As we look at taxes through a new lens this year, the Tax Cuts and Jobs Act brings a number of valuable tax-saving planning opportunities to businesses.
In general, most individual provisions expire at the end of 2025, but the corporate changes are made permanent.
The following article outlines changes enacted in the tax reform bill for you to consider as we round out the year.
Corporate Tax Rate and Entity Planning
Let’s start with the story making big headlines—the corporate tax rate has been reduced from 35% to 21%. The 21% tax is a flat rate that applies across all C corporations. As always, businesses can fully deduct state and local taxes, but individuals are capped at $10,000. Many business owners now wonder if they should structure or restructure their business entity to a C corporation to take advantage of the new flat rate. In short, it’s complicated.
While C corporations benefit from the flat 21% rate, they are also subject to double taxation, once at the entity level and once again when dividends are distributed to shareholders. As you’ll see below, businesses that distribute earnings to their owners will still generally pay less total tax operating as a “pass-through” entity than a C Corporation. If the corporation cycles profits back into the business to invest in growth, they will not be subject to the distribution tax. There are rules that prevent a company from holding on to cash to avoid tax on distributions. Should cash accumulate and exceed the reasonable needs of the business, it could result in having to pay the accumulated earnings tax or personal holding company tax.
Additionally, if your business holds assets that will appreciate in value, like real estate, double taxation may be inevitable if the assets are sold for significant gains.
Depending on your business operations, restructuring to a C corporation may be advantageous if you can avoid being double taxed; however, maintaining a pass-through entity has its benefits under the tax reform bill as well.
Qualified Business Income Deduction
As hinted above, Congress did not ignore “pass-through” entities in the reform act and provided an equitable benefit for businesses operating as sole proprietors, partnerships, LLCs and S corporations. These “pass-through” entities are allowed a new deduction of 20 percent of their qualified business income (QBI) under Section 199A. QBI is the net amount of items of income, gain, deduction and loss to any qualified trade or business. The QBI deduction provides an incentivizing tax benefit for “pass-through” entities, the new effective tax rate is reduced to 29.6%, which is higher than the corporate flat 21% rate.
There are certain limitations and thresholds to consider before taking this deduction. For taxpayers with taxable income exceeding $315,000 married filing jointly ($157,000 for single filers), the deduction is subject to limitations based on the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business. A business without enough qualified wages or property will be phased out of the deduction completely if the owner’s taxable income exceeds $415,000 married filing jointly ($207,500 for single filers).
Specified service trades or businesses are also phased out of this deduction at these levels. Specified service trades or businesses are defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. This area of the law is complicated and new territory. Fortunately, the treasury has provided initial guidance in the form of proposed regulations that takes a narrow view of these definitions that is generally taxpayer friendly. Businesses should consult with tax advisors who have studied this new area of law to determine whether they qualify for this new deduction as this already has an impact on estimated tax payments.
For taxpayers with qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, 20 percent may be deducted from the combined total, not subject to limitations on W-2 wages or UBIA of qualified property.
Please note: The QBI deduction has many detailed layers outside the scope of this article, but we may offer some general planning opportunities to consider.
Businesses may consider adjusting W-2 wages to maximize their deduction or even converting independent contractors to employees where possible. Run the numbers to ensure the deduction amount outweighs the increased payroll tax burden and employee benefits offered. You could also invest additional capital into your business or sell business property as yearend approaches. Discuss your position with an advisor to optimize your deduction amounts.
Increased and Expanded Section 179 and Bonus Depreciation
If you are considering purchasing new business assets, now is the time to do it. The tax reform bill generously increased the Section 179 expense limit to $1 million, up from $510,000 in 2017. The phaseout threshold also increased to $2.5 million.
In addition, the new law expands the definition of Section 179 property to include:
- Certain tangible personal property used primarily to furnish lodging.
- Certain improvements to nonresidential real property, such as roofs, HVAC, fire protection, and alarm and security systems.
Bonus depreciation has also been enhanced and increased. For both new and used qualified property placed in service after September 27, 2017, a business can also claim 100 percent first-year bonus depreciation under the new law through December 31, 2022. Bonus depreciation is phased out from years 2023-2026.
Corporate AMT Eliminated
More good news for businesses is the corporate AMT is eliminated for tax years beginning after Dec. 31, 2017. If a corporation has an unused AMT credit from previous years, it can carry the credit forward and receive a 50 percent refund between tax years 2018-2020 and a 100 percent refund beginning in 2021.
Simplify and Switch to Cash Method
Now, businesses with three-year average annual gross receipts of $25 million or less can begin using the cash method, a simpler, more straight-forward approach to managing your accounting.
Some Business Deductions Eliminated or Restricted
While most changes in the new law provide meaningful tax benefits to businesses, there are some limits and restrictions to some business deductions.
Net Operating Losses
The deduction for net operating losses (NOLs) is now limited to 80% of taxable income. And in general, NOLs can no longer carry back into previous tax years, but they can be carried forward indefinitely. There are carry back exceptions for farming and insurance company losses.
Several fringe benefits that can continue to be provided tax-free to an employee will no longer be tax deductible by the employer.
- Moving Expenses: Certain moving expenses were previously allowed as either an above-the-line deduction to the employee or a tax-free fringe benefit if reimbursed by the employer. Both the above-the-line deduction and the taxable income exclusions provisions have been suspended for taxable years between 2018 and 2025. There is an exception for members of the Armed Forces.
If the employer reimburses these expenses, they will be considered taxable compensation to the employee (and deductible to the employer), similar to a relocation bonus.
- Transportation Fringe Benefits: Employers are unable to deduct expenses incurred for providing transportation, payment or reimbursement for travel between an employee’s residence and place of work, with the exception of providing employee safety. Some examples of the former transportation fringe benefits included transit passes, qualified parking and vanpooling.
- Entertainment Expenses: The days of deducting 50 percent of certain business-related entertainment expenses are gone. Employers can no longer deduct expenses for entertainment or recreation, including membership and club dues used for social purposes. There are limited exceptions, such as certain recreational and social events for employees (like a company holiday party) will be deductible.
Employers can continue to deduct 50 percent for food and beverage business-related expenses. For example, employers may apply this 50 percent deduction for traveling employees, expenses related to food and beverage provided on premises of the employer and any other de minimis provided at the workplace, such as working or overtime meals (especially during tax season!).
Research and Development (R&D)
Currently, a business may make an election to immediately deduct research and development costs. After Dec. 31, 2021, however, businesses will be required to write off certain expenditures gradually, amortizing over a 5-year-period (15 years for foreign research). In addition, all software development costs will be regarded as research or experimental expenditures under Section 174.
New Business Interest Expense Limit
Starting in 2018, if your business averages an excess of $25 million in annual gross receipts over a three-year period, your net business interest deduction is limited to 30 percent of adjusted taxable income.
This limitation applies to all entity types across the board and typically applied at the entity level. Any excess interest not deductible in the taxable year due to the limitation may be carried forward indefinitely until fully absorbed.
Small businesses under $25 million in annual gross receipts will not be subject to this new rule. Other exceptions include real property businesses, farming businesses and certain utility companies, where they may elect the Alternative Depreciation System (ADS).
Other Provisions to Note
Like-kind exchanges are now limited to real property. Gains from the sale of business assets such as equipment, fixtures, and vehicles are no longer deferred and carried over to replacement property.
Almost every business—small or large—can benefit from year-end tax planning, but this year is particularly vital considering the record overhaul of the tax code. Please contact me at firstname.lastname@example.org or (805) 963-7811 if you have any questions or would like to get started right away.