The New Tax Bill: Changes for Businesses in 2018
The tax reform legislation was signed into law in December 2017, bringing overall positive changes for small businesses.
While the biggest business tax cuts are reserved for corporations, most small businesses structured as pass-through entities also benefit, with a first-ever deduction on business income. As with most tax legislation, many of the main provisions are complicated by restrictions and exceptions, making it important for businesses to start their 2018 tax planning early to be able to take full advantage of benefits offered by the tax bill.
Corporate tax rate reduction: The simplest provision to understand is the across the board reduction of the corporate tax rates. The graduated tax structure with its top tax rate of 35% is replaced by a flat tax rate of 21% for all corporations. The new corporate tax rate is permanent.
“Qualified business income” 20% deduction for pass-through businesses: Businesses that are “pass-through” entities, such as sole proprietorships, partnerships, LLCs, and S-corporations, are allowed to take a 20% deduction against “Qualified Business Income (QBI).” QBI is defined as the net amount of income, including gains, deductions and losses, generated from a trade or business. QBI doesn’t include reasonable compensation received from an S-corporation. That restriction prevents business owners from taking an artificially low salary in order to maximize QBI and the resulting deduction.
Service-based business restriction: There are two additional restrictions limiting the use of the pass-through deduction. Service-based businesses, such as accounting, law, consulting, athletics, financial services, medical, and any professional service field where the reputation and skill of the principles or one or more employees is the primary asset of the business, are limited in their use of the deduction, depending on the amount of income they earn. The deduction is phased out on taxable incomes of $157,500 for individuals and $315,000 for married couples. The final bill excluded architects and engineers from the exception.
Wage restriction: The deduction is also limited by the amount of total wages paid by the business. The maximum deduction allowed is the lesser of 20% of business income of 50% of total W2 wages paid. For businesses with a small payroll and high investment in capital, the maximum deduction is based on 25% of payroll plus 2.5% of the unadjusted basis of “qualified property,” which can include equipment, machinery, and real estate the business has purchased and is still using for as long as it can be depreciated (minimum of 10 years). Again, if the total income of a business owner does not exceed $157,500 per individual or $315,000 per married couple, the full 20% deduction is allowed.
It’s important to note that the pass-through deduction is a part of the individual tax package, which is scheduled to expire at the end of 2025 unless Congress renews it.
Enhanced expensing through Section 179 and bonus depreciation: Businesses that purchase property and equipment will enjoy two major expensing enhancements. Section 179 of the Internal Revenue Code, which previously allowed businesses to expense up to $500,000 of the cost of qualified business property, has been expanded to $1 million. The enhancement also increases the total amount of property a business can purchase before the expense is phased out dollar-for-dollar. The phase-out threshold has been increased from $2 million to $2.5 million. In addition, the new tax bill expands the types of property that can be expensed to include HVAC systems, fire and security systems, and new roofs. The maximum allowance is still limited to the amount of income generated from business activity.
The other expense enhancement boosted the first-year “bonus depreciation” deduction from 50% to 100% for five years. Businesses can now write off the entire expense of many types of property in the first year, except for land and buildings. The new tax bill also extends the deduction to include used equipment.
The deduction was always tenuous, with the amount fluctuating from year to year, which complicated tax planning. Previously scheduled to phase out over the next three years, the 100% bonus depreciation deduction is now locked in for five years and then decreases by 20% until its expiration in 2027.
Start 2018 tax planning Now: The pass-through deduction and expense enhancements present many businesses with two significant opportunities to reduce their taxes. But, according to Jeremy Masters, senior accountant at Kee & Associates, Certified Public Accountants in Roseville, California, businesses should start their tax planning earlier this year, instead of waiting until summer. And, because many of the details in the new law are somewhat murky, he recommends that businesses check with their accountant before making any major purchases. Some businesses may want to consider restructuring their businesses to take full advantage of the new tax law, but he looks at that on a business by business basis. In working with the new tax law, Jeremy says there is “no one shoe that fits all businesses."