Either the walls of our office building are thin or I work with naturally loud individuals. Either way, I can easily hear the conversations of my neighbors. One common refrain I seem to be hearing more and more often from the partner next to me is that nothing is ever simple. That certainly holds true for the Tax Cuts and Jobs Act of 2017 that was signed into law by President Trump on December 22, 2017. Going way beyond simply reducing income tax rates, large-scale changes to the entire taxation system were made. This new system may result in lower taxes for corporations and business owners, however, the road they now need to navigate is more convoluted and winding then ever before.
Choice of entity
The form and substance of this bill changed drastically from inception to its final version. The one certainty that existed from the start was that C-Corporation income tax rates were going to be cut significantly. Due to the reduced C Corporation income tax rates, the number one client asked question this past summer and fall was whether conversion from a pass-through entity to a C-Corporation was beneficial.
The answer to this question then and now remains the same: It depends. While a number of questions need to be addressed to accurately assess a conversion, it can be analyzed at a high level assuming a business has enough earnings to be taxable at the highest tax bracket and that the owners desire consistent distributions.
Going forward, a C corporation will pay income tax at a flat 21 percent. This leaves 79 percent of corporate profits to distribute. Once the corporation dividends out the profits, the owners are required to recognize income. Assuming the individual is in the highest income tax bracket, the dividends would be assessed a 23.8 percent tax rate. The combination of the corporate tax rate and individual tax rate on dividends would result in the owners ultimately receiving 60.2 percent of the company profits in cash.
While C corporation tax rates were slashed from a high of 35 percent down to 21 percent (a potential decrease of 40percent for highly profitable corporations), individual rates were reduced from a high of 39percent down to 37percent. A relatively paltry drop of 5percent for large income individuals. In order to make pass-through business entities competitive with C corporations, a new Pass-Through Deduction of 20 percent of Qualified Business Income was adopted.
This deduction calculation is performed at the individual level. Joint filers with taxable income of $315,000 or less ($157,500 or less for all others) have a relatively simple calculation. Add up all qualified business income from all pass-through sources (effectively segregate business operation income from non-operations such as investments, capital gains, etc.) and take 20 percent of the sum. This is the tentative deduction allowed to be taken against taxable income (tentative as it is further limited to 20 percent of the individual's taxable income over any capital gains).
If the individual has income over $415,000 (joint) or $207,500 (all others) further limitations exist in order to be able to realize the deduction. For starters, income from certain service businesses will not qualify at all (construction and real estate development qualify, but weep for your accountants and attorneys). In addition, the amount of qualified business income allowable is limited to the smaller of (1) 20 percent of qualified business income or (2) the larger of (a) 50 percent of W-2 wages or (b) 25 percent of W-2 wages plus 2.5 percent of the original costs basis of property currently being depreciated for tax purposes. Essentially, for larger income individuals, they restricted the pass-through deduction to only be available on income from businesses with wages or large capital investments. Note that this limitation is performed at the business entity level, so they prevented individuals from utilizing wages of one business to claim this deduction on the income of another.
For my construction base, this limitation will be of concern in regards to joint ventures they have formed. Unless the joint venture has wages or a large number of fixed assets, it may be impossible to qualify their earnings for the pass-through deduction without restructuring the entire venture.
Back to our original problem—full utilization of the pass-through deduction would result in a reduction in tax of 7.4 percent (37 percent top rate x's 20 percent deduction). This translates to an overall top rate of 29.6 percent, resulting in the owner being able to keep 70.4 percent of their profits. Compared to the 60.2 percent the C corporation owner achieved, in our overly simplified example, the pass-through entity came out on top. So why are people still contemplating the entity conversion? It all relates to the time value of money. While the pass-through entities will be assessed with a 29.6 percent tax rate in our example, C corporations will only be immediately assessed a 21 percent rate and can defer the additional tax on dividends until a distribution is made.
For pass-through owners able to make full use of the pass-through deduction, the resulting decrease from the previous high of 39 percent down to 29.6 percent represents a tax cut of nearly 10 percent. Even though the decrease is not as drastic as the corporate tax cuts, it still has a significant impact to the bottom-line.
In line with the changes to tax rates, some more good news came in the form of depreciation. Previously, bonus depreciation allowed for the 50 percent immediate write-off of all qualifying assets (brand new equipment, furniture, land improvements, and certain non-structural building improvements). Starting with assets placed in service after September 27, 2017, bonus qualifies for used as well as new property and allows for the write-off of 100percent of the cost of the asset.
The Section 179 Deduction is another tool that allows for accelerated depreciation on qualified assets (equipment, furniture, certain building improvements). The law has given a specified dollar amount that can be utilized to write off qualified assets immediately. The dollar amount has been increased from $510,000 to $1 Million for the 2018 tax year. Given that bonus depreciation will be 100 percent, a Section 179 deduction is somewhat duplicitous in nature and can be more restrictive given that it cannot be used to generate an overall tax loss. However, starting in 2018 Section 179 can be utilized on improvements made to commercial property for the replacement of roofs, HVAC systems, fire protection systems, alarm systems, and security systems. None of these items qualifies for bonus depreciation and therefore provides a great planning opportunity to utilize 179.
Interest expense limitations
Unfortunately, the law isn't all unicorns and rainbows—Congress giveth and Congress taketh. Up through 2017, with a few exceptions, businesses were able to deduct any interest expense they incurred. Going forward, business entities will be required to perform a calculation to determine if their interest expense deduction is limited.
The amount of interest expense allowable is capped at 30 percent of adjusted taxable income. For years 2018 through 2021, adjusted taxable income is basically defined as taxable income plus interest expense, depreciation, and amortization (EBITDA). Starting in 2022, depreciation and amortization are no longer added back. Note with all the accelerated depreciation now allowable, businesses may want to think about making certain capital investments prior to 2022 if the resulting depreciation will limit their ability to claim interest expense. This calculation is performed at the entity level, thus an individual owning multiple business ventures cannot utilize the income from one entity to help claim interest expense on another. Any disallowed interest expense gets carried forward indefinitely.
There are some exceptions to this rule. Small businesses are specifically exempt from the interest expense limitation. A business would be considered small if the average of the past three years of gross receipts is under $25 million (note aggregation rules for commonly owned businesses apply). In addition, real property trades or businesses (construction qualifies) can make an irrevocable election to be exempt. The trade-off for those making the election would be that they would be forced to utilize slower depreciation methods on real property and qualified improvement property.
For taxpayers with an overall taxable loss (corporate and individuals), previously we could carry these losses back two years and forward to utilize against future income. For losses generated prior the 2018 taxable year, these old rules apply. However, for losses generated in 2018 and beyond, the carryback period is eliminated, but the carryforward period is indefinite. In addition, rather than being allowed to offset future income dollar for dollar, losses created after 2017 can only offset 80 percent of income in future years. For example, if a taxpayer has a loss of ($400,000) in 2018, it immediately carries into 2019. If they have $300,000 of income in 2019, they can only use $240,000 of the loss carryover resulting in having to pay tax on $60,000 of income. The remaining $160,000 of the loss then carries forward indefinitely.
For individuals, they added an additional layer for losses that previously only applied to farmers. Essentially, individual taxpayers will need to segregate all items of income and loss on their individual return between personal (wages, investments, etc.) and business. An individual will only be allowed to utilize $500,000 (married) or $250,000 (single) of business loss against non-business income. Any business loss that cannot be utilized in the current year will be carried forward indefinitely into future years. For example, a married individual has a $1 million loss from their business activity and a $1 million W-2. They can only use $500,000 of the business loss to offset against the wage income. They would have to pay tax on the remaining $500,000 of wages and carry the remaining loss into next year.
The tax landscape is vastly different today than it was prior to this bill being enacted. The reduction in tax rates, pass-through deduction on business income, and availability to massively accelerate depreciation represent a significant boon to taxpayers. The strings attached to qualify, as well as the new limitations relating to interest expense and tax losses, require businesses to have the foresight to maneuver and plan to avoid any potential tax traps. Due to the complexity of the new law, it would be beneficial to talk to your tax advisor throughout the year ensure the benefits of the law can be utilized. Savvy business owners will need to put some thought into how to properly structure new (or restructure existing) ventures in order to receive the most benefit from tax reform.
Adam Thaine is a principal based out of our Rochester, NY office.