Normally at this time of year, I am sitting down with all of my contractor clients and digging into their numbers to try and come up with strategies to mitigate their income tax coming due. Typically, this consists of trying to find ways to defer income, accelerate expenses, or favorably change character of gains. Hard enough to do, but in general, this was a fairly straightforward endeavor. Nearly a year ago, the Tax Cuts and Job Act was signed and threw the tax world for a loop. For a tax bill that was sold as a means to simplify income tax filings for the masses, it did the exact opposite in regards to filings for business entities as well as their owners.
For anyone that thought Congress rushed the Affordable Care Act, the speed in which this bill was written and passed was impressive. Unfortunately, the bill reads as if it was put together too hastily and leaves many important questions unanswered. In cases where the law is unclear, regulations get written in order to clarify Congress' intent. While we recently received over 430 pages of regulations dealing with one component of the bill, we are still waiting with bated breath for additional guidance to come in. Until that occurs, we are left to guide our clients as best we can. While the devil is definitely in the details when discussing tax law, until we have more certainty, I am taking a big picture stance with my clients. The following are the big ticket items I will be discussing and strategizing for this year-end.
CHOICE OF ENTITY:
Details: Corporate tax rates were cut from a maximum of 35% down to 21% making C-Corporations more tax friendly. However, double taxation still exists as shareholders taking a dividend from the company would still need to report that as income. Individual tax rates were slashed overall and came down from a high of 39.6% to 37%. In order to compete with corporate tax rates, business income from a pass-through may qualify for a 20% deduction (see discussion further below), effectively getting a maximum tax rate of around 30%.
Takeaway: In general, pass-through entities are still going to give the better tax answer to most owners. However, any company that will not qualify for the 20% deduction or one which plans on being in a growth phase for a long period of time (no dividends going out to owners) may want to consider switching to a C-Corporation structure. The ultimate fly in the ointment on this analysis is that tax law today may not be tax law for a long period of time. Constantly changing control in D.C. is evident, and views vary drastically between the two parties.
199A 20% PASS-THROUGH DEDUCTION:
Details: Net business income (capital gains and investment income are excluded) from pass-through entities may qualify for a 20% deduction. This deduction is based off data at the entity level, but is claimed on the individual owner's tax return. If the individual has income over $415K of income ($207.5K if single) the deduction is subject to additional limitations. For these individuals, the deduction relating to a particular entity cannot exceed 50% of wages from that entity or 25% of wages plus 2.5% of the cost of certain qualifying fixed assets from that entity. In general, this calculation is done on an entity by entity basis, so the wages or cost of qualified fixed assets from one business cannot be utilized on another. In addition, individuals over this income benchmark cannot claim a deduction on business income from certain industries (service based businesses such as accountants, attorneys, etc.)
Takeaway: Pass-through entities with owners that expect to exceed $415K of income ($207.5K if single) should make sure they have enough wages and/or fixed assets in order to fully take advantage of the 20% deduction. If need be, consider taking steps to increase wages (accelerate bonuses) or decrease income to ensure there is no limitation on the deduction or else have the individual get under the income thresholds.
BUSINESS INTEREST LIMITATION:
Details: Companies with a three year average of gross receipts exceeding $25 Million (commonly controlled entities need to be aggregated into this calculation) are subject to limitations on the amount of interest that can be deducted. The amount of interest allowable is capped at 30% of taxable income plus depreciation, amortization, and interest expense. Any interest disallowed carries into the following year and is added into that year's calculation. Starting in 2022 depreciation and amortization will not be added back to income when calculating the interest cap.
Real property trades or businesses (of which construction qualifies) can elect out of limitation. The downside to electing out is that they must depreciate their fixed assets at a slower rate and may lose out on the ability to expense assets immediately under bonus depreciation provisions.
Takeaway: Business owners with multiple entities may need to revisit how they are leveraged. For example, if they have multiple businesses with lines of credit but they are out heavily on one line they may want to borrow some on the others to reduce the one in order to spread the related interest charge out.
Anyone that qualifies to elect out will need to decide if being limited on future depreciation is a good enough price to pay in order to deduct all interest expense today.
LIMITATION ON USE OF BUSINESS LOSSES:
Details: Individual taxpayers must divide their income between personal and business related. If there is an overall net loss on business activities, there is a cap of $500,000 that can be utilized to offset personal activity income. So, if someone were to have capital gains of $1,000,000 from the sale of stock within their personal brokerage account and $800,000 of loss from their construction pass-through entity, they would still have to pay tax on $500,000 of income. The $300,000 of loss not utilized carries forward to the following year and becomes part of that year's business loss limitation calculation.
Takeaway: This adds one more layer of complexity to tax planning. For anyone with business losses, they need to try and avoid going over $500K of personal income. For example if they are close, they should have a discussion with their broker not to trigger any additional capital gains.
Details: Corporate as well as individual taxpayers are no longer allowed to take losses created in a year and carry them backwards to get a refund of prior income tax paid. Instead, losses carryforward only. To add salt to the wound, any loss that carries forward can only offset 80% of income generated in a future year.
Takeaway: Rather than aiming to wipe away all profits, taxpayers may be motivated to get as close to $0 income in order to avoid not having full utilization of a loss in the following year. Why make a large expenditure on 12/31/18 if it is going to create a loss that has limitations for future usage while the same expenditure on 1/1/19 would fully offset all 2019 income.
Details: Section 179 (allowing for immediate expensing of qualifying capital assets such as equipment) and Bonus Depreciation have been around for several years, allowing for the ability to accelerate depreciation deductions. The maximum Section 179 deduction has been increased to $1 Million and bonus depreciation increased to 100%.
Takeaway: With the exception of the purchase of real property and building improvements, the new depreciation rules will allow most taxpayers to immediately write off all their fixed asset acquisitions.
Details: Companies with a three year average of gross receipts exceeding $25 Million (commonly controlled entities need to be aggregated into this calculation) are eligible to change the way they account for construction contracts away from percentage of completion recognition. Instead they can account for these contracts on a cash basis (recognize contract revenue when received) or completed contract basis (recognize job profit only when a job is finished).
Takeaway: Qualifying companies should switch accounting methods to take advantage of using a method that would allow for significant deferral of income. As with much of the changes in this tax act, this will make taxes more complicated. Some may be familiar with Alternative Minimum Tax (AMT). For those that aren't, in reality there are two tax systems (Regular Tax and AMT) in which taxpayers calculate their tax under each set of rules and pay tax on the larger of the two. For AMT purposes, contracts are required to be calculated on the percentage of completion method so any method change made would not apply under this calculation. This takes away some of the advantage to making these switches, but income deferral would still apply to most taxpayers. It just becomes burdensome to estimate the true benefit. For C-Corporations, this tax act removed AMT (still applies to individuals) so any that qualify will want to take advantage of this provision.
Astute readers will notice that taking advantage of one of these changes will impact calculations on others. Accounting method and depreciation changes may allow for the ability to manage income within certain thresholds, but taxpayers and their advisors will need to put some thought towards what income level gives them the most benefit. Normally, attempting to create as big of a tax loss as possible would give the best tax answer. With net operating losses now only offsetting a maximum of 80% of income in following years, it may give a better overall answer to create additional income in the current year. With the wage limitation attached to the 20% pass-through deduction, it may be beneficial to recognize an even amount of income over a period of years versus a situation in which a large amount of income is pushed out of one year and into another. This would happen if there are not enough wages to fully get the 20% deduction in years with large amounts of income. Overall, you may want to pay tax earlier rather than give up this deduction on a portion of the company profit.
Overall this bill creates significant complexity for anyone trying to budget their income tax burden and will certainly create additional administration for taxpayers and their practitioners. The information presented above is meant to give a brief overview of the main provisions of the tax bill, but each section has additional nuance and details not outlined in this article that will need to be adhered to. The good news is that with complexity comes opportunity.
It's a brave new world out there for tax navigation but with some proper planning, taxpayers should experience significant savings.
Adam Thaine is a partner based out of our Rochester, NY office.