While not explicitly sold in this way, I believe this round of tax reform was largely driven by the desire to reduce corporate level income tax. The perception is that US corporate tax rates were among the highest in the developed world. This tax bill is intended to remedy that fact and pull the US rate down closer to the average rate in developed economies. Anyway, here are the key components to the TCJA with an impact on businesses both large and small.
Corporate Tax Rate
Quite simply, the highest marginal income tax rate for C Corporations is now 21% from a previous high of 35%. In reality, very few small businesses elect to be treated as C Corporations because of the double taxation. Several large businesses announced one-time bonuses for their employees and pointed to the decreased tax burden as the reason why. I don’t expect many of my clients to suddenly clamor to be taxed as C Corps because of this bill. There may be some consideration of utilizing C Corp status now but that will have to be determined on a case-by-case basis.
Pass-Through Entity Deduction
PAY CLOSE ATTENTION THERE WILL BE A QUIZ AT THE END OF THIS SECTION!
Perhaps the most arduously debated and likely least understood component of the TCJA is the so-called “Qualified Business Income” deduction (QBI) now afforded pass through entities (partnerships, LLC’s and S Corporations). This deduction also applies to Schedule C filers (sole proprietorships) and rental properties reported on individual Schedule E.
The basic idea is if an entity qualifies for the QBI deduction the taxpayer would receive a deduction up to 20% of the net income from that business. For example, if an entity had $100k of QBI the taxpayer would receive a $20k tax deduction ($100k times 20%) which would reduce the taxpayer’s taxable income.
Well, of course, nothing is that easy when it comes to the tax code! Instead, various roadblocks and limitations are placed on qualification for the QBI deduction. A full analysis is WAYYYYY beyond the scope of this blog post but here are the key limitations to plant a seed.
- Wage Limitation-The QBI deduction may not exceed 50% of W2 wages reported by the pass through entity. This limitation is waived, however, for married taxpayers with taxable income below $315k. Meaning many small businesses will qualify for the QBI without application of the wage limitation.
- Service businesses not eligible-The bill excludes “specified service activities” from taking the QBI deduction. The bill further defines specified service activities as a business involving the performance of service referenced in a specific tax code section. Essentially this eliminates attorneys, accountants, investment professionals, consultants, health care providers, etc. from taking the deduction. However, as above this limitation only applies to to married taxpayers with taxable income above $315k.
- Investment Income–The law specifically states that any type of investment income from a pass-through business is NOT eligible for the QBI deduction.
- Rental Property–Because most rental properties do not have wages, they would not qualify for the QBI were it not for an alternative limitation calculation. Essentially, this would allow taxpayers to use 2.5% of the entities unadjusted basis of depreciable property. Thus a rental property with an original cost basis of $500k would have a QBI deduction limitation of $12,500.
Interestingly, although all of the calculations related to the QBI deduction are done at the entity level, the qualification for the various limitations are done at the individual tax level. Thus, it is possible for two partners to have differing allowances of the QBI deduction.
Well if you are confused, I don’t blame you. But this is a potentially huge tax deduction that needs to be looked at individually. Many taxpayers will be below the limitation thresholds and will realize the benefit of the deduction without too much worry. Others may need to do some planning to make sure they maximize it.
Depreciation Changes
There are several changes to the calculation of depreciation. Most notably, an increase in the amount of allowable Section 179 deduction and an increased bonus depreciation allowing up to 100% first year bonus depreciation. This will be particularly attractive for rental property owners who, of course, are not eligible for Section 179 treatment. There are other changes to depreciation that are more narrow in focus and beyond the scope of this writing.
Section 1031 Like Kind Exchanges
Section 1031 exchanges have long been an attractive means of deferring gain on the sale of an asset used in a trade or business. The TCJA changed the application of Section 1031 by limiting it’s usage to ONLY real property. That means like kind exchanges still work for rental properties and other real property used in a trade or business but is no longer applicable to other assets. Thus personal property assets (autos, equipment, etc.) will have to recognize gain on exchanges that previously allowed for tax deferral.
There are also limitations on deduction of interest expense adopted as a part of this bill. I don’t think this limitation will be applicable to any of our clients, however.
As always, if you see something that looks like it may impact you, please do not hesitate to contact us. We are happy to assist you in better understanding this new comprehensive tax reform and frame its impact on you and your business.