On November 16, 2017, the House of Representatives passed The Tax Cuts and Jobs Act. It is said to provide bold tax reform legislation that will create more jobs, increase paychecks, and make the tax code simpler for everyone. Now all attention has fallen on the Senate Finance Committee, which has its own version of tax reform in the pipeline that is currently being debated and will be held to a vote sometime after the Thanksgiving break. Although both proposals have differences that will need to be reconciled, there are many similarities that could remain in the final bill that could be presented to President Trump for his approval.
For privately-held companies, the principle benefits under the proposals involve reductions in the individual tax rates to some degree offset by potential increases in the taxable income arising from lost tax incentives and certain itemized deductions. The significant benefits for business owners involve a 20 percent tax rate for C-corporations and a potential tax rate reduction on a portion of income from pass-through entities. On the surface, such benefits may appear straightforward but they become more complex once you dive into the details. Under the current proposal, many of these changes could take effect in 2018.
While both the House and Senate proposals involve a great level of detail, here is a breakdown of some of the key provisions that could impact pass-through businesses.
Individual Income Tax Brackets
Under the House plan, individual income tax rate brackets will be permanently reduced to four brackets. The current top rate bracket of 39.6 percent is retained, but will not apply until taxable income for a joint return filer reaches $1 million and $500,000 for all other filers. There is a new bubble in the rates from $1.2 -$1.6 million of income, where taxpayers will have the lower 12 percent rate brackets phased out. The impact is an indirect higher 45.6 percent rate on taxable income falling within this range. Once past the $1.6 million rage, the rate is 39.6 percent.
Under the Senate plan, the current structure of seven brackets is retained with a new current top bracket of 38.5 percent when income is over $1 million for joint filers and $500,000 for all other filers. There is no bubble rate in the brackets. These tax rates will expire after December 31, 2025 when the current tax rates will apply again.
Under both proposals, taxpayers should consider the use of deferral techniques for 2017 to help tax plan their income below the top brackets, in order to take advantage of these new rates taking effect in 2018.
Under the House Plan, state and local tax deductions are scheduled to be repealed and replaced with a limited deduction of up to $10,000 for real estate taxes. The Senate plan eliminates the entire deduction for state and local taxes altogether.
Both plans will raise the tax base for many business owners, as they currently benefit from a deduction for state and local taxes (“SALT”) that arise on their business profits. Business operations within and residents of high income tax areas like New Jersey and Philadelphia will likely be more adversely impacted than others.
Business owners who are potentially impacted should consider prepaying state and local tax liabilities by December 31, 2017 in order to receive a tax deduction this year for what may otherwise provide no tax benefit going forward. Caution is required, however, should a prepayment give rise to alternative minimum tax.
Under the House plan, mortgage interest is set to be limited to mortgages of $500,000 and under. The Senate plan retains the mortgage interest deduction limit at $1,000,000.
The current phase-out of certain itemized deductions due to high income limits will be repealed under both the House and Senate plans. This current phase-out is a hidden tax increase and many business owners will benefit from this change.
Alternative Minimum Tax (AMT)
Under both the House and Senate plans, the AMT for corporations and individuals is scheduled to be repealed. Under current tax law, this tax created an extra layer of complexity and additional tax costs for business owners who fell into the 28 percent tax bracket or who took advantage of certain industry-specific tax incentives. This could be seen as a positive for small businesses that now have the ability to utilize certain accounting methods to best defer their business income.
Accounting Methods for Small Businesses
Use of the cash method can provide businesses more flexibility when it comes to tax planning and is preferred over the accrual method of accounting when there could be delays in collecting accounts receivable in a business
Business Property Expense Limits
Both the House and Senate proposals provide businesses with an enhanced opportunity to fully expense business property under the current Section 179 and bonus depreciation rules.
Under the House plan, the Section 179 expense limitation has been raised from $500,000 to $5 million of immediate expense for qualified property placed in service during the year. The eligible property limitation has been raised from $2 million to $20 million for eligible property placed in service before the Section 179 expense begins to be limited. Also, the House plan allows 100 percent bonus depreciation for assets placed in service from September 27, 2017 through January 1, 2023. It also expands the definition of bonus eligible property to include used assets.
Under the Senate plan, the Section 179 expense has been expanded from $500,000 to $1 million of immediate expense for qualified property placed in service during the year. The eligible property limitation has been raised from $2 million to 2.5 million for eligible property placed in service before the Section 179 expense begins to be limited. No other changes have been made to bonus depreciation.
This will have a significant impact on taxpayers that invest heavily in machinery and equipment each year and have been limited or phased out of this deduction for the amount of equipment purchases.
Domestic Production Activity Deduction (DPAD)
Since 2005, certain qualifying businesses have been able to obtain an additional permanent tax deduction on their construction or manufacturing related activity. This deduction equated to about a 3 percent reduction in their effective tax rate. For a business owner currently in the 39.6 percent tax bracket, this deduction has the impact of lowering the effective rate of qualifying income to roughly 36 percent.
Under both the House and Senate plans, this incentive is expected to be repealed. This may partially offset some savings that will otherwise arise from the reduction in tax rate for individuals, corporations, and pass-through businesses.
Special Tax Rate for Pass-Through Businesses
The major differences in the House and Senate plans lies in the treatment of pass-through businesses. Both plans call for a partial tax rate deduction on pass-through business profits but are achieved in different ways that have varying results.
Under the House plan, a reduced rate of 25 percent would apply to pass-through businesses (S-corps, partnerships, etc.). However, taxpayers that are considered service-related businesses (lawyers, accountants, engineers, etc.) would be exempt from this reduced rate, which would result in their entire income being subject to ordinary income tax rates.
Taxpayers who are passive or active in a non-service business will qualify for this special rate. However, for taxpayers who are passive in a pass-through business, all of their income will be eligible for the special 25 percent tax rate. For taxpayers who are considered active in the business, the proposals provide a special allocation, of which 30 percent of the Qualified Business Income from the pass-through business be eligible for the special 25 percent tax rate. The remaining 70 percent will be taxed at the new, revised individual rates.
A taxpayer can choose to do an alternative calculation to increase the allocation above 30 percent, but will need to make an election on their tax return to take advantage of this. The risk in making this election is that they will be required to use this method over the next five years - even if the allocation dips below the 30 percent. The calculation involves more complexity and we only see this benefiting companies that make significant investments in capital (i.e. manufacturers, heavy highway contractors, etc.). This alternative calculation could perhaps yield a better result, but it comes with some complexity and risk.
Companies that do not invest heavily in capital will only be limited to the 30 percent calculation. This could provide an unfair tax advantage to businesses in some industries when compared to a business that invests heavily in capital and could see more of its business income subject to the lower pass-through rate. Also, with the loss of certain tax incentives like the SALT and DPAD deductions, this increase in the tax base with a reduced tax rate may result in very little tax relief.
The Senate plan takes a different approach and allows a deduction of 17.4 percent from the qualified business income of a pass-through business instead of a reduced tax rate. This deduction applies to all owners of pass-through businesses (active or passive) but not to service-related businesses. The deduction is limited to 50 percent of the allocable W-2 wages of the pass-through business.
The 50 percent wage limitation could impact pass-through businesses that are limited or do not have any W-2 wages (e.g., real estate companies). The proposal provides an exception where the limitation does not apply if the taxpayer’s income is below $500,000 for joint filers and $250,000 for all other filers.
The impact of the deduction will equate to about a 34 percent effective tax rate for pass-through businesses. Again, compared to the tax rates under the current law and the House proposal, this proposal provides some tax relief, but they are not expected to receive as significant a windfall under these proposals as C-Corps.
Finally, the Senate proposal is not permanent and will be set to expire at the end of December 31, 2025. This could provide temporary relief to pass-through businesses where, again, they could see a tax increase beginning in 2026.
Under both the House and Senate proposals, C-Corp rates are permanently scheduled to be reduced to a flat 20 percent. Personal Service Companies will also see their rates reduced down to 25 percent under the House plan and 20 percent under the Senate plan. Under the House plan, this will take effect beginning after December 31, 2017 while the Senate’s plan is effective beginning after December 31, 2018.
With such a drastic decrease in the C-Corporation tax rates compared to pass-through entities, some company owners may wish to consider switching to a C-Corporation going forward. Generally, you may see current tax savings here if the C-Corp will retain a material level of profits. The potential for a subsequent second incidence of tax has historically weighed heavily in favor of pass-through treatment and the pros and cons of each entity type will likely take on renewed interest.
There are many winners and losers under both the House and Senate proposals. Take time to review how these changes will impact your business. It will also help to be more vocal to your local Congressional representatives over the next month about the proposals’ potential impact to your business and your industry. Some of the tax savings gained from the reduction in the individual income tax and pass-through rates and deductions could be offset by the loss of the DPAD and the SALT deduction, especially since the remainder of the pass-through business income would still be taxed at the higher individual tax rates. We will have to see how this will play out over the next few months, but it appears the C-Corporation may be an attractive choice for the future.
If you have any questions or would like to discuss this subject further please do not hesitate to contact a member of Kreischer Miller’s Tax Strategies group at 215.441.4600.
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