This is the first year in which businesses will report under the Tax Cuts and Jobs Act passed in December 2017.
Many of the new deductions and changes will benefit large and small businesses.
“A lot of the provisions are very pro-taxpayer,” said Greg Gandy, senior tax director at Colorado Springs CPA firm BiggsKofford. “Overall, for this community — a community of small businesses — it’s a very beneficial tax law.”
But the law also factored in some offsetting provisions that eliminate or change deductions businesses are used to taking.
And because of the law’s complexity, many businesses will need to provide more information to their tax preparers than in the past and be prepared to pay more to get their returns done.
For small businesses, the biggest and most important change this year is the qualified business income deduction.
In essence, the new law allows owners of pass-through entities such as S corporations, sole proprietorships and partnerships to deduct up to 20 percent of their qualified business income (net noninvestment business income) on their personal income tax returns. Previously all pass-through business income was subject to personal income tax.
“The law attempted to put smaller businesses on par with corporations,” said Robb Conner, partner and tax specialist at the accounting firm BKD’s Denver office. “Pass-through entities are some of the biggest job creators in the country.”
But a complicated set of regulations determines who will be able to take the deduction and how much is deductible.
For starters, individual owners of pass-through companies earning up to $157,500 and married couples earning $315,000 in 2018 may be eligible for the full deduction of 20 percent, applied to the income claimed on Form K-1, Schedule E and Schedule C.
Above those amounts, the deductible percentage decreases and the calculations become more complicated, especially for business owners in professional services — such as lawyers, accountants or consultants. When taxable income exceeds $415,000 for married couples filing jointly or $207,500 for all other filers, the deduction goes away for many service or trade business owners. However business owners in nonservice industries may still qualify for up to the full QBI deduction, subject to limitation tests.
The deduction goes away when taxable income exceeds $415,000 for married couples filing jointly or $207,500 for all other filers.
“The final calculations are done on individual tax returns,” said Judy Kaltenbacher, CPA and tax partner in charge at Stockman Kast Ryan + Co. “You don’t know until you get down to your own 1040. That’s why we have to look at the whole big picture and what it looks like there.”
The type of business an entrepreneur owns also plays a role in calculating the QBI deduction.
“Service businesses start to phase out of this deduction when income exceeds $315,000,” Conner said, adding nonservice business owners, such as manufacturers, may be able to take the deduction at higher income levels. But it is limited to 20 percent of qualified business income or 50 percent of total W-2 wages paid to employees, whichever is less.
“We’ve taken a lot of sole proprietors to S corporations to meet the wage requirements,” said Jordan Empey, CPA and tax partner at Stockman Kast Ryan + Co. “That’s a big one for a lot of small businesses. If they get above the cap, they’re going to start losing all the benefits if they don’t have employees. But it’s important to carefully consider what legal entity structure would accomplish your goals.”
Many more nuances and complexities are built into calculating the QBI deduction.
“It’s going to be vital how you report [QBI] on your business return,” Empey said. “You have to pay extra attention to make sure your partnership or S corporation return is done correctly with the required disclosures. If you don’t disclose, for example, wages paid, you’d technically not be eligible” for the deduction.
New law’s benefits
The centerpiece of the new tax law is the reduction of the corporate tax rate. Under the old rules, C corporations were subject to a graduated scale — 15 percent at the low end and 35 percent the highest rate. The new law brings the corporate rate to a flat 21 percent.
The law makes the change permanent, which means it won’t go away in 2025, when many other new provisions of the law will expire.
Some businesses that previously were subject to the 15 percent rate could be paying more in taxes, but few corporations have net income of $50,000 or less that made them eligible for the 15 percent rate.
The tax law also increases the so-called Section 179 deduction, another benefit favorable to smaller businesses. Section 179 of the tax code permits businesses to deduct the purchase price or lease amount of equipment purchased during the tax year.
In 2017, the deduction limit was $500,000. This year, it’s doubled, and businesses can deduct the full cost of equipment up to $1 million. Last year, the deduction would begin to be phased out when more than $2 million worth of tangible personal property was purchased and placed into service during the year. The new law increases the threshold to $2.5 million.
The law also increases the percentage of depreciation a company may fully expense.
“Under the old law, in order to claim bonus depreciation, the accelerated amount had to be brand new and the amount was limited to 50 percent of the cost of the asset,” Conner said. “Under the new rules, you can temporarily expense 100 percent of the cost of equipment put in service before the end of the year, and it doesn’t have to be brand new.”
This is one area in which businesses can still affect their taxable income.
“If you have a need for equipment, you may be better off to purchase it before the end of the year if you’re in a taxable situation,” Conner said.
Another significant change for smaller businesses allows those with average annual gross receipts of $25 million or less in the prior three-year period to switch from an accrual basis to a cash method of accounting. According to the IRS, the new tax law exempts these small businesses from certain accounting rules for inventories, cost capitalization and long-term contracts.
“One of the things we’re focusing on is making sure we’re taking advantage of the change in accounting methods,” Gandy said. “If I have $5,000 in inventory at the end of 2018, from a tax perspective, I can write that off. You get the big initial bang in the first year you make that election.”
Businesses also need to be aware that some deductions are no longer available.
Deductions for entertainment expenses such as tickets for sports events are no longer allowed, but business meals remain 50 percent deductible, said Jason Homec, managing partner at Erickson, Brown & Kloster.
The domestic activities production deduction, a 9 percent deduction on taxable income earned from manufacturing and production conducted within the United States and Puerto Rico, was designed to help American manufacturers compete against foreign competitors. The new tax law repealed the provision.
Manufacturing companies “are not going to be hurt necessarily,” Homec said. “They just have to realize they lost that but in turn received” other benefits under the new tax law.
All businesses should be aware that starting this year, business interest expenses above certain thresholds will not be deductible.
“This is another situation where the best advice is to reach out to your tax adviser to discuss whether you’re going to be subject to this limitation,” Kaltenbacher said.
Year-end tax planning
“It’s more important to do year-end tax planning this year than ever before,” Kaltenbacher said. “If you don’t do year-end planning, you might not be able to take advantage of immediate expensing.”
Homec said, “We always educate our clients to go ahead and buy that additional piece of equipment, that additional truck, whatever helps improve their business and make it more efficient. Other items such as year-end bonuses for employees, retirement plan contributions, health savings account contributions and charitable contributions can help reduce taxable income.”
Pass-through entities need to understand the owner’s personal tax situation before decisions are made at a company level, Conner said, adding that “we’re placing greater emphasis on targeting income for owners to put them in the most beneficial position. That may not mean accelerating deductions and deferring income.”
Conner said many clients are asking whether they should convert from an S to a C corporation to take advantage of the lower corporate tax rate.
“I would urge caution,” he said. “That decision is permanent for at least five years. If you’re drawing earnings out of the corporation, there’s a second layer of taxes — roughly 23.8 percent if the owner is in the top bracket.”
The new tax law contains the most sweeping changes in more than 30 years. After 13 months of dealing with it on a daily basis, “we still come up with questions and have to analyze how things fit,” Kaltenbacher said. “Every taxpayer’s personal situation is going to determine the best strategy for them, now more than ever.”
Editor’s note: This story has been corrected to reflect business owners start to phase out of the qualified business income deduction when taxable income exceeds $315,000 (not $350,000 as first reported) for married couples filing jointly.