Tax Reform: Selected Business Deductions, Exchanges, and Accounting Methods

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the seventh in a series of articles reviewing some of the more important changes.  This post deals with the new rules for selected business deductions, like-kind exchanges, and small business tax accounting methods.

Business Meals and Entertainment

No deduction is permitted after 2017 for business entertainment, amusement or recreation activities, facilities, or related membership dues.  There appears to be a difference of opinion about whether meals for client meetings remain 50% deductible.  Are meals part of entertainment?  IRS Publication 463 states that meals are a form of entertainment.  Therefore, there is a chance that business meals may not be deductible!  IRS guidance is needed.  But it appears that if meals are connected with entertainment they are not deductible.  For business meals not connected with entertainment, they should remain 50% deductible.  Other changes include:

·      Meals furnished to employees for the convenience of the employer are no longer 100% deductible after 2017 but are 50% deductible through 2025.  After 2025 such meals will no longer be deductible.

·      Employee business meals incurred while traveling remain 50% deductible.

·      Meals are 100% deductible if the cost is included in employee wages, billed to or reimbursed by clients, or incurred for social, recreational, or similar activities primarily for the benefit of employees other than the highly compensated (e.g., office holiday parties or summer office picnics).

Business Interest Expense

For tax years beginning after 2017, deductible business interest expense is limited to 30% of adjusted taxable income plus business interest income.  There is no grandfathering of existing debt!  The business interest limitation does not apply to investment interest expense which has its own limitation.  Adjustments required to calculate adjusted taxable income include the following:

·      Nonbusiness income and deductions are excluded.

·      The net operating loss deduction is excluded.

·      The 20% qualified business income deduction is excluded.

·      Depreciation, amortization, and depletion (EBITDA) are excluded for tax years beginning in 2018 through 2021.

·      For tax years beginning after 2021, depreciation, amortization, and depletion expenses are not added back (EBIT) thus lowering the 30% deduction threshold.

The IRS issued Notice 2018-28 wherein it states that for, for purposes of the limitation for C corporations, all interest income is considered business interest income and all interest expense is considered business interest expense.

The limitation is determined at the entity filer level and not at the owner level.  There are complicated pass-through entity allocation rules for allocating excess adjusted taxable income or interest expense.  Disallowed interest can be carried forward indefinitely.  Businesses exempt from the limitation include:

·      Floor plan financing businesses (e.g., auto, boat, farm implement dealers).

·      Companies with $25 million or less average annual gross receipts are exempted.

·      Farming businesses and real property development, construction, rental, operation, brokerage businesses may elect out of the interest expense limitation.  But the election comes at the cost of having to use longer depreciable periods and losing the ability to claim bonus depreciation.

Some implications of the 30% interest expense limitation to consider are the following:

·      Taxpayers may want to elect to “slow down” tax depreciation after 2021 to increase the adjusted taxable income limitation.

·      If earnings decline, there could be a loss of the interest deduction.

·      While the disallowed interest expense carries over, it will still be limited to 30% of EBITDA/EBIT in the future, whereas if the interest expense were part of a net operating loss, it could offset 80% of taxable income.

·      If a taxpayer has multiple entities, some with debt and some without, the debt may need to be restructured across entities since the 30% test appears to be applied on a separate business entity basis.  IRS guidance is needed.

·      Small businesses with a high level of debt that will cross the $25 million gross receipt threshold will need to plan for a possible interest expense limitation.

Like-Kind Exchanges

Tax deferred like-kind exchanges are restricted to real property exchanges after 2017.  After 2017, business or investment personal property exchanges are taxable.  A transition rule permits personal property exchanges to be completed tax-free in 2018 where the taxpayer disposed of the relinquished property (forward exchange) or acquired the replacement property (reverse exchange) before 2018.

Businesses that trade in old machinery and equipment for new will be treated as selling their old machinery and equipment since the exchange is now taxable.  But with 100% bonus depreciation (through 2022) and with §179 expensing, there might not be a net tax increase, at least through 2022.

Small Business Tax Accounting Simplified

For tax years beginning after 2017, tax accounting methods are simplified for businesses having average annual gross receipts for the 3-prior tax years of $25 million or less.  Simplifications include:

·      C corporations may use the cash method of tax accounting.  Previously C corporations could only use the cash method if average annual receipts were $5 million or less.  Prior law exceptions to the required use of the accrual method continue to apply for personal service corporations, partnerships without C corporation partners, and S corporations regardless of the amount of their gross receipts.

·      Businesses with inventory can use the cash method.  Previously businesses with inventory could only use the cash method if average annual gross receipts were $1 million or less ($10 million or less for certain industries).

·      The uniform capitalization of indirect costs to ending inventory is not required for resellers or producers.  Previously resellers were exempt if average annual receipts were $10 million or less, and there was no small taxpayer exception for producers.

·      Construction contractors may use the completed contract method instead of the percentage of completion method for construction contracts entered into after 2017 that are expected to be completed within two years.  Previously the exception to the percentage of completion method had a $10 million average annual gross receipt test.  However, the percentage of completion method is still required for alternative minimum tax purposes and so full simplification for small contractors has not been achieved.

Tax Reform: Revised Tax Depreciation Rules

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the sixth in a series of articles reviewing some of the more important changes.  This post deals with the new rules for depreciation.

Bonus Depreciation

The percentage deduction is increased from 40% (the scheduled reduction for 2018) to 100% for business personal property purchased and placed in service after September 27, 2017 and before January 1, 2023.  After 2022 the percentage is reduced to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% after 2026.  An asset is considered placed in service when it is ready, available, and capable of performing its intended function.  Other changes include:

·      The new or “original use” requirement is dropped in favor of the taxpayer’s “first use” of the property not acquired from a related party (thus “used” property now qualifies for bonus depreciation).

·      Taxpayers may elect 50% instead of 100% for the first tax year ending after September 27, 2017.

·      Bonus depreciation is extended to film, TV, and theatrical performance assets.

·      Qualified improvement property (QIP, improvements to the interior of nonresidential real property that are placed in service after the date the building is placed in service) eligible for 15-year depreciation qualifies for bonus depreciation.  It appears that a technical correction is necessary to ensure that QIP placed in service after 2017 is eligible for 15-year instead of 39-year depreciation and therefore eligible for bonus depreciation.  The statute appears clear that QIP placed in service after September 27, 2017 and before 2018 is eligible for 15-year and bonus depreciation.  QIP does not include improvements attributable to the enlargement of a building, or any elevator or escalator, or internal structural framework of a building.

·      Bonus depreciation is denied to taxpayers who are exempt from the 30% interest expense limitation (other than by reason of the $25 million average gross receipts exemption):

o   Floor plan financing businesses

o   Real property businesses electing out of the interest limitation

o   Farm businesses electing out of the interest limitation

Section 179 Expensing

The current $520,000 §179 expense limitation for 2018 is increased to $1,000,000.  The dollar for dollar phase out of the deduction purchases of qualified property exceed $2,070,000 is increased to $2,500,000.  Other changes include:

·      Eligible property is expanded to include nonresidential property improvements for roofs, HVAC, fire protection and alarm systems, and security systems.

·      Eligible property is expanded to include qualified improvement property (QIP) eligible for 15-year depreciation.

·      Eligible property is expanded to include tangible personal property used predominantly to furnish lodging (e.g., beds, furniture, appliances).

·      The current $25,000 limit for heavy SUVs, certain trucks, and certain passenger vans remains but it is now indexed for inflation after 2018.

Choosing Between Bonus and §179

The following is a list of factors to consider when choosing between claiming bonus or §179 depreciation:

·      If 2017 will be a net operating loss, choose bonus depreciation to drive the loss even higher because NOLs generated in tax years beginning before 2018 can offset 100% of taxable income in future years instead of only 80%.  Alternatively, NOLs generated in tax years ending before 2018 can be carried back.

·      §179 is limited to taxable income, it can’t create or increase an NOL whereas bonus depreciation can both create and increase an NOL.

·      §179 is subject to phase-out if total purchases exceed $2,500,000 which can result in permanent loss if a taxpayer owns an interest in more than one pass-through entity each claiming §179.  Bonus depreciation is not subject to phase-out based on purchases.

·      §179 can only be used when business use exceeds 50% whereas, except for passenger automobiles, bonus depreciation can be used for any percentage of business use.

·      §179 requires recapture income if business use falls to 50% or less whereas there is no recapture for bonus depreciation.

·      §179 cannot be deducted by trusts or estates whereas bonus depreciation is permitted.

·      §179 may be claimed or revoked on an amended return unlike for bonus depreciation.

·      §179 allows individual assets to be selected, it isn’t an all or nothing choice for an asset class like it is for electing out of bonus depreciation.

·      §179 is permitted, and bonus depreciation is not permitted, for taxpayers required to use the alternative depreciation system (tax-exempt use property, tax-exempt financed property, or property used outside of the U.S.)

·      179 is permitted, and bonus depreciation is not permitted, for taxpayers electing out of the 30% limitation on business interest or using floor-plan financing.

·      While Utah follows Federal law, some states may not permit bonus depreciation while allowing some amount of §179 expensing.

·      Remember the annual election to expense asset purchases of up to $2,500 (or $5,000 for taxpayers with an “applicable financial statement”) per unit of property under a taxpayer’s capitalization policy.  Such expensing is preferred over bonus and §179 because the asset is never recorded on the depreciation schedule.

Increased “Luxury” Auto Depreciation Limits

Yearly auto depreciation limits are increased for property placed in service after 2017.  For passenger automobiles purchased after September 27, 2017 and placed in service after 2017, first year bonus depreciation of $8,000 is allowed and is added to the 1st Tax Year amount below.  However, if the purchase was made prior to September 28, 2017 and the automobile placed in service after 2017, first year bonus depreciation is only $6,400 according to Rev. Proc. 2018-25.

Year	Current Law	New Law
1st Tax Year	$3,160	$10,000
2nd	$5,100	$16,000
3rd	$3,050	$  9,600
4th & thereafter	$1,875	$  5,760

Farm Property

The depreciation period for “new” or “original use” machinery and equipment placed in service after 2017 and used in a farming business is shortened from 7 to 5 years.  However, such property does not include grain bins, cotton ginning assets, fences, or other land improvements.  “Used” machinery and equipment therefore continue to have a 7-year depreciation period.  In addition, the 200% declining balance method applies instead of the 150% method for farm property (new or used) placed in service after 2017.  However, 15-year and 20-year property continue to use the 150% method.

Farming businesses that elect out of the 30% interest deduction limitation must use the alternative depreciation system (ADS) to depreciate any property with a recovery period of 10 years or more, such as single purpose agricultural or horticultural structures, trees or vines bearing fruit or nuts, farm buildings and certain land improvements.

Tax Reform: The New C Corporation Tax Rate and Whether to Reorganize as a C Corporation

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the fifth in a series of articles reviewing some of the more important changes.  This post deals with the new 21% C corporation tax rate and whether businesses should reorganize as C corporations to take advantage of the new low tax rate.

Overview of the New 21% Tax Rate

Corporations are divided into two basic income tax classifications: “C” and “S”.  A corporation will be taxed as a C corporation unless it has made an election, approved by the IRS, to be taxed as an S corporation.  A C corporation pays income tax on its taxable income and its shareholders pay tax on the income only when the C corporation pays dividends.  The shareholders of an S corporation pay income tax on the S corporation’s taxable income and generally do not pay tax on dividends from S corporation profits.  C corporation shareholders economically bear a double income tax:  once at the corporate entity level and again on dividend distributions.  S corporation shareholders bear a single tax.  An S corporation is often referred to as a “pass-through” or a “flow-through” entity because only one level of tax is paid, and that responsibility passes or flows through to the shareholders.

The new law replaces the current four C corporation tax rate brackets of from 15% to 35% with a flat tax rate of 21% for tax years beginning after 2017.  C corporations with fiscal tax years ending other than on December 31^st will have a prorated tax rate.  The tax of a fiscal year filer is computed twice, once using old law rates and again using new law rates.  The two taxes are then prorated by the number of days in the fiscal year before the January 1, 2018 effective date of the new law and the number of days in the fiscal year after December 31, 2017.  The calculation works out to be roughly a 1.17% monthly effective tax rate increase above 21% for each month in the fiscal year prior to January 1, 2018.

Under the new law, there is no special higher tax rate for personal service corporations, but the personal holding company and accumulated earnings penalty taxes still apply.

Should You Reorganize Your Pass-Through Entity or Proprietorship as a C Corporation?

While the low 21% C corporation rate looks attractive, adding a state corporate tax rate (5% for Utah) plus the cost of double taxation on distributed earnings quickly makes for a high effective overall tax rate.  Assuming a top shareholder qualified dividend or long-term capital gain tax rate of 20%, a net investment income tax (under the ACA) rate of 3.8%, and a (Utah) individual tax rate of 5%, the combined effective tax rate on distributed after-tax C corporation earnings is 46.6%.

The 20% qualified business income deduction was discussed in a prior post.  If all the income is eligible for the deduction, the combined federal and state effective top tax rate for income of a pass-through entity is 33.6% for an owner who materially participates in the business, or 37.4% for a passive owner, the difference being the 3.8% NIIT.  Without the 20% QBI deduction (e.g., income is from a specified service business), the effective tax rate rises to 42.0% and 45.8% depending upon the owner’s level of participation in the business.

For businesses qualifying for the 20% QBI deduction, it appears that remaining a pass-through entity is the preferred choice.  However, other factors enter into the decision.  Will the entity reinvest profits to grow the business or to pay down debt?  If so, the C corporation will have less current tax.  On the other hand, will profits be distributed to owners or will the owners sell their interests in the future?  If so, then the pass-through entity will have less overall tax.  In addition, if the business won’t distribute profits or be sold for years into the future, the present value cost of the double tax can be dramatically lowered depending upon the present value discount rate.

For specified service businesses that don’t qualify for the 20% QBI deduction, there may be ways to restructure the business to carve out a portion of the business into a separate entity that qualifies for the deduction.  The balance of the service business then might consider becoming a C corporation.  Before undertaking such a reorganization, it is advisable to wait for official guidance from the IRS as to how it will apply rules to related party carve-outs.

Making the decision to reorganize as a C corporation requires careful analysis of many factors.  One factor that must be considered, but which can’t be quantified, is the risk of a future Congress changing the tax rules again in a manner detrimental to those who have reorganized as C corporations.

Tax Reform: The New 20% Qualified Business Income Deduction

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the fourth in a series of articles reviewing some of the more important changes.  This post deals with the new 20% deduction for qualified business income.

Qualified Business Income

QBI is domestic ordinary income less deductions.  QBI does not include wages earned as an employee or guaranteed payments received as a partner of the business.  S corporation shareholder-employees must be paid a reasonable wage for their work.  However, there is no such requirement to pay a reasonable guaranteed payment to a partner of a partnership.  QBI does not include investment income such as interest, dividends, or capital gain, but “business” interest income is included.  QBI includes ordinary gains and losses on the sale of business assets, but not §1231 capital gain.  A QBI loss in one tax year carries over to the next year in calculating the 20% QBI deduction.  QBI does not include business income of a “specified service business.”

Specified Service Business Income

With an exception for “small” taxpayers, specified service business income is not eligible for the 20% QBI deduction.  Specified service businesses are defined as those in the fields of:  health, law, accounting, actuarial science, performing arts, consulting, athletics, financial & brokerage, investment management, trading, dealing in securities, or any business where the principal asset of the business is the reputation or skill of one or more of its owners or employees.  Importantly, engineering and architecture are excluded from this definition.

There is much uncertainty in applying this definition.  Many business entities have several different business activities that can be distinguished one from another.  Does the predominant activity govern the whole or are they separately accounted for?  While special tax rules have applied to service businesses for many years, in many situations it is not always clear how the definition applies.

A special “small” taxpayer exception permits the 20% QBI deduction for specified service businesses.  A taxpayer is considered “small” if taxable income does not exceed $315,000 for those filing a married joint tax return and $157,500 for others.  The deduction for small taxpayers phases out over the next $100,000 of taxable income for MFJ and $50,000 for others.  A very high marginal tax rate applies during the phaseout range, perhaps 175% times the normal tax rate, so managing taxable income near the threshold levels is extremely important.  On the other hand, deductions lowering taxable income in the threshold range are very valuable.

Amount of the Deduction

The deduction is often termed the 20% “pass-through entity” deduction.  That is a bit of a misnomer in that an entity is not required.  The deduction applies to sole proprietorships as well.  In addition, it is not the entity that claims the deduction, it is the individual, trust or estate that owns the business that claims the deduction.  The deduction is not available for C corporations.

The 20% QBI deduction is effective for tax years beginning after 2017 but not after 2025.  It is unknown when the deduction takes effect for fiscal year pass-through entities.  One line of thought is that since the deduction is taken by the entity’s owners, the income from the entity’s fiscal year ending in 2018 should be eligible.  Another line of reasoning is derived from looking at how the IRS applied the effective date of the domestic production activities deduction.  The DPAD is claimed under Section 199.  The 20% QBI deduction is claimed under Section 199A.  There are many similarities between the two provisions.  The DPAD was enacted to apply to tax years beginning after 2004.  In Notice 2005-14, the IRS interpreted the effective date to apply to fiscal year pass-through entities in tax years beginning after 2004 and not tax years ending after 2004.  Assuming a similar interpretation, the 20% QBI deduction may not apply to fiscal year pass-through entity income until the fiscal year beginning after 2017.  Note that the new law repeals the DPAD for tax years beginning after 2017 to coincide with the start of the 20% QBI deduction.

The deduction lowers the top 37% Federal tax rate to a 29.6% effective tax rate.  The deduction is not a deduction for adjusted gross income, nor is it an itemized deduction.  The deduction is a calculation for taxable income.  The deduction is permitted for alternative minimum tax without adjustment.  The deduction is only for income tax, not for the net investment income tax or for the self-employment tax.  The deduction is not permitted in calculating a net operating loss.

Limitations on the Amount of the Deduction

The 20% QBI deduction cannot exceed 20% of the excess of taxable income over net capital gain.  Net capital gain is the excess of net long-term capital gains over net short-term capital losses.  In addition, for taxpayers with taxable income equal to or above $415,000 for a married taxpayer filing a joint tax return; or $207,500 for others; the deductible amount for each trade or business is limited to the greater of:

·      50% of W-2 income allocable to the QBI of the business, or

·      The sum of 25% of W-2 wages plus 2.5% of the unadjusted basis of tangible, depreciable property for which the depreciable period has not ended

The depreciable period begins on the date the property is first placed in service and ends on the later of 10 years after that date or the last full year in the applicable recovery period.  There is some uncertainty whether property that has been “expensed” under Section 179 can be included in the 2.5% limitation.  Property that has received 100% bonus depreciation is included because the deduction is considered depreciation.

W-2 payments to S corporation owners are included in the W-2 limit, but equivalent payments made by a partnership or sole proprietorship to an owner do not count for the W-2 limitation because such payments are not in fact reported on Form W-2.

Small Taxpayer Exception

The W-2/unadjusted basis limitation doesn’t apply if taxable income is equal to or less than $315,000 for a married taxpayer filing a joint tax return or $157,500 for other filing statuses.  But the limitation phases in during the next $100,000 / $50,000 of taxable income.  During the phase-in range, if the W-2/unadjusted basis limit is lower than 20% of QBI, then the phase-in percentage times the difference is subtracted from 20% of QBI.

Specified service businesses will be subject to both a phase-in of the W-2/unadjusted basis limitation and to the 20% QBI deduction phase-out during this income range.

It is important to note that while the overall deduction is limited to 20% of ordinary taxable income, any type of taxable income (including capital gains) counts in the W-2/unadjusted basis limit phase-in range or in the specified service business phase-out range.

Implications

Below is a bulleted list of possible planning steps that should be considered to enhance the amount of the 20% QBI deduction.  The use of the word “small” means that the small taxpayer exception is met.  The use of the work “large” means that the W-2/unadjusted basis limit applies or that the deduction has phased out for a specified service business.  The following list is based upon the commonly accepted interpretation of the statute.  Some advisors are suggesting an alternate interpretation of how owner compensation is treated for purposes of computing the deduction.  In this alternate interpretation, owner compensation does not reduce QBI and owner W-2 wages are not included in the W-2 wage limitation calculation.  If this alternate interpretation ends up being correct, the implications listed below could change.

·      “Small” S corporations may wish to become an LLC partnership or LLC sole proprietorship to avoid shareholder W-2 reasonable compensation that doesn’t qualify as QBI.  But consider whether S corporation payroll tax savings and the tax cost of liquidating the corporation outweigh the benefits of the 20% QBI deduction.

·      “Small” partnerships should avoid guaranteed payments to partners as such payments don’t qualify as QBI.

·      “Large” S corporations should be sure that enough W-2 is paid to avoid the W-2 limitation.

·      “Large” sole proprietors with insufficient employee W-2 may wish to become S corporations so that a portion of the owner’s compensation can be reported as W-2 wages and to save payroll tax on S corporation profit distributions.

·      A business with low wages may wish to “own” its equipment rather than “leasing” it to qualify for the 2.5% of unadjusted basis test.  Or the business may wish to hire employees instead of using independent contractors.

·      Paying a portion of business income as W-2 wages to the owner only reduces the 20% QBI deduction to the extent the owner’s wages and other non-QBI exceed itemized or other tax return deductions because of the overall 20% of taxable income limitation.

·      “Small” wage earners may want to become independent consultants to qualify their income for the 20% deduction.

·      Individuals making gifts in trust may wish to set up separate trusts for each beneficiary, instead of using a single pot trust for multiple beneficiaries, to get multiple small taxpayer limitations.

·      Retirement plan contributions may be less advantageous because the deduction may reduce the 20% QBI deduction, yet when distributed will be subject to the full income tax rate.  On the other hand, such contributions could be very valuable for a specified service business in the taxable income phase-out range.

·      A “large” service business with capital or expansion needs may consider converting to a C corporation for the low tax rate.

·      A C corporation in combination with a pass-through entity could make sense for a service business in managing the taxable income phase-out threshold.

·      “Large” taxpayers whose 20% QBI deduction is limited by the 20% ordinary taxable income limit can increase the deduction by generating other non-capital gain income, such as by a Roth IRA conversion.  The marginal tax cost of the additional income will be reduced by the increased deduction.