Editor’s Note: This is the first in a three-article series on the new federal tax law. The other articles are as follows:
- The Tax Cuts & Jobs Act: What It Means for Businesses
- The Tax Cuts & Jobs Act: What It Means for Pass-Through Entities
- The Tax Cuts & Jobs Act: What It Means for Individuals
On December 22, 2017, President Donald Trump signed the “Tax Cuts and Jobs Act” into law, marking one of the most dramatic transformations in the history of the modern tax code. Designed to spur investment and economic growth, the law is at the same time simple in concept and yet extremely complex in execution.
With that in mind, it is imperative for small business owners to become familiar with the law and its provisions as they impact both business and individual tax strategies. In this three-part series, we’ll examine some of the key policy highlights that business owners should be aware of as they plan for the future.
Business Taxes and Deductions
In today’s business environment, there are two very distinct business entity models. Businesses that pay corporate taxes on their own earnings are commonly organized as “C” corporations, whereas businesses that pass their earnings through to their owners, shareholders or members (i.e. “pass-through entities”) are commonly organized as “S” corporations or partnerships, or they may be registered at the state level as LLCs. It is worth noting that sole proprietorships are also treated as pass-through entities by the IRS.
Understanding this distinction allows us to evaluate the law’s impact on businesses, because the changes to the tax code are not the same for these two kinds of entity formats.
Businesses that pay corporate taxes will see their federal corporate tax rate change from a graduated rate that previously ranged from 15% to 35%, to a flat tax rate of 21% instead. In addition, the corporate Alternative Minimum Tax (AMT) has been repealed, and in fact an AMT credit can be applied for tax years between 2017 and 2022 which could offset regular tax liabilities.
So far, the changes noted have only impacted corporations such as “C” corps. This next change can have a positive impact for all businesses.
The ability to deduct (or “expense”) the cost of certain property acquired, rather than recover though depreciated deductions, is addressed in IRS code 179 and is a popular tool for small businesses.
Under the new law, the maximum amount a taxpayer may expense for qualifying property placed in service for the tax year increases from a previous cap of $500,000 to a new cap of $1 million. This was accompanied by a number of changes to the phase-out threshold, the cost recovery basis to be applied, and the definition of qualified property. The first-year bonus depreciation option remains unchanged and has been increased to 100% through 2019, with different phases and limitations. In addition, it sunsets completely after 2026.
Real estate is another area significantly impacted by the changes in cost recovery policy, with variations to the prior law based upon a number of factors, including the type of use (i.e. residential, nonresidential, restaurant, etc.), and the nature of the depreciation method(s) previously used.
The new law also changes the policy on deduction of business interest. Under the new law, every business (regardless of form) is subject to a disallowance of a deduction for net interest expenses in excess of 30% of the adjusted taxable income for the business.
The net interest expense disallowance, however, is handled in multiple ways. In most cases, it is determined at the tax filer level, except in the case of pass-through entities, where the determination must be made at the entity level (for example, at the partnership level rather than the partner level — or at the LLC level rather than at the member level).
It is also notable that the new law generally eliminates the two-year carry back provision that previously applied to Net Operating Losses (NOL). The prior policy provided a two-year carry-back period and a 20-year carrying period to offset taxable income.
A major change that small business owners need to take note of is the shift in policy regarding deductions for meals and entertainment. Under prior law, both meals and entertainment were subject to a 50% deduction under certain conditions. With the new law, entertainment expenses are no longer allowed so the deduction only remains in place for meals.
An expansion of eligibility does now include certain on premise meals or cafeteria services, but a longstanding and widely utilized deduction for employee transportation fringe benefits (such as a transit benefit offered by employers in urban areas), are no longer allowed (although employees still do not need to count the value of the benefit as income on their own taxes).
One brand-new credit is that employers will now be able to deduct a portion of the value of wages they pay to employees under the Family & Medical Leave Act (FMLA), beginning at 12.5% and scaling up, where the value of the wages being paid during the leave period is at least 50% of the employee’s normal wages.
Accounting Methods and Rules
The new law also made some significant shifts in the policy treatment of accounting methods, including adjustments to the rules pertaining to both cash basis and accrual basis businesses.
For example, the new law takes a more restrictive view of when and under what conditions an accrual basis taxpayer can recognize income in a future tax year (such as “advance income” when funds are received prior to delivery of goods or services). Under the new law, generally speaking, income must be recognized no later than the tax year in which such income is taken into account as income on their financial statements. In addition, the new law updates and revises the policy for the application of deferrals for advance payments.
In addition, the law changed the eligibility requirements for cash basis accounting. Previously, a corporation, or a partnership with a corporate partner, could generally only use the cash method of accounting if it met the ‘gross receipts’ test, wherein the average annual gross receipts the entity received for the three-tax-year period ending with the earlier tax year would not exceed $5 million. Under the new law, that cap has been increased to $25 million.
In addition, the prior requirement that the accrual method be mandated for businesses with average gross receipts of greater than $1 million per year who track and report inventory has been changed so that businesses who meet the new standards for the cash method can now use that method, whether or not they track and report inventory.
There are also numerous industry-specific exceptions, adjustments and modifications. One that is of particular note is the change in policy pertaining to the percentage-of-completion method (PCM) exemption employed by construction businesses with annual gross receipts of $10 million or less for long-term contracts.
Under the PCM exemption, such businesses have been allowed to deduct costs associated with construction when they are paid and recognize income when the building is completed. Under the new law, the PCM exemption is expanded to apply to contracts for the construction or improvement of real property where the project is expected to be completed in two years or less, and the customer is a taxpayer who meets the $25 million gross receipts test (i.e. a small construction firm executing a project for a small business client).
The highlights shared in this article are just a summary of key points in the law. In the second article of this series, we will address specific provisions of the law that impact pass-through entities (such as LLCs and “S” corporations) and their owners. A third article in the series will focus on impacts of the new tax law on individuals (i.e. the business owner).
Remember that the actual law itself is 1,097 pages in length, and contains numerous provisions and adjustments that could impact your small business, and you as a small business owner. Make sure to meet with your CPA or tax preparer proactively to review the impact of the new law in detail, and prepare to adjust and update your tax strategy accordingly.