2018 Business Tax Changes under the Tax Cuts and Jobs Act
The recently enacted Tax Cuts and Jobs Act (TCJA) is a major overhaul for businesses. The new law permanently reduces the corporate tax rate to 21%, repeals the corporate alternative minimum tax, imposes new limits on business interest deductions, limits on meal expenses, disallowance of entertainment expenses, and other numerous changes involving expensing and depreciation.
Below is a summary of some of the more common elements of the tax law that will affect all businesses including S-Corporations, sole-proprietorship’s, and partnerships.
Corporate Tax Rates Reduced
Pre-Tax Cut Law: Before the changes, the income tax rate imposed on ordinary corporations was:
. . . 15% on the first $50,000 of its taxable income,
. . . 25% on any amount in excess of $50,000 and up to $75,000,
. . . 34% on any amount in excess of $75,000 and up to $10,000,000, and
. . . 35% on any amount in excess of $10,000,000.
New Tax Cut Law: The new corporate tax rate is a flat 21%
Like Kind Exchanges
Pre-Tax Cut Law: In a like-kind exchange, a taxpayer doesn’t recognize gain or loss on an exchange of like-kind properties if both the relinquished property and the new property are held for productive use in a trade or business or for investment purposes.
New Tax Cut Law: Generally, for exchanges completed after Dec. 31, 2017, the new law limits tax-free exchanges to exchanges of real property that is not held primarily for sale (real property limitation). So, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges.
Bonus Deprecation Increased to 100%
Pre-Tax Cut Law: The bonus depreciation deduction allowed for the taxable year in which qualified property is placed in service included an allowance equal to 50% of the adjusted basis of the qualified property.
New Tax Law: The 50% is increased to 100%. Therefore, the new law increases the bonus depreciation from 50% to 100% bonus depreciation. Another bonus – USED property is now eligible for 100% depreciation deduction.
Summary: The change from 50% to 100% bonus depreciation can be applied only to qualified property and specified plants placed in service after the first tax year ending after Sept. 27, 2017 and before January 1, 2027.
This bonus depreciation should not be confused with Section 179 bonus depreciation, which is different and separate (see below).
Section 179 Depreciation Expense limit increased
Pre-Tax Cut Law: A taxpayer’s annually allowable section 179 expense couldn’t exceed $500,000 as adjusted for inflation. The dollar limit had to be reduced (i.e., phased down) by the amount by which the cost of section 179 property placed in service by the taxpayer during the tax year exceeded $2,000,000 adjusted for inflation.
New Tax Cut Law: The Tax Cuts and Jobs Act doubles the pre-inflation-adjusted annual dollar limit from $500,000 to $1 million and the pre-inflation-adjusted annual beginning-of-phase-down threshold from $2 million to $2.5 million. Also the term “qualified section 179 property” has greatly been expanded allowing for more types of property to be eligible.
Summary: The changes have effectively lowered the cost of acquiring capital assets by making substantial changes to the income tax rules for bonus depreciation and cost recovery. For property placed in service in 2018 the inflation-adjusted figures will be $520,000 and $2.07 million.
Luxury Vehicle Depreciation deduction increased
Pre-Tax Cut Law: Section 280F of the tax code limits the amount of section 179 depreciation deduction on certain passenger cars, a.k.a – luxury vehicles. Passenger autos placed in service in 2017, for which the additional first-year depreciation deduction under Code Sec. 168(k) is not claimed, the maximum amount of allowable depreciation deduction is:
$3,160 for the year in which the vehicle is placed in service
$5,100 for the second year
$3,050 for the third year
$1,875 for the fourth and later years in the recovery period
New Tax Cut Law: For passenger automobiles placed in service after Dec. 31, 2017 and if the additional first-year depreciation deduction under Code Sec. 168(k) is not claimed, the maximum amount of allowable depreciation (indexed for inflation) is increased to:
$10,000 for the year in which the vehicle is placed in service
$16,000 for the second year,
$9,600 for the third year
$5,760 for the fourth and later years in the recovery period.
For passenger autos eligible for bonus first-year depreciation, the maximum first year depreciation allowance remains at $8,000.
Summary: Businesses are able to claim more depreciation in the early years for vehicles.
Entertainment not deductible – Meal expense limited
Pre-Tax Cut Law: You could deduct ordinary and necessary expenses for an activity of a type generally considered to be entertainment, amusement, or recreation, or for a facility used in connection with such an activity, if the taxpayer established that the expense was directly related to or associated with the active conduct of the taxpayer’s trade or business or income-producing activity.
If this condition is met, the deduction allowed for meals and entertainment expenses was limited to 50% of the otherwise deductible amount of the expense. Housing and meals provided for the convenience of the employer on the business premises of the employer were excluded from the employee’s gross income. Various other fringe benefits provided by employers are not included in an employee’s gross income, such as qualified transportation fringe benefits.
New Tax Law: The new law repeals the rule that allowed a deduction for entertainment, amusement, or recreation that was directly related to or associated with the active conduct of the taxpayer’s trade or business which makes them non-deductible for tax purposes.
The current 50% limit on the deductibility of business meals is expanded to meals provided through an in-house cafeteria or otherwise on the premises of the employer (ie – eliminating the 100% meals deduction); and deductions for employee transportation fringe benefits (e.g., parking and mass transit) are disallowed, but the exclusion from income for such benefits received by an employee is retained. In addition, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees (e.g., between the employee’s home and the workplace), except as provided for the safety of the employee.
Summary: With some exception, amounts incurred or paid after December 31, 2017, these entertainment expenses are completely nondeductible for tax purposes, regardless of whether they are directly related to or associated with the taxpayer’s business and the 100% meals deduction is eliminated.
Employer Paid Family Leave Tax Credit
Pre-Tax Cuts law: Prior to the new laws there was not an employer credit for paid Family Medical Leave.
New Tax Cut Law: The law provides a new credit to certain employers for paid family and medical leave. It’s a general business credit equal to the applicable percentage of the amount of wages paid to qualifying employees during any period in which those employees are on family and medical leave. The applicable percentage is 12.5% increased (but not above 25%) by 0.25 percentage points for each percentage point by which the rate of payment exceeds 50%.
Summary: Employer pays $10,000 of wages to qualifying employees during a period in which those employees are on family and medical leave. This amount is 50% of the wages normally paid to the employees for services rendered to the employer. Employer can claim a paid family and medical leave credit of 12.5% of $10,000, or $1,250.
New Recovery Period for Real Property
Pre–Tax Cut Law: The cost recovery periods for most real property are 39 years for nonresidential real property and 27.5 years for residential rental property. The straight-line depreciation method and mid-month convention are required for such real property
New Tax Cut Law: For property placed in service after Dec. 31, 2017, a general 15-year recovery period and straight-line depreciation are provided for qualified improvement property,
Thus, qualified improvement property placed in service after Dec. 31, 2017, is generally depreciable over 15 years using the straight-line method and half-year convention, without regard to whether the improvements are property subject to a lease, placed in service more than three years after the date the building was first placed in service, or made to a restaurant building.
Restaurant building property placed in service after Dec. 31, 2017, that does not meet the definition of qualified improvement property, is depreciable as nonresidential real property, using the straight-line method and the mid-month convention.
Research or Experimentation (R&E) Expenses
Pre-Tax Cut Law: Taxpayers could elect to deduct the amount of certain reasonable research or experimentation (R&E) expenses paid or incurred in connection with a trade or business. Alternatively,
taxpayers could elect to forgo a current deduction by capitalizing their research expenses, and recover them ratably over the useful life of the research, but in no case over a period of less than 60 months. Or, they may elect to recover them over a period of 10 years.
New Tax Cut Law: For amounts paid or incurred in tax years beginning after Dec. 31, 2021, “specified R&E expenses” must be capitalized and amortized ratably over a 5-year period (15 years if conducted outside of the U.S.), beginning with the midpoint of the tax year in which the specified R&E expenses were paid or incurred.
Specified R&E expenses subject to capitalization include expenses for software development, but not expenses for land or for depreciable or depletable property used in connection with the research or experimentation (but do include the depreciation and depletion allowances of such property). Also excluded are exploration expenses incurred for ore or other minerals (including oil and gas).
Net Operating Loss Limitations
Pre-Tax Cut Law: Under pre-tax cut law, a net operating loss (NOL) may generally be carried back two years and carried over 20 years to offset taxable income in such years.
New Tax Cut Law: For tax years ending after Dec 31st 2017, the two-year carryback and the special carryback provisions are deleted meaning you cannot carry back losses (unless you have a farming business, then the two-year carryback still applies).
For losses arising in tax years beginning after Dec. 31, 2017, the NOL deduction is limited to 80% of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation, and, except as provided below, NOL’s can be carried forward indefinitely. However, NOLs of property and casualty insurance companies can be carried back two years and carried over 20 years to offset 100% of taxable income in such years.
AMT for Corporations repealed
Pre-Tax Cut Law: In addition to corporate income tax, a second tax system called the alternative minimum tax (AMT), applied to non-corporate and corporate taxpayers. The taxpayer’s total tax liability for the year was equal to the sum of (i) the taxpayer’s regular tax liability, plus (ii) the taxpayer’s AMT liability for the year. The purpose of AMT was to reduce a taxpayer’s ability to avoid taxes by using certain deductions and other tax benefits. AMT was imposed on a corporation to the extent that the corporation’s “tentative minimum tax” exceeded its regular income tax for the tax year.
A corporation’s tentative minimum tax was equal to 20% of the corporation’s “alternative minimum taxable income” (AMTI) in excess of an exemption amount, minus the corporation’s AMT foreign tax credit.
New Tax Law: AMT on corporations is eliminated.
Summary: The new laws also reduce the corporate tax rate to 21% so the elimination of corporate AMT can make it possible for some businesses to lower their effective tax rates below 21% with various deductions, something they could not achieve if AMT still applied.
New deduction for “qualified business income”
Pre-Tax Cut Law: There was no special deduction for qualified business income (QBI).
New Tax Law: A taxpayer with “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, is allowed to deduct 20% of that income which is defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business.
The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business).
The deduction is taken “below the line,” meaning it reduces your taxable income but not your adjusted gross income. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss you can carryforward to the next year.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Summary: The deduction is intended to reduce the tax rate on qualified business income to a rate that is closer to the corporate tax rate.
New Recovery Period for Farming Equipment
Pre-Tax Cut Law: Depreciable assets that were used in agriculture activities were assigned a recovery period of seven years. These items included (but are not limited to) machinery and equipment, grain bins, and fences (but no other land improvements), that are used in the production of crops or plants, vines, and trees; livestock; and various farming activities.
New Tax Law: New property placed in service after Dec. 31, 2017, the cost recovery period is shortened from seven to five years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business.
Interest Deduction Limitations
Pre-Tax Cut Law: Interest that is paid or accrued by a business is generally deductible but it is subject to a number of limitations. For a taxpayer other than a corporation, the deduction for interest on a debt that is allocable to property held for investment (investment interest) is limited to the taxpayer’s net investment income for the tax year.
A deduction may not be allowed for disqualified interest paid or accrued by a corporation in a tax year if: (1) the payor’s debt-to-equity ratio exceeds 1.5 to 1.0 (the safe harbor ratio); and (2) the payor’s net interest expense exceeds 50% of its adjusted taxable income
New Tax Law: All business are generally subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income. A special rule applies to pass-through entitles, which requires the determination to be made at the entity level, for example, at the partnership level instead of the partner level.
Summary: The amount of any business interest not allowed as a deduction for any taxable year is carryforward as business interest paid or accrued in the next taxable year. Business interest may be carried forward indefinitely, subject to certain restrictions applicable to partnerships
Domestic Production Activities Deduction
Pre-Tax Cut Law: Corporate taxpayers could claim a domestic production activities deduction (DPAD) under equal to 9% (6% in the case of certain oil and gas activities) of the lesser of the taxpayer’s qualified production activities income or the taxpayer’s taxable income for the tax year. The deduction was limited to 50% of the W-2 wages paid by the taxpayer during the calendar year.
New Tax Law: For tax years beginning after Dec. 31, 2017, the DPAD is repealed.
Summary: The credit is eliminated. Bye Bye!
Cash Method of Accounting
Pre-Tax Cut Law: A corporation or a partnership with a corporate partner could generally use the cash method of accounting if it met the gross receipts test (average annual gross receipts for a three-year period does not exceed $5 million. Farm corporations and partnerships could only use the cash method if gross receipts did not exceed $ 1 million in any year (certain family farm corporations were excluded from this rule). A personal service corporation could use the cash method without regard to the gross receipts test.
New Tax Cut Law: Under the new law, the cash method can be used as long as the business satisfies a $ 25 million gross receipts test.
In summary: Starting in 2018, a taxpayer could use the cash method regardless of whether the purchase, production, or sale of merchandise is an income-producing factor and as long as the average gross receipts for the three prior tax years does not exceed $ 25 million.
Special Note: For tax years beginning after Dec. 31, 2017, taxpayers that meet the new gross receipts test aren’t required to account for the cost of goods sold using inventories and therefore aren’t required to use the accrual method of accounting, but rather may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.
Accounting for Inventory
Pre-Tax Cut Law: Business that carry inventory were generally required to use the accrual method of accounting. However, the cash method could be used for certain small businesses that meet a gross receipt test with average gross receipts of not more than $1 million – in which case they treat the inventory as non-incidental materials and supplies.
New Tax Law: For tax years after Dec. 31, 2017, if a business meets the $25 million gross receipts test it is not required to account for inventories under the accrual method. The business can use an accounting method that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.
Inventory Capitalization Changes
Pre-Tax Cut Law: If a business had average gross receipts of $ 10 million or more , the uniform capitalization (UNICAP) rules generally required that certain direct and indirect costs associated with the inventory or property manufactured by a business be included in either inventory value or capitalized into the basis of such manufactured property. If a business didn’t have gross receipts of $ 10 million the UNICAP rules didn’t apply.
New Tax Law: For tax years ending after December 31, 2017 if a business meets the $ 25 million or more gross receipts test they are exempt from the UNICAP rules. Note – The exemptions from the UNICAP rules that are not based on a taxpayer’s gross receipts are retained.
There are significant changes to the tax code which affects individuals with pass-though income from S-Corporations, Sole-Proprietorship’s and partnerships in addition to C Corporations. Most of these changes allow businesses to claim more initial depreciation and lowers the overall tax rates. If you own a business these changes can have a big impact on you and your business.
Source: Steve Nelson, Michael Kitces, Kelly Phillips Erb