What owners of small and medium-size businesses need to know.
On Dec. 22, the Tax Cuts and Jobs Act (TCJA) was signed into law. This column briefly summarizes the most important of the many changes in the TCJA that will affect small and medium-size businesses and their owners. Here goes.
1. New flat 21% tax rate for corporations
Under old law (meaning tax law in effect before the TCJA), C corporations paid graduated federal income-tax rates of 15%, 25%, 34%, and 35%. Personal service corporations (PSCs) paid a flat 35% rate. For tax years beginning after Dec. 31, 2017, the TCJA establishes a flat 21% corporate rate, and that reduced rate also applies to PSCs. Good!
2. No more corporate alternative minimum tax
Under prior law, the corporate alternative minimum tax (AMT) was imposed at a 20% rate. However, corporations with average annual gross receipts of less than $7.5 million for the preceding three tax years were exempt. For tax years beginning after Dec. 31, 2017, the TCJA repeals the corporate AMT. Good!
3. New deduction for “pass-through” business income
Under prior law, net taxable income from so-called pass-through business entities (meaning sole proprietorships, partnerships, LLCs that are treated as sole proprietorships or as partnerships for tax purposes, and S corporations) was simply passed through to owners and taxed at the owner level at standard rates.
For tax years beginning after Dec. 31, 2017, the TCJA establishes a new deduction based on a noncorporate pass-through entity owner’s qualified business income (QBI). This break is available to eligible individuals, estates, and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels. The QBI deduction is not allowed in calculating the noncorporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it is treated the same as an allowable itemized deduction.
W-2 Wage Limitation: The QBI deduction generally cannot exceed the greater of the noncorporate pass-through entity owner’s share of: (1) 50% of amount of W-2 wages paid to employees by the entity during the year or (2) the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property. Qualified property means depreciable tangible property (including real estate) owned by a qualified business as of the tax year-end and used by the business at any point during the tax year for the production of qualified business income. Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint-filers.
Service business limitation: The QBI deduction is generally not available for income from specified service businesses, such as most professional practices. Under an exception, the service business limitation does apply until an individual owner’s taxable income exceeds $157,500 or $315,000 for a married-joint filer. Above those income levels, the W-2 wage limitation is phased in over a $50,000 phase-in range or a $100,000 range for married joint-filers.
Key point: The W-2 wage limitation and the service business limitation don’t apply as long as your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
4. Liberalized asset expensing and depreciation provisions
More Generous Section 179 Deduction Rules: Under the TCJA, for qualifying property placed in service in tax years beginning after Dec. 31, 2017, the maximum Section 179 deduction is increased to $1 million (up from $510,000 for tax years beginning in 2017). The TCJA also expands the definition of eligible property to include certain depreciable tangible personal property used predominantly to furnish lodging. The definition of qualified real property eligible for the Section 179 deduction is also expanded to include qualified expenditures for roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential real property.
Much More Generous First-Year Bonus Depreciation Rules: Under the TCJA, for qualified property placed in service between Sept. 28, 2017 and Dec. 31, 2022 (or by Dec. 31, 2023 for certain property with longer production periods), the first-year bonus depreciation percentage is increased to 100% (up from 50%). The 100% deduction is allowed for both new and used qualifying property. In later years, the first-year bonus depreciation deduction is scheduled to be reduced as follows:
* 80% for property placed in service in calendar year 2023.
* 60% for property placed in service in calendar year 2024.
* 40% for property placed in service in calendar year 2025.
* 20% for property placed in service in calendar year 2026.
More Generous Depreciation Deductions for Passenger Vehicles Used for Business: For new or used passenger vehicles that are placed in service after Dec. 31, 2017 and used over 50% for business, the maximum annual depreciation deductions allowed under the TCJA are as follows:
* $10,000 for Year 1.
* $16,000 for Year 2.
* $9,600 for Year 3.
* $5,760 for Year 4 and thereafter until the vehicle is fully depreciated.
Key point: For 2017, the old-law limits for passenger cars are $11,160 for Year 1 for a new car or $3,160 for a used car, $5,100 for Year 2, $3,050 for Year 3, and $1,875 for Year 4 and thereafter. Slightly higher limits apply to light trucks and light vans. So the new rules are much more beneficial.
5. More businesses can use cash method accounting and avoid inventory recordkeeping hassles
The eligibility rules to use the more-flexible cash method of accounting are liberalized to make them available to many more medium-size businesses. Also eligible businesses are excused from the chore of doing inventory accounting for tax purposes.
6. New limits on business interest deductions
Subject to some restrictions and exceptions, prior law generally allowed full deductions for interest paid or accrued by a business. Under the TCJA, affected corporate and noncorporate businesses generally cannot deduct interest expense in excess of 30% of “adjusted taxable income,” starting with tax years beginning after Dec. 31, 2017. For S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes, this limitation is applied at the entity level rather than at the owner level.
For tax years beginning in 2018-2021, adjusted taxable income is calculated by adding back allowable deductions for depreciation, amortization, and depletion. After 2021, these amounts are not added back in calculating adjusted taxable income.
Business interest expense that is disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that cannot be deducted in the current year can generally be carried forward indefinitely.
Exceptions: Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years are exempt from the interest deduction limitation. Real property businesses that elect to use a slower depreciation method for their real property are also exempt. Farming businesses that elect to use a slower depreciation method for farming property with a normal depreciation period of 10 years or more are also exempt. Another exemption applies to interest expense from dealer floor plan financing (e.g., financing by dealers to acquire motor vehicles, boats or farm machinery that will be sold or leased to customers).
7. Stricter rules for deducting losses
For business net operating losses (NOLs) that arise in tax years ending after Dec. 31, 2017, the maximum amount of taxable income that can be offset with NOL deductions is generally reduced from 100% to 80%. In addition, NOLs incurred in those years can long longer be carried back to an earlier tax year (except for certain farming losses). Affected NOLs can be carried forward indefinitely.
A brand-new limitation applies to deductions for “excess business losses” incurred by noncorporate taxpayers. Losses that are disallowed under this rule are carried forward to later tax years and can then be deducted under the rules that apply to NOLs. This new limitation applies after applying the passive activity loss rules. However, it only applies to an individual taxpayer if the excess business loss exceeds the applicable threshold.
8. Reduced or eliminated deductions for business entertainment and some employee fringe benefits
Under prior law, taxpayers can generally deduct 50% of expenses for business-related meals and entertainment. Meals provided to an employee for the convenience of the employer on the employer’s business premises are 100% deductible by the employer and tax-free to the recipient employee. Various other employer-provided fringe benefits are also deductible by the employer and tax-free to the recipient employee.
* Under the TCJA, for amounts paid or incurred after Dec. 31, 2017, deductions for business-related entertainment expenses are completely disallowed.
* Meals expenses incurred while traveling on business are still 50% deductible.
* The TCJA disallows employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety.
* The TCJA eliminates employer deductions for the cost of providing qualified employee transportation fringe benefits (e.g., parking, mass transit passes, and van pooling), but those benefits are still tax-free to recipient employees.
9. New limitation on Section 1031 like-kind exchanges
The Section 1031 rules that allow tax-deferred exchanges of appreciated like-kind property is only allowed for real estate for exchanges completed after Dec. 31, 2017 (no more like-kind exchanges for personal property assets). However, the old-law rules still apply if one leg of an exchange has been completed as of Dec. 31, 2017 but one leg of the exchange remains open on that date.
10. Other important changes
* Several new provisions will affect S corporations, partnerships, and LLCs treated as partnerships for tax purposes.
* Compensation deductions for amounts paid to principal executive officers generally cannot exceed $1 million a year, subject to a transition rule for amounts paid under binding contracts that were in effect as of Nov. 2, 2017.
* Specified R&D expenses must be capitalized and amortized over five years, or 15 years if the R&D is conducted outside the U.S., instead of being deducted currently—starting with tax years beginning after Dec. 31, 2021.
* For amounts paid or incurred after Dec. 31, 2017, the TCJA repeals the 10% rehabilitation credit for expenditures on pre-1936 buildings. The new law continues the 20% credit for qualified expenditures on certified historic structures, but the credit must be spread over five years. Certain transition rules apply.
* And many more changes that cannot be covered here without this turning into something that is way too long.
The last word
This is not really the last word. Over the next few months, you will see many more words about other changes in the new tax law along with more details and analysis and updated tax planning strategies. So please stay tuned for all that good stuff.
A18-005868 Exp 2.6.19