Business Tax Planning after the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) has altered the tax landscape for a lot of businesses. The changes are extensive, and this summary provides a high-level overview of some of the highlights to keep you informed. Due to the sweeping nature of the changes, we’d welcome the opportunity to have a conversation with you to discuss planning opportunities for your specific situation.
New Corporate Tax Rate
The graduated corporate tax rates have been consolidated into one 21% flat rate. These changes are effective for tax years beginning after December 31, 2017. For fiscal-year corporations, the calculation of tax will be determined using a blended rate based on the number of months at the old versus the new rate structure.
Tax Tip: In some circumstances, such as low or no corporate income, overall taxes may be reduced if the corporation pays dividends instead of a bonus to a shareholder-employee.
The New Pass-through Deduction
You may have heard a lot of talk in the news about a new deduction for “pass-through” income, but it’s actually available for qualified business income from a sole proprietorship (including a farm), as well as from pass-through entities such as partnerships, LLCs, and S corporations. Under the TCJA, individuals may deduct up to 20% of their qualified business income. (For individuals in the new top 37% tax bracket, this means that qualified business income is taxed at an effective top marginal rate of 29.6%.) However, the deduction is subject to various rules and limitations. We will provide more details about this new deduction in the next installment of our tax reform series.
Rethink Entity Choice
The TCJA makes major changes to the choice of entity decision. Because C corporations are now taxed at a flat rate of 21% (as opposed to a top rate of 35% under prior law), many business owners wonder whether they should structure or restructure their business operations as a C corporation. Unfortunately, the answer is not simple. For one thing, the top individual tax rate also fell, from 39.6% to 37%. Also, the new qualified business income (QBI) deduction isn’t available for C corporations or their shareholders. Knowing how much income will be eligible for the QBI deduction is critical to determining whether it’s advantageous to be an S corporation.
It’s also important to note that C corporations are subject to double taxation, meaning that corporate income is taxed once at the entity level and again when it’s distributed to shareholders as dividends. This double taxation can be avoided if the corporation retains all profits to finance growth. However, this opens the door to the accumulated earnings tax (or personal holding company tax) if profits accumulate beyond the reasonable needs of the business.
Although C corporations are now more attractive thanks to the lower rate, it may make more sense to continue operating as a pass-through entity. This is particularly true if (1) you can claim the full 20% deduction for qualified business income and (2) either most profits will be distributed as bonuses or dividends, or you plan to exit the business in a relatively short period of time.
Some companies will find that the QBI deduction is limited, either because not all their income is considered to be qualifying business income or because it is subject to one of several limitations.
“The biggest determinant on if you should go to C is how much of the profits you expect to distribute as dividends,” said Mel Schwarz, director of tax legislative affairs in Grant Thornton LLP’s National Tax Office in Washington. “If you’re going to distribute all the profits as dividends as a C corporation, your tax rate is going to be higher than if you are a pass-through.”
Most S corporations should sit tight for a while unless they are a highly profitable service business that plans to retain much of its profits for growth or another business reason.
The choice of entity decision is complicated, but we’re here to help. We would be happy to analyze your particular circumstances to see if a C corporation is right for you.
Alternative minimum tax (AMT) repeal for C Corporations
The corporate AMT has been repealed by the TCJA.
Tax Tip: With the elimination of corporate AMT, the law allows a corporate taxpayer to utilize AMT credit carryforwards against its regular tax liability. For tax years 2017 – 2021, corporate taxpayers may claim a refund of AMT credits equal to 50% of the excess of the tax credit for the tax year over the amount of the credit allowable for the year against the regular tax liability. In 2022 the percentage refundable goes to 100%.
Bonus Depreciation and Sec. 179 Expensing of Fixed Assets
The new tax law has increased the bonus depreciation percentage to 100% until 2023, when it will decrease by 20% until it reaches zero. Bonus depreciation now applies to both new and used qualified property. The Sec.179 expense limit is now $1 million of allowable expensing with a total purchase threshold of $2.5 million. If you purchase more than $2.5 million in eligible fixed assets during the taxable year, the expense limit allowed will be reduced.
Vehicles are eligible for bonus depreciation although they are generally limited to an extra $8,000 of depreciation if the vehicle has a gross vehicle weight rating (GVWR) of less than 6,000 pounds.
Tax Tip: There has never been a better time tax-wise to buy a new vehicle especially one with a GVWR of 6,000 pounds or more. Also, there is a relaxed rule for a truck with an interior bed of 6 feet or more or certain delivery vans.
Qualified Improvement Property was supposed to be eligible for bonus depreciation but due to an apparent legislative omission it does not qualify. It is expected that a technical corrections bill will fix the glitch. Qualified improvement property means any improvement to an interior portion of a nonresidential building if the improvement is placed in service after the building was first placed in service. But, qualified improvement property does not include any improvement for which the expenditure is attributable to: (1) enlargement of the building, (2) any elevator or escalator, or (3) the internal structural framework of the building.
Tax Tip: If you are planning a large remodeling of nonresidential property, you may want to wait a little while for a technical correction although it is expected that a technical correction would be retroactive to January 1, 2018.
Qualified improvement property is eligible for Section 179 expensing but is subject to all the Sec. 179 limitations including the "business income" limitation. In addition, for tax years beginning in 2018 and beyond, the TCJA expands the definition of real property eligible for Sec. 179 to include roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential buildings.
Interest Expense Deductibility
The TCJA introduced a limit on the deductibility of business interest to 30% of taxable income. However, this limitation does not apply to most taxpayers with gross receipts of $25 million or less. If your gross revenues exceed $25 million, we recommend having a discussion with us about the impact on your business.
Entertainment Expenses
The TCJA repealed the deduction for business entertainment. Entertainment includes expenditures such as taking clients to sporting events and shows and paying for season tickets for various entertainment events.
Tax Tip: Since entertainment expenses are no longer deductible, your accounting program should have a separate account set up to capture them so you will not have to identify them in a Meals & Entertainment account at tax time.
Like-kind Exchange Restrictions
The new tax law restricts a like-kind exchange to real property (e.g., buildings and land). Other property (e.g. a vehicle) is no longer eligible.
Credit for Paid Family and Medical Leave
A new tax credit was created under the TCJA for employers who provide eligible employees paid family and medical leave, subject to certain conditions. The credit is only for tax years beginning in 2018 and 2019. It is equal to 12.5% of the amount of wages paid to qualifying employees on family and medical leave. However, the employer must pay at least 50% of the wages normally paid to the employee. The credit is increased by 0.25 percentage points (but not above 25%) for each percent by which the payment rate exceeds 50%.
You must have a written policy in place that provides at least two weeks of annual paid family and medical leave to qualifying full-time employees. (The two week requirement is prorated for qualifying part-time employees.) The maximum length of paid family and medical leave that can qualify for the credit is 12 weeks per employee, per tax year.
Wages must be paid for qualifying family and medical leave. This generally includes leave for the birth, adoption, or fostering of a child; care for a spouse, child, or parent with a serious health condition; an employee’s serious health condition; and qualifying needs of a spouse, child, or parent who is a covered veteran or member of the Armed Forces. Vacation leave, personal leave, and medical or sick leave (other than specifically defined as qualifying leave) don’t qualify for the credit.
The credit only covers wages paid to qualifying employees. These are individuals who have been employed for one year or more and didn’t have prior-year compensation exceeding a threshold amount. For 2018, this amount is $72,000. This means that employees who were paid more than $72,000 in 2017 do not qualify in 2018.
Tax Tip: An employee benefits package may need only a few small changes to qualify for this new tax credit for paid maternity or other qualified leave. Please let us know if you pay for qualified family or medical leave if we prepare your income tax returns.
Adopt a More Favorable Accounting Method
The cash method of accounting, which allows you to recognize sales when cash is received, is attractive to many small businesses due to its simplicity. For tax years beginning after 2017, the ability to use the cash method is greatly expanded. Any entity (other than a tax shelter) with three-year average annual gross receipts of $25 million or less can use the cash method regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.
The $25 million threshold also now applies to the requirements to use the Section 263A Uniform Capitalization rules and the Section 460 percentage of completion long-term contract method of accounting.
Assuming a change from any of these methods would be beneficial, we can file the appropriate paperwork with the IRS to change your method of accounting.
Tax Tip: The reduction in taxable income could be as much as the amount of accounts receivable at year end.
Consider Qualified Equity Grants
The TCJA provides a new tax election for equity-based compensation from private employers. Specifically, the election covers stock received in connection with the exercise of an option or in settlement of a Restricted Stock Unit (RSU). From a tax perspective, many employees struggle with these forms of compensation because they don’t have the ability to liquidate their shares to pay their tax bill. This new election provides some relief.
Starting with options exercised or RSUs settled after 2017, qualified employees of eligible private companies may elect to defer income from those instruments for up to five years. To take advantage of this election, various requirements must be met. This includes having a written plan under which at least 80% of full-time employees are granted stock options or RSUs.
Set up a Qualified Small Business Corporation
As we mentioned earlier, the TCJA establishes a flat 21% federal income tax rate for C corporations, including Qualified Small Business Corporations (QSBCs). A QSBC is generally a domestic C corporation whose assets don’t exceed $50 million. In addition, 80% or more of the corporation’s assets must be used in the active conduct of a qualified business. There are other requirements as well, but we can fill in the details if you decide a QSBC is right for you.
By far, the biggest benefit of owning QSBC stock is the ability to shelter 100% of the gain from a stock sale. A more-than-five-year holding period requirement must be met to claim this exclusion. Another major benefit of owning QSBC stock is the ability to roll over (defer) the gain on a stock sale to the extent you acquire replacement QSBC stock within 60 days of the original sale. You must have held the QSBC stock for more than six months to take advantage of this break. Once the gain is rolled over, you must reduce the tax basis of the replacement stock by the amount of gain deferred. However, if the replacement stock is QSBC stock when it’s sold, the applicable gain exclusion break is available if the more-than-five-year holding period requirement is met.
The 100% gain exclusion and rollover breaks combined with the flat 21% corporate tax rate can make operating a newly formed business as a QSBC more tax-efficient than operating it as a pass-through entity (sole proprietorship, partnership, LLC, or S corporation). That is big news because pass-through entities have traditionally been the first choice for most small and medium-sized businesses. However, not all start-up businesses will qualify for QSBC status.
Other Notable Changes
Domestic Production Activities Deduction. Under prior law, businesses could deduct a percentage of the income earned from certain manufacturing and other production activities. The TCJA eliminates this deduction for tax years starting in 2018.
Net Operating Losses (NOLs). Under the TCJA, a business’s NOL deduction is limited to 80% of taxable income. In addition, most businesses can no longer carry back their NOLs to the prior two tax years. However, rather than expiring after 20 years, NOLs can be carried forward indefinitely.
Fringe Benefits to Employees. Your business may no longer deduct the cost of providing transportation fringe benefits (parking, for example) to employees. However, your employees can still exclude the value of such benefits from their income. Also, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees (except as provided for the employee’s safety).
Tax Tip: If you pay for your employees parking or commuting, put these costs in a separate account for ease of identification at year end. Also, know that the law can be interpreted as requiring all employers to not deduct parking costs even if the costs are indirect such as parking in an employer owned lot or a lot included in a building lease. We are waiting for clarification.
Research and Development (R&D) Credit. In a bit of good news, the TCJA preserves the R&D tax credit. However, certain R&D expenses (for software development, for example) paid or incurred after 2021 must be capitalized and amortized ratably over five years.
Final Thoughts
While the TCJA is effective now, there are still many uncertainties. Additional technical guidance and regulations are necessary to provide more clarity on some of the changes. The Internal Revenue Service is working to provide that guidance, which we expect later this year.
We would like to help you identify opportunities within the new law. Please contact us if you would like to see how these new provisions could impact your situation. Planning ahead can help minimize your tax bill and increase your cash flow.