Last week’s post attempted to simply summarize, at a very high-level, the Tax Cuts and Jobs Act (“the Act”) as it relates to individuals. This post offers a similar high-level simplified summary of the Act as it relates to business taxation. There are some very important changes commencing in 2018 that you should review with your professional tax advisor if you own or partially own a corporation, partnership or operate a business as a sole proprietor.
Initially, there was much confusion about the Act’s business tax provisions ranging from sole proprietors wanting to quickly form S-corporations to some folks thinking there were no longer any business tax deductions at all. Some of the initial takeaways on the Act made no sense. As with anything related to the U.S. tax code, it depends on your specific situation. Much clarification is needed from Congress and the IRS on business tax reform in order for tax professionals to offer advice with manageable risk. The below simplified summary is only intended to make you aware of certain significant business tax law changes at a very high level and hopefully nudge you to discuss their application to your specific situation with a professional tax advisor. My discussion is not intended to be tax advice of any nature.
My simplified summary of the Act as it pertains to businesses:
- C Corporation Tax Rates – only one rate now instead of the previous graduated four. A flat 21% with no special rate for personal service corporations. This change is permanent.
- New Deduction for Partnerships, S Corporations and Sole Proprietorships (“Flow-Thru or Pass-Thru Entities”) – This one caused and still causes much confusion. Clarification on its application is necessary from Congress and the IRS. Taxable income from the above entities “pass-thru” to the owner’s personal tax return. So, this new deduction does not apply to C Corporations. By the way, limited liability corporations (“LLC”) do not exist in the U.S. tax code. You must elect whether your LLC is taxable as a single-member (like a sole-proprietor), a partnership or a C Corporation.
a. Deduction – 20 percent of the business’s combined “qualified business income” but cannot exceed your personal taxable income(determined without regard to the new deduction) attributable to ordinary income and qualified dividend income.
b. Qualified Business Income Definition – the NET (yes, after deduction of business expenses; they did not go away) amount of income, gain, loss and deduction from a qualified trade or business except capital gains and losses are excluded.
c. OK, What’s a Qualified Trade or Business? – any trade or business EXCEPT for:
i. those involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. NOTE: Architects and Engineers are not excepted.
ii. where the business’s principal asset is the reputation or skill of one or more of its employees.
iii. one involving the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and
iv. the trade or business of performing services as an employee
d. The Exception to the Exception – If your personal taxable income before this new deduction is less than $157,500 ($315,000 for married filing jointly), you can take the new deduction no matter what trade or business you are in. So, in this case you can ignore the service business exceptions in items i-iii above. The deduction phases out for service businesses between the above amounts and $207,500 and $415,000 for single filers and married filing jointly respectively. Between those amounts you have to calculate a percentage of qualified business income.
e. High Income Individuals with a Pass-Thru Qualified Trade or Business Interest – Gets even more complicated. If your taxable income exceeds $207,500 ($415,000 for married filing jointly) and your trade or business is not in the service related industries detailed above, the 20% deduction is further limited. In this case, the deduction cannot exceed the greater of:
i. 50% of the W-2 wages paid by the business, or
ii. 25% of the W-2 wages paid by the business, plus 2.5% of the unadjusted basis of depreciable property owned by the business (Sheesh! No normal person can calculate this stuff. Maybe that’s why this law has been referred to as the CPA permanent employment act!).
f. Expiration Date – This new deduction ends in 2025 under the Act.
g. An Example – How about me? I am a married, filing jointly, financial service provider. If my joint taxable income is less than $315,000, I am eligible take 100% of the 20% deduction off my business net income. If my joint taxable income is between $315,000 and $415,000, I can only take a calculated percentage of the deduction. If my joint taxable income exceeds $415,000, I can take none of the new deduction because I am in an excepted service industry. In this regard, maybe I should call myself a “financial planning architect” or an “investment engineer”! If I were an architect, I could continue to take the deduction with joint taxable income greater than $415,00, but I would have to apply the further limitations in 5. above. By the way, in the case of joint filers, if the spouse also has a pass-thru business, you can analyze both businesses and take two deductions within the above limitations.
- Expansion of Section 179 Expensing – Annual cap increases to $1 million from $500,000. The phaseout threshold also increases to $2.5 million from $2 million.
- Carried Interest (AKA: Investment Manager Incentive Fee or Profits Interest) – the holding period of the underlying investments is now three years for preferential long-term capital gain treatment.
- Section 1031 Like-Kind Exchanges – Now only available for real property (e.g., real estate). Prior law included any personal property held for business or investment use. No more.
- Entertainment Expenses – Totally disallowed under the new law. Taking clients or business associates to a baseball, or any other type of game, is no longer deductible for tax. Prior law allowed 50%.
I can go on, but the above list is what I believe to be the significant provisions affecting most businesses. There are several other provision changes, for example, C Corporation dividends received deduction, tax depreciation, deductibility of business interest, etc. so the above list is not all-inclusive. Please see your professional tax advisor for more detail and how the Act’s provisions affect your business interest, because no one else will be able to figure this out.
Comments or corrections are very welcome.
Hillhurst Wealth Management LLC