After drafting legislation at a breakneck pace with little or no public input and speeding through the conference committee process, the House and Senate reached a compromise on their versions of the tax reform bill, formerly the Tax Cuts and Jobs Act, on December 15. The Senate passed the reconciled bill on December 19, and the House will vote soon followed by the signature from the President.
If the goal for the tax reform bill was simplification, the reconciled bill appears to fall short. If the goal was simply to cut taxes, there are winners and losers. The principal provisions of this compromise bill are effective starting in 2018, with a few provisions being effective for the last few months of 2017. The primary beneficiaries of the tax reform bill will be businesses and their owners, regardless of how the business is structured and regardless of how the owner holds his or her interest.
In the first part of our tax reform plan series, we will focus on provisions for domestic businesses. Upcoming articles will deal with individual, estate and gift, and international changes.
Corporate Tax Provisions
For businesses and their owners, the highlights of the reconciled bill include a 21 percent corporate tax rate. This is an increase from the draft legislation’s 20 percent rate, but still a 40 percent reduction from the current 35 percent rate. The corporate rate increase allowed Congress to eliminate some of the previously proposed revenue raisers.
Most analysts predict that the lower corporate rate will result in increased dividend distributions and stock redemptions that will benefit corporate shareholders. The rate will be effective in 2018 instead of the Senate’s proposed delay to 2019. Further, fiscal year businesses having a period that straddles Jan. 1, 2018 will be subject to a blended rate that will effectively subject income earned after Dec. 31, 2017 to the lower rate.
Personal service corporations will also be able to claim the 21 percent rate, whereas the House bill called for a 25 percent rate. Another win for corporations is the repeal of the corporate AMT. The corporate AMT was briefly revived in the final Senate bill, but its implementation would have negatively affected other corporate tax benefits, such as the research and development credit and the new international territorial tax system.
Pass-Through Business Tax Provisions
Another business friendly provision is the adoption of a new 20 percent deduction for qualified business income received from a pass-through entity. This provision was modified from the Senate proposal, which originally called for a 23 percent deduction. Therefore, an individual taxed at the committee’s maximum proposed rate of 37 percent would pay an effective rate of 29.6 percent on income subject to the 20 percent deduction.
Qualified business income is defined as business income from domestic sources (including Puerto Rico) from a qualified trade or business, excluding investment income (investment interest income, most dividends, capital gains, commodities gains, and foreign currency gains). Qualified business income does not include any amount paid by an S corporation as reasonable compensation of the owner/shareholder, or any amount that is a guaranteed payment for services from a partnership. A qualified trade or business means any trade or business other than a specified service trade or business and other than the trade or business of being an employee. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities, respectively.
Notably, engineering and architectural services are not included as a specified service, leaving those industries among qualified trades or businesses that are eligible for the deduction. On the other hand, inclusion of the somewhat ambiguous category “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” has already caused concern, particularly within the small business community.
The availability of the deduction is limited in several ways. The Senate had proposed a wage limitation that would have limited the deduction to the lesser of 20 percent of qualified business income or 50 percent of W-2 wages (wages including bonuses, elective deferrals, and deferred compensation). Under the final bill, the deduction is limited to the greater of (a) 50 percent of W-2 wages, or (b) 25 percent of W-2 wages plus 2.5 percent of qualified property. For purposes of the limitation, W-2 wages do not include amounts that are not properly allocable to qualified business income. The provision would appear to exclude guaranteed payments from a partnership and compensation paid to an S corporation shareholder/owner from the definition of W-2 wages, however, explanatory comments in the chairman's mark of the earlier Senate version of the tax reform bill (as well as other professional commentators) indicate that compensation paid to an S corporation shareholder/owner is included as W-2 wages.
For example, assume an S corporation that is a qualified pass-through business has one shareholder, $1 million in qualified business income, one employee who was paid $200,000 in W-2 wages, and machinery with an unadjusted basis immediately after acquisition of $5 million. The shareholder would first compute her 20 percent deduction ($200,000). Then the shareholder would compute each wage limitation. The 50 percent limit would be $100,000. For the other wage limitation, the limit would be $175,000 (25 percent of the $200,000 wages + 2.5 percent of the $5 million dollar asset). Because this is larger than the 50 percent wage limit, but smaller than 20 percent of qualified business income, the deduction would be limited to $175,000.
There are some additional restrictions that apply when computing the wage and property limits. As mentioned, W-2 wages do not include guaranteed payments paid to partners and appear to also exclude compensation to S corporation shareholder/owners. Second, eligible W-2 wages are allocated to shareholders and partners in the same proportion as the original deduction for such wages. Third, qualifying property is limited to tangible property held by, and available for use in, a qualifying pass-through trade or business. The property can be included in this calculation each year until its depreciation period has ended (a special 10-year minimum depreciation period is deemed to exist solely for this purpose when the MACRS period ends earlier than such a 10-year period). If the property is no longer held by, or available for use in, the qualifying trade or business (for example it is sold during the year), it cannot be used in determining the wage plus property limitation. Furthermore, the combined bill calls for the IRS to develop anti-abuse regulations in the case of related party transactions and sale-leaseback transactions.
As an incentive for certain taxpayers with lower amounts of taxable income, the 50 percent wage limitation and the wage plus property limitation will not apply. As a further incentive for such taxpayers, the exclusion from the definition of a qualified business for specified service trades or businesses also will not apply. The threshold amount of taxable income for such taxpayers is $157,500 ($315,000 for joint returns), indexed for inflation. There is also range over which relief from these limits will be phased out, with the limits being fully applicable for taxpayers whose income exceeds $207,500 ($415,000 for joint returns).
The final version of the pass-through deduction is a marked difference from the provisions of the House bill. The House bill favored passive investors and passive investments over active business owners who benefit more under the Senate bill. Under the House bill only passive investors would have fully benefitted from their proposed 25 percent tax rate. Active owners would have only been able to use the 25 percent rate for 30 percent of their pass-through income, (an effective rate of 35.2 percent using the House bill’s maximum individual rate of 39.6 percent) unless such owners used a complicated allocation formula based on capital invested. Also, under the House bill, service businesses were completely ineligible to use the reduced rate.
Capital Investment Provisions
The 50 percent allowance for bonus depreciation is increased to 100 percent for most property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, and will apply to used property as well as new property. The bonus deprecation percentage will phase down 20 percent per year starting in 2023, until it is phased out in 2027. As a result of the pre-2018 bonus depreciation incentive (which is deductible at the higher 2017 corporate tax rates), corporations should take advantage of this provision before the deduction becomes less valuable in 2018 at the lower corporate tax rates.
The expensing election under Code Section 179 is also increased to $1 million per year and will begin to phase out after qualifying purchases exceeding $2.5 million. Furthermore, property eligible for section 179 expensing would be enhanced to include nonresidential real property improvements such as roofs, HVACs, fire protection and alarm systems, and security systems. As a result of the bonus depreciation provisions, the Section 179 provisions are made largely irrelevant; however, certain real property improvements not eligible for bonus depreciation are eligible under Section 179 (under the current law definition of qualified improvement property, together with the new types of qualifying property stated previously).
Business Interest Provisions
For any type of entity, business interest deductions will be limited to the sum of business interest income plus 30 percent of adjusted taxable income (computed without regard to deductions allowable for interest, depreciation, amortization, depletion, net operating losses, and the pass-through entity deduction), with additional benefits for auto dealerships. Businesses with average annual gross receipts for the prior three taxable years that do not exceed $25 million are exempt.
Unused business interest expense can be carried forward indefinitely. At the taxpayer’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation would not apply. A similar election is available for any farming business.
Other Business Provisions
In most cases, net operating losses can no longer be carried back two years, but may be carried forward indefinitely. The carryforward deduction is limited, however, to 80 percent of taxable income (determined without regard to the deduction) for losses arising in taxable years beginning after Dec. 31, 2017. Furthermore, business losses for non-corporate taxpayers (such as individuals) are limited to $250,000 per year ($500,000 for joint returns) for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. The limitation applies to the aggregate of all personal and pass-through losses for the year. As a result, this provision effectively prevents individuals from deducting losses from partnerships and S corporations in excess of these levels. Disallowed losses are added to the individual’s net operating loss carryforward. In most cases, individual net operating losses may be applied against 90 percent of taxable income.
Numerous other changes for businesses survived or were dropped from prior bills:
- Technical terminations of partnerships, which can occur when more than 50 percent of a partnership’s interest are transferred and can allow the partnership to “restart” its depreciation, has been repealed.
- Tax deferred treatment of like-kind exchanges completed after Dec. 31, 2017 is limited to real property that is not held primarily for sale for exchange.
- The cash method of accounting will be available to more taxpayers, as the gross receipts threshold for qualifying taxpayers is increased to $25 million for the three prior tax-year periods.
- The Domestic Production Activities Deduction (DPAD) is repealed for most taxpayers for taxable years beginning after Dec. 31, 2018.
- Carried interests will only be eligible for long term capital gains treatment if held for more than three years.
- Accrual basis taxpayers with qualifying financial statements must include income no later than the time it is included on their financial statements.
- Proposals to make contributions to the capital of corporations taxable were scaled back and will generally only apply to any contribution in aid of construction or any other contribution as a customer or potential customer.
- Deductions for business entertainment, club dues and qualified employee transportation fringe benefits were curtailed or eliminated. Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).
- The Work Opportunity Tax Credit (WOTC) and the New Markets Tax Credit were retained, as was the ability to use municipal bonds for stadium financing.
Stay tuned for further articles exploring the provisions of the merged tax reform bill. In the meantime, consult your CBIZ MHM tax professional for information on how these changes affect you and your business.
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