AAFCPAs Provides Guidance on Business Tax Provisions in the Tax Cuts and Jobs Act
On Friday, December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (H.R. 1) (the “TCJA”). The TCJA represents a dramatic overhaul of the U.S. tax code, and the final legislation is lengthy and complex. AAFCPAs’ Tax Practice provides an overview of the major provisions affecting commercial businesses.
Change in Tax Rates
Starting in 2018, the tax rate imposed on C corporations has been reduced from 34% to a flat rate of 21%.
Depreciation and Cost Recovery
The TCJA retains much of the prior system, with two significant changes. The first applies to Section 179 Expense, which allows for immediate write off of most fixed asset purchases.
In 2017, the deduction is limited to $510,000 so long as total acquisitions placed in service are under $2,030,000, at which point the maximum allowable deduction starts to phase out. For 2018, the deduction is increased to $1,000,000, with the phase out level increasing to $2,500,000. Existing rules limiting the deduction of Section 179 Expense to profitability were not changed by the law.
The more significant change with respect to cost recovery involves Bonus Depreciation. Through 2017, businesses were allowed to deduct up to 50% of the cost of “new” fixed assets, with no limitations based on acquisition levels or profitability.
Under the TCJA, the deduction is increased to 100% for items acquired after September 27, 2017. Moreover, the prohibition on new property has been removed.
For state tax purposes, in recent years a number of jurisdictions had previously decoupled their tax systems from federal law with respect to both Section 179 Expense and Bonus Depreciation, and it would not be surprising to see this trend increase.
Net Operating Losses
Under prior law, including the 2017 tax year, Net Operating Losses were available for carryback and carryover. The respective carryback and carryforward periods were 2 and 20 years, with unused losses expiring after 20 years. Unless losses were limited by Section 382 (a corporation provision not changed by the new law), losses were allowed to fully offset income in a carryback or carryforward year.
The TCJA has made three significant changes with respect to Net Operating Losses generated in years starting January 1, 2018: (1) the carryback period has been eliminated; (2) the carryforward period is now indefinite; and (3) losses may only offset up to 80% of income in a profitable year.
For example, if a company incurs a net operating loss of $100,000 in 2018 and generates $70,000 of taxable income in 2019, only $56,000 ($70,000 x 80%) of the loss may be used in 2019. The remaining 2018 loss of $44,000 ($100,000 – $56,000) remains available for use in future years.
Note that loss carryovers from 2017 and prior years are not subject to this 80% limitation. In the above example, if the company also had a $150,000 loss carryover from 2017, it would have been able to fully offset the 2019 income of $70,000.
Flow Through Entities (Qualified Business Income Deduction)
The TCJA added a new deduction available to investors in flow through entities (primarily sole proprietorships, partnerships and S corporations). For purposes of this discussion, the term “partnerships” includes LLCs, LLPs, LPs, and other entities taxed as partnerships. For an individual in the top bracket of 37% who qualifies for the maximum deduction, this lowers the effective tax rate to 29.6%.
The deduction is equal to a maximum 20% of flow through income, subject to multiple limitations. One is based on the higher of (a) 50% of wages paid by the entity, or (b) the sum of 25% of wages paid by the entity plus 2.5% gross cost of fixed assets. The second limitation is based on the individual partner’s or stockholder’s taxable income, net of capital gains.
For example, assume a married owner of a manufacturing company generates K-1 income of $400,000. The business paid $600,000 of wages, and the gross cost of their equipment amounts to $1,000,000. The owner, on her personal return, has taxable income of $425,000, which includes $75,000 of capital gain.
The starting point for computing the deduction is to multiply the K-1 income of $400,000 by 20%, which equals $80,000. This amount is compared to 50% of W-2 wages (or $300,000), or the sum of 25% of W-2 wages ($150,000) and 2.5% fixed assets ($25,000), for a total of $175,000. The higher of these two figures ($300,000) is compared to the $80,000 starting point. Since 20% of K-1 income results in the lower result, the tentative deduction is equal to $80,000.
Lastly, this figure is compared to 20% of taxable income net of capital gain income. In our example, this figure is $70,000 (($425,000 – $75,000) x 20%). The net deduction is equal to the lower of these two figures, or $70,000.
In addition to the base rule discussed in the above example, income earned from flow through entities performing specified personal services (accounting, actuarial science, athletics, brokerage services, investment management, consulting, financial services, health, law, or the performing arts) face additional limitations on the deduction once an individual owner’s taxable income reaches $315,000 for joint filers ($157,500 for single filers).
It is important to reemphasize that the deduction is calculated at the owner level. Accordingly, an LLC with ten equal owners could easily have ten different results, depending on each individual owner’s personal circumstances. As noted in the above example, the calculations are detailed and complex, with no two situations alike. AAFCPAs is available to provide more guidance on this issue.
AAFCPAs has highlighted the following additional business-related provisions changed as a result of the Tax Cuts and Jobs Act, all of which are effective beginning in 2018.
- Like Kind Exchanges under Internal Revenue Code Section 1031 are now limited to real estate transactions only. Previously, many different types of assets (most frequently vehicles) were eligible for Like Kind treatment.
- The Domestic Production Activities Deduction (DPAD) has been eliminated.
- Interest expense is now limited to 30% of a business’s adjusted taxable income. Disallowed interest may be carried forward indefinitely. This limitation does not apply to businesses whose average gross receipts over the preceding three years is less than $25 million.
Accounting Method Reform
Under prior law, there were varying levels of gross receipts that required businesses to apply certain accounting methods. These levels ranged from $5 million for use of the cash basis of accounting by C corporations, to $1 million for the use of the UNICAP method of accounting for inventories, $10 million for contractors to use the percentage of completion method, and so forth.
Under the TCJA, these disparate income levels have been simplified into a single $25 million test, effective for years beginning in 2018. It is possible that a business that recently changed an accounting method to be in compliance with prior law will have the opportunity to revert back to their previous accounting method. AAFCPAs is available to provide guidance regarding the mechanics of making this change.
The changes outlined create numerous planning opportunities for clients, which require additional discussion with your AAFCPAs tax advisor:
- Should S corporations or LLCs convert to C corporations? While the variance in top tax rates may initially tilt the argument in favor of C corporations, the ability of flow through entity owners to withdraw profits on a tax free basis has not been changed by the Tax Cuts and Jobs Act, nor has the existing rule allowing an owner’s basis in their stock to increase by the amount of undistributed profits.
- Companies that have either purchased real estate or incurred substantial leasehold improvement costs may wish to consider a cost segregation study as part of completing their 2017 tax returns. A cost segregation study may allow you to front load depreciation deductions into the 2017 tax year, prior to the 2018 rate reductions taking effect.
- Similarly, there are other accounting method changes in 2017 that businesses may wish to consider applying for on an automatic basis. Examples include advance deduction for prepaid service contracts, and partial income deferral for long term service contracts where payment is collected up front. When rates were constant, the advisability of these method changes was generally limited to high dollar situations, but the tax rate reduction may make it worthwhile to elect these changes in order to accelerate deductions into 2017.
The wording of the TCJA is such that we anticipate additional clarifications will be forthcoming on a number of these changes. The tax practice of AAFCPAs will continue to monitor the legislative process and keep you informed as significant changes occur or provisions become clarified. If you have any questions please contact your AAFCPAs partner, or Richard Weiner, CPA, MST at 774.512.4078, firstname.lastname@example.org.
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- AAFCPAS’ TAX PRACTICE RECOMMENDS INDIVIDUAL TAX PLANNING CONSIDERATIONS WITH RESPECT TO THE TAX CUTS AND JOBS ACT