What is it?
As many of you know, the Tax Cut and Jobs Act (“the Tax Reform Act”) was signed into law on December 22, 2017 and imposes the biggest changes to the Internal Revenue Code since 1986. This article provides an overview of the key provisions of the Tax Reform Act and highlights how these provisions may impact you and your business.
Why do you care?
The Tax Reform Act has the potential to greatly reduce a taxpayer’s tax liability on both the business and individual side. Taking advantage of the savings opportunity requires each taxpayer to reevaluate their business structure, choice of entity decisions, major asset purchases, and potential future mergers and acquisitions on both the buy and sell side. Everyone’s tax situation is different and taking advantage of the planning opportunities requires individualized attention.
On the most basic corporate level, the Tax Reform Act significantly reduces the corporate tax rate to a flat 21%. For pass-through business owners of S-corporations, partnerships, LLCs and sole proprietorships, the Tax Reform Act provides a 20% qualified business income deduction (QBID) to the business owner from their allocable share of “qualified business income” of the pass-through entity (this 20% deduction is very complicated and described in more detail below and future articles).
For a simple corporate example, a business taxed as a C-Corporation with $1,000,000 of taxable income will see savings of over $100,000 in taxes under the Tax Reform Act. On the pass-through side, an owner of a single member LLC with $300,000 of taxable income (filing jointly with her spouse) and utilizing the 20% QBID for pass-through businesses could save upward of $25,000 in taxes under the Tax Reform Act. Of course, these are very simple examples, and the details are critical to understanding whether you qualify, and what the planning opportunities might be. Also, you should be aware that the IRS has not yet issued many of the regulations and clarifications regarding how this Act will be interpreted, so working with your tax professional will be critical. The most important takeaway is that the potential for significant tax savings is real, and is worthy of a conversation with your tax professional.
What should you do about it?
Make sure you and your tax advisors are proactively focused on the aspects of the Tax Reform Act that impact you individually or your business. Make an appointment to discuss these changes and planning opportunities with your tax professionals soon. As mentioned above, we will be publishing future alerts addressing how the Tax Reform Act impacts choice of entity decisions, M&A, private equity, international business, and pass-through businesses. You should also review tax distribution provisions in your current operating agreements as they may be outdated.
Please call us with any questions on the Tax Reform Act. While we focus more on the business aspects of this law, we are happy to work with you and your CPA in dissecting the law and its impact on you.
For more information on the key provisions of the Act, keep reading below…
The Basics and Big Picture
On the individual side, the Tax Reform Act reduces the maximum marginal tax rate to 37%, increases the standard deduction, eliminates the personal exemption, reduces or eliminates many of the itemized deductions, including providing a cap on mortgage interest and state and local tax deductions, expands the child and dependent tax incentives and reduces or eliminates certain employee tax-free fringe benefits. Most of these changes are temporary and sunset in or around 2025, depending on the provision.
On the corporate and business side, the Tax Reform Act drastically reduces the corporate tax rate to a flat 21%. It also provides substantial write-offs for capital expenditures in the year such expenditures are incurred, reduces the tax on business owners of pass-through business entities, limits certain interest deductions for some businesses, reduces the net operating losses (NOLs) that may be deducted in a given year, and much more.
We will be providing updates on the Tax Reform Act over the next few months, to include not only legislative and regulatory updates that clarify and elaborate on some of the tax law changes, but also to provide insight on how this new law impacts choice of entity decisions, business planning and expansion plans, mergers and acquisitions, private equity, and international expansion, among other topics. We will also spend time dissecting the 20% Qualified Business Income Deduction that impacts pass-through businesses such as sole proprietorships, S-Corporations, LLCs and partnerships.
KEY INDIVIDUAL CHANGES
- Individual Tax Rates and Brackets. The highest marginal tax rate was reduced from 39.4% to 37% and the marginal tax rates were reduced in all 7 tax brackets and income levels. By way of example, a married couple earning $300,000 of taxable income would have been in the middle of the 33% marginal tax bracket in 2017. In 2018, that same couple would be at the higher end of the new 24% marginal tax bracket. This could result in over a $20,000 tax savings.
- Personal and Standard Deductions; Child Tax Credit. Under the Tax Reform Act, the personal exemption has been eliminated and replaced with higher standard deductions. The standard deduction has increased from around $13,000 to $24,000 for joint filers. The child tax credit has also been doubled and it phases out at much higher income levels: phasing out at $400,000 for joint filers, where before it phased out at $110,000 for joint filers. The impact of these changes results in significantly fewer taxpayers itemizing their deductions, since joint filing taxpayers would now need to exceed $24,000 in deductions to make itemizing worth it. From a policy standpoint, this limits the usefulness of the mortgage deduction, state and local tax deductions, and the charitable deductions, as they are all itemized deductions.
- Mortgage Deduction; State and Local Tax Deduction. For mortgages taken out after December 14, 2017, individuals may only deduct interest on the first $750,000 of mortgage debt. Previously, taxpayers could deduct interest on up to $1,000,000 of mortgage debt plus $100,000 of home equity debt. Interest on home equity loans is no longer deductible. This affects interest on all home equity loans, even if the loan was taken out prior to December 15, 2017, unless the home equity loan was used to buy, build or substantially improve the home securing the loan. Under the Tax Reform Act, the deduction for state and local taxes are capped at $10,000. Both of these changes impact taxpayers regardless of state, but may have a greater impact on those living in states with high tax burdens and higher costs of living (more expensive houses).
KEY BUSINESS CHANGES
- Corporate Tax Rate Changes. In probably the most talked about provision, the Tax Reform Act drastically reduces the corporate tax rate on C-corporations to a flat 21% tax. It also eliminates the special tax rate for personal service corporations. For Corporations, the Tax Reform Act also reduces the percentage of dividends excluded from income under the dividends received deduction and repeals the alternative minimum tax.
- Net Operating Loss Changes. Under the Tax Reform Act, only 80% of taxable income may be offset by NOLs. The remaining 20% will be taxed at the 21% corporate rate. Corporations will be able to carryforward losses generated in tax years ending after 12/31/2017 indefinitely (previously this was limited to 20 years). Corporations will no longer be able to carryback NOLs in tax years after 12/31/2017.
- Business Interest Expense Limitation. Under the Tax Reform Act, the taxpayer’s deduction for business interest expense cannot exceed (1) the taxpayer’s business interest income plus (2) 30% of the taxpayer’s adjusted taxable income. This limit does not apply to “small businesses” with average annual gross receipts over a three year period of $25 million or less. Under the Tax Reform Act, highly leveraged businesses will not be able to fully deduct interest expense. This may change the way businesses are funded and the mix of debt and equity going forward.
- 20% Qualified Business Income Deduction. This is one of the most complicated provisions in the Tax Reform Act, and we will dissect this provision in much more detail in upcoming months, particularly as the IRS is anticipated to release more guidance on the QBID as a higher priority. For now, note that a deduction will be allowed for individuals in an amount equal to 20% of business income. This deduction applies to income effectively connected with a trade or business in the U.S. It does not apply to wages, guaranteed payments, or capital gains paid by the business to the owner. The QBID is subject to certain limitations and restrictions. First, the deduction is limited to the greater of (i) 50% of the taxable allocable share of W-2 wages paid by the business or (ii) 25% of such W-2 wages PLUS 2.5% of the original acquisition cost of depreciable property used in the business. Second, income derived from certain disqualified “services” may not be eligible for the deduction, depending on taxpayer’s taxable income. Such disqualified services include services in the fields of health, law, accounting, actuarial science, performing arts and consulting, among others, where the principal asset is the reputation or skill of 1 or more of its employees. Taxpayers with taxable income below $315,000 (joint return) or $157,500 (single) are not subject to the above-mentioned limitations or restrictions. For taxpayers with taxable income above $315,000 (joint return) or $157,500 (single), a phase-out applies. Upon reaching $415,000 (joint return) or $207,500 (single), business owners deriving income from disqualified services are not entitled to any QBID deduction. All other business owners with taxable income above $415,000 (joint return) or $207,500 (single) must calculate the QBID based on the limitations set forth above. For business owners who fully qualify for the 20% QBID, it could mean a 10% lower effective tax rate on taxable income.
- 100% Bonus Depreciation. The Tax Reform Act increases the first year “bonus” depreciation deduction to 100%, which allows taxpayers to immediately write off the cost of certain qualified property. This deduction applies to new and used property so long as the acquiring taxpayer had not previously used the property and did not acquire it from a related party. From a planning standpoint, asset acquisitions are much more attractive to buyers because they could immediately write-off the stepped-up basis of acquired property.
- Enhanced Section 179 Expensing. The Tax Reform Act increases the maximum amount a taxpayer may expense under Code Section 179 to $1,000,000 and increases the phase-out threshold amount to $2,500,000.
- Modification of Like Kind Exchange (1031) Rules. The Tax Reform Act modifies the rule for like-kind exchanges by limiting its application to real property not held primarily for sale. In the past, certain personal property was also allowed under the like-kind rules.
- Entertainment Expenses. Under the Tax Reform Act, no deduction is permitted for any activity considered to be entertainment, amusement, or recreation, or membership dues with respect to any club organized for business, pleasure, recreation or other social purposes. The Tax Reform Act did not repeal the deduction for 50% of food and beverage expenses associated with operating a trade or business, including meals consumed by employees during away from home travel. This means that tickets to sporting events are no longer deductible business expenses. We will separately address how this new rule applies to the deductibility of the traditional client lunch.
- Carried Interest. Under the Tax Reform Act, certain profits interests are now subject to a three-year holding period for long term capital gain treatment. This applies to partnerships involved in (1) raising or returning capital and (2) investing in or developing securities, commodities, real estate held for rental or investment, and certain financial instruments.