There have been a lot of articles written about the recent tax bill, The Tax Cuts and Jobs Act, since it became law at the first of the year. There are many provisions within the law that will change the way both individuals and business owners will plan for future tax filings and run their businesses. Throughout this article, I will review some of the provisions as they relate to business owners and certain niches in the contracting industry as well as provide some guidance on changes that may be appropriate for the exiting business owner.
First and foremost, it will be less expensive to operate your business in 2018 than it was in 2017. Aside from the various provisions, one key element is that tax rates have dropped.
C Corporations will enjoy the greatest benefit as rates dropped from 34 percent to 21 percent.
Individual rates will still have seven brackets but each bracket has been reduce by 2 to 4 percentage points
The income brackets have been slightly increased, so it will take more taxable income for an individual to move into the next highest bracket.
Pass through entities (sole proprietors, partnerships, S Corporation and Trusts and Estates) will still be taxed at the individual income tax rates, however their provisions that can effectively eliminate 20 percent of the income from being taxed. I’ll talk a little further about the 199A deduction later in the article.
Some key provisions that will influence the marketing side of businesses in general are the elimination of the meals and entertainment deduction. The previous law allowed for a 50 percent deduction for any meals and entertainment expenses incurred in the normal course of a business’ sales cycle. This deduction has now been lost. Meals paid for the benefit of employees that are necessary for them to work beyond normal hours continue to be 100 percent deductible.
A provision that does provide a benefit to a business owner’s tax situation is the increase of the Section 179 deduction. This deduction allows a business owner to fully expense the cost of a capital asset in the year it was placed in service. The previous deduction provided for a $500 thousand limit on expensing. The new limit was raised to $1 million and the phase out was also increased from $2 million to $2.5 million.
The definition of “eligible property” was also expanded. Here’s where the new provision can really help commercial contractor niches increase revenue. The provision expands the definition of qualified real property eligible for Section 179 expensing to include improvements to non-residential real property placed in service after the date such property was first placed in service. This expanded definition includes roofs, heating, ventilation, air conditioning property, fire protection and alarm systems and security systems.
Customers can now fully expense the cost up to $1 million provided they do not acquire other tangible personal property that exceeds the $2.5 million cap. This should encourage owners to invest in updated technologies and provide additional opportunities and revenues in this contacting niche.
Previous law required the cost of installation of new equipment to be capitalized and depreciated over 39 years. In light of the industry’s efforts to get Congress to reduce the new equipment depreciable life to one, the more it closely resembles the true economic value. Previous efforts included bills introduced in the 110th, 111th and 112th Congress session but action has been taken on these bills.
In addition to the Section 179 deduction, the bonus depreciation rules were also expanded. This is one of the few changes that affect 2017 tax computations. The provisions allow for property acquired after Sept. 27, 2017 and placed in service prior to Dec. 31, 2022 to expense 100 percent of the cost.
Where this provision previously only allowed for expensing of new equipment, the new law expands the definition to include used equipment. The act clearly rewards business owners making capital investments.
The other key provision in the act affects the pass through entities. As discussed previously in this article the pass-through entities were also granted a further reduction to compete with the C corporation tax break.
Section 199A deduction
There is a specific provision in the Act called the Section 199A deduction. This is the area of the law that provides for a 20 percent deduction for owners of pass through entities. Now a straight 20 percent exclusion of income sounds great and would certainly follow this administrations goal of tax simplification, but nothing of the sorts has been accomplished with this law.
The general 20 percent deduction is applicable for single taxpayers with taxable income under $157,500 and joint filers with taxable income under $315,000 will generally get the full 20 percent deduction. However, as income levels increase above these limits, the formula deduction looks at W-2 wages paid to employees and at the depreciable property held by the pass through entity.
For these high-income taxpayers, in some cases the deduction gets limited to 50 percent of the W-2 wages paid by the entity or 25 percent of the wages paid by the entity plus 2.5 percent of qualified property’s original cost. For the property to qualify it cannot be greater than 10 years old or past its last full year of depreciation. Income levels between the upper and lower limits gets a phase in of the W-2 and property requirements. So much for simplification!
For those that conduct business in the personal service industry such as accountants, attorneys and consultants, they will lose the deduction altogether once their income exceeds the upper limits as previously discussed. There is an exception to this rule, however. Engineers and architects do not fall under the exclusion and would follow the ordinary business definition for application of the 199A deduction.
The fundamental question asked is, “Why not convert the pass through entity to a C corporation?” On the surface, one would think that this is a wise decision. However, it is important to note that anytime income is taken out of a C corporation, there is generally a second layer of tax. I say generally because for an “exiting owner” there could be some good opportunities to utilize a C corporation as an exiting tool and eliminate capital gains on the transaction while benefiting from a lower annual income tax rate.
There are some other key provisions that business owners should be aware of under the new act:
- Lifetime Gift and Estate Tax exclusion has been doubled and now is $11.2 million per individual. Meaning married couples with estates below $22.4 million will be free of federal estate and gift taxes;
- Annual gift tax exclusion has been increased to $15,000 per donor per gift;
- Personal exemptions have been eliminated and are now covered under the increased $24,000 standard deduction;
- Miscellaneous itemized deductions have been eliminated. Investment fees are no longer deductible;
- Medical expenses are now deductible in excess of 7.5 percent of adjusted gross income;
- Alimony payments for agreements entered into after December 2018 are no longer deductible by the payer or includible as income by the recipient;
- Interest home equity lines of credit are no longer deductible;
- Mortgage interest on loans in excess of $750,000 are no longer deductible;
- Net operating losses generated from business, trust and estates that exceed current year income in excess of $250,000 for singles and $500,000 for joint filers cannot be fully deducted in the current year. It must be carried forward and subject to 90 percent of subsequent year’s income;
- Alternative minimum tax has been repealed for “C corporation.” The individual AMT still exists; however, the exemption amount has been increased substantially;
- When itemizing deductions, the tax deduction is capped at $10 thousand annually. There is no cap on tax deductions for businesses;
- 1031 Gain deferral has been changed to eliminate personal property and now only applies to real estate transactions.
As you can see, there have been many new changes to the tax laws that, generally, became effective on January 1. While I’ve attempted to highlight some of the key items that will affect business owners it’s important to look at these changes and see how they will affect your business going forward.
Once a thorough analysis has been completed, there may be a need to make changes in your financial and legal strategies such as operating agreements, income allocation, wage and income distributions and estate tax documents.
Furthermore, it is important to understand that similar to previous tax bills that were enacted into law there are sunset provisions to consider. With the exception of the C corporation tax rates, many of the provisions of this law will sunset, or expire, on Dec. 31, 2025.