tax provision will expire after the 2025 tax year.
This new tax provision has many nuances and will likely generate a significant number of tax planning ideas.
Here are a few preliminary thoughts to whet your appetite:
Couples who have been filing jointly to benefit from the combined income tax brackets may be able to lower their tax burden by filing separately in certain circumstances. For example, we will look at a taxpayer working as a partner in a law firm who earns $300,000 with a spouse that is working as a partner in an investment management firm earning $150,000. Since both of these companies are specified businesses, the owners will not receive the passthrough deduction if they exceed certain income thresholds. If they file jointly, the combined income of $450,000 will exceed the income threshold and no passthrough deduction will be permitted. If they file separately, the investment management spouse will be able to receive the full passthrough deduction as that spouse’s separate income is below the $157,500 threshold.
Effect on operating decisions
The passthrough deduction may impact the cost/benefit analysis of various operating decisions. For example, renting vs. buying real estate used by the company or outsourcing a particular function. The passthrough deduction is restricted by limitations as a percentage of wages and property basis as noted above. Therefore, the owner may be able to increase the passthrough income deduction by buying real estate used by the company for its offices/operations and/or bringing a function back in house in certain situations. Now is the time for owners to consider these extra tax benefits as part of the quantitative analysis for these decisions.
Fourth quarter planning could boost deduction
Businesses may be able to adjust their fourth quarter capital investments to increase the passthrough deduction. Although the wage limitation is based on wages paid during the year, the qualified property variable in the limitation is based on capital property purchased and in use by year end. The business could review the year to date income at the start of the fourth quarter to determine whether sufficient wages and capital property expenditures have been made to maximize the deduction. If more capital investment is needed for the passthrough limitation, the business should consider the option of moving forward capital property purchases from the subsequent year to Q4 of the current year.
Business owners, contact your tax advisor at Apple Growth Partners to discuss whether this projection would be relevant in your situation.
Specified businesses excluded from the passthrough deduction
The passthrough deduction is not available to owners of specified businesses if the owner’s income exceeds the thresholds noted above. Personal service businesses precluded from taking the deduction include accounting, law, health, consulting, athletics and investment management.
The tax law also disallows a deduction for a broad array of businesses “where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” This type of excluded business may not need to be service in nature.
The wording of this broad exclusion parallels the types of businesses excluded from the exemption on gain of small business stock in place since 1993. Guidance from the IRS, Congress and the courts have been sparse on the type of businesses that will fall under this broader exclusion. The IRS is expected to provide more guidance in Treasury Regulations since the passthrough deduction will affect many more taxpayers than the small business stock exemption.
Is your businesses principal asset the reputation or skill of one or more of its employees or owners? Most businesses in the modern economy would answer the affirmative. Nevertheless, the business may still be eligible for the credit. Due to the ambiguity in defining an excluded specified business, be sure to review the nature of your business in detail with your trusted tax advisor at Apple Growth Partners to determine whether you are eligible for the deduction.
The new tax law changed tax rates substantially for businesses and individuals.
Corporate tax rates for regular C corporations declined from a 35% top marginal tax rate to a 21% flat rate. Special personal service corporation tax rates were eliminated. Individual dividend income tax rates remain the same ranging from 0% to 20% depending on the shareholder’s individual marginal tax rate. The new corporate rates start in 2018 and are permanent.
Passthrough entity owners will benefit from declining individual income tax rates and higher thresholds to move between tax brackets. The new tax rate structure has tax rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%. Unless the entity is an excluded business, owners of passthrough entities will also receive a 20% deduction on QBI further lowering the effective tax rate. The tax provisions affecting will expire after 2025.
C corporation vs. passthrough entity choice
Business owners have increasingly set up their businesses as passthrough entities over the past few decades to avoid the double taxation of business income inherent in a C corporation structure (high corporate tax followed by dividend taxation). The decision will need more analysis now that these tax changes are in place. For example, high income owners of specified service businesses such as law, accounting or consulting are not eligible for a passthrough deduction. If the owners plan to retain their earnings, they may decide to be taxed as a C corporation to take advantage of the lower 21% flat tax rate. An owner of a comparably profitable business in an LLC or partnership entity would be subject to both a 37% marginal income tax rate plus self-employment tax.
Bonus impact to owner/employee
Owners of C corporations often paid a year-end bonus to themselves to distribute corporate income with its higher tax rate into income taxed to the individual. The owner will need to reevaluate the amount of income to be taxed in the corporation vs. personally.
Business owners, review your current entity structure with your Apple Growth Partners tax advisor to determine the most tax efficient method to grow your business.
Alternative Minimum Tax (AMT)
AMT affects many small business owners at both the business level and the individual level leading to a higher aggregate tax liability. The new tax law eliminates AMT on C corporations and increases exemptions for AMT on individuals. The changes to the corporate AMT is permanent. The changes to the individual AMT expire after 2025.
Alternative Minimum Credit Carryforward
Taxpayers may have an AMT tax credit carryforward representing the excess of AMT over their regular tax liability since AMT’s inception. Under prior tax law, this minimum tax credit could only be used to offset regular tax liability in the event the regular tax liability exceeded AMT. If taxpayers were in AMT each year, the credit continued to increase without benefit to the taxpayer. The new tax law permits C corporations to use their aggregate AMT credit to offset regular tax liability starting in 2018. Even if the C corporation does not have a regular tax liability due to deductions, etc. A portion of the credit is refundable annually between 2018-2022.
If you are a C corporation owner who has been liable for AMT, talk with your advisor at Apple Growth Partners about the effect of the credit in your situation.
AMT and Entity Choice
AMT has been eliminated for C corporations, but not for individuals. Passthrough businesses with significant AMT adjustments due to the nature of their business may decide to switch to a C corporation to lower their aggregate annual tax liability.
The new tax law permits larger deductions for a broader range of capital investments.
Property formerly eligible for 50% bonus depreciation in the first year will now be eligible for a 100% deduction in the first year. Most equipment and furniture bought by businesses are eligible for the higher bonus depreciation.
The types of property eligible for the increased deductions has also been expanded. Purchased used and new property is now eligible compared to only purchased new property under the old law. Roofs, HVAC and security systems for commercial property may now be eligible for full deduction in the year placed into service.
Although passenger vehicles are not eligible for 100% expensing, businesses can deduct more depreciation on an annual basis compared to prior law.
The provision applies to certain property purchased and placed into service after September 27, 2017. The full deduction provision applies through 2022. The bonus depreciation deduction percentage will then decline annually until eliminated in 2027.
The new tax law could have a profound effect on the classic net present value analysis used to evaluate whether aging equipment should be replaced. The analysis has historically included the present value of tax savings derived from depreciating the cost of the property over a few years. The new tax law includes two significant tax changes sharply increasing the tax benefits of the new capital investment that should be considered in these calculations. The cost of the equipment may be deductible immediately in many cases by taking advantage of the 100% bonus depreciation or the Section 179 depreciation. Also, in certain situations, 2.5% of the original cost of equipment used by the business will be added to the eligible passthrough deduction for the longer of 10 years or the standard tax depreciation life of the asset. Therefore, the business could receive two separate tax deductions for the same capital investment. The effective benefit could equal $125 or more of tax deductions for $100 of capital investment over the period that the asset is used. These new tax laws should make more marginal asset purchases feasible for businesses.
Business owners, reach out to your trusted tax advisors at Apple Growth Partners to determine whether you are eligible for these additional tax benefits.
Business Interest Limitation When Gross Receipts Exceed $25 Million
The new tax law limits the deduction for business interest to 30% of adjusted taxable income plus interest income earned.
The tax provision does not apply to the following:
- electing real estate businesses
- electing farming businesses
- any business with gross receipts less than $25 million average over trailing three years
- floor plan financing interest
Adjusted taxable income adds back depreciation and amortization for tax years beginning before January 1, 2022.
Disallowed interest is carried forward indefinitely until deductibility room is available. C and S corporations maintain the carryforward at the business level. Partnerships pass the disallowed amounts to the partners to be carried forward at the individual level.
Auto dealers need to pay special attention to the floor plan financing interest exemption. Businesses in this industry can deduct all the interest on this type of debt without restriction. For more information on this rule and other special depreciation rules in the new tax law particular to auto dealer industry businesses, contact Adam Pearce (Leader of Auto Niche) at Apple Growth Partners.
Debt vs. Equity considerations
Funding a business through debt has historically benefited the issuer with the tax advantage of interest deductibility. Dividends paid to equity holders, on the other hand, are not deductible to the business. Those businesses that face the interest expense deduction limitation under the new tax law may move towards more equity funding. Even though the business cannot deduct the dividend either, the dividend income is more favorably taxed to the investor. If the investor wants the less risky, steadier stream of income common to debt, the business may attempt to structure equity issuance to mirror these debt characteristics such as fixed payments and a put option. The IRS has released guidance on the tax treatment of certain hybrid instruments (i.e. investment with characteristics of both debt and equity). Owners of businesses with interest expense limitations should discuss with their legal counsel and tax accountants whether restructuring their financing mix would be beneficial.
Businesses with interest deduction limitations should also review their related party debt. The business may decide some of this debt should be restructured as equity.
Businesses with fluctuating income
The 30% limitation is calculated each year. Companies with fluctuating income may lose interest deductions during the low income years. Even though the interest can be carried forward to a future year, the tax benefit will now be deferred instead of immediately deductible per the prior tax law.
Disallowed interest reduces the partner’s basis in the partnership in the current year even though the interest is only deductible against income in the future. Although there is a rule to adjust basis back in the event of a sale of the partnership interest, the reduction in basis may affect taxability of distributions and deductibility of business operating losses for some taxpayers.
Stay tuned for future articles and case studies related to tax reform including the following topics:
- More flexibility for businesses with changes to the tax laws related to accounting methods
- Tax law changes affecting families
- Losing some charitable deductions?: Consider qualified charitable distributions from IRA
- New net operating loss and excess business loss restrictions
- Deductibility of entertainment expenses eliminated
The information contained in this article is current through the published date and may change when regulations and other guidance are issued. Content has been vetted by Apple Growth Partners’ internal tax reform team of licensed CPAs. For more information about this content, or any other matters related to tax reform, please contact your Apple Growth Partners advisor.