The Tax Cuts and Jobs Act became law on December 22, 2017, with most provisions taking effect January 1, 2018. The last six months has seen an unparalleled amount of interpretations of the new law with many issues still awaiting guidance to provide clarity. This article will update you on what we know to be true for 2018 and where we expect to receive more guidance before the end of the year.
Choice of Entity After Tax Rate Change
The new law eliminated the graduated rate structure and significantly decreased the top income tax rate for corporations from 35% to 21%. With the qualified dividend rate at 15%, under certain income thresholds, you could be looking at a 36% combined tax rate for corporate owners in comparison to pass-through entities such as S corporations and partnerships that would be subject to the top individual ordinary income rate of 37%. There are a number of factors to discuss including but not limited to the new pass-through income deduction, deductibility of state taxes, increase in dividend rates over certain income thresholds and the 3.8% net investment income tax.
Bonus depreciation is a valuable tax-saving tool for businesses as it allows for an immediate first-year deduction on the purchase of new equipment with no phase out restrictions. The new law increases bonus depreciation to 100% for property acquired and placed in service after September 27, 2017 and before 2023, after which it will be phased out to zero. Bonus depreciation has also been expanded to include purchases of used equipment.
In addition to bonus depreciation, Section 179 allows for the full expensing of new and used equipment, as well as purchased “off-the-shelf” software. The new law increases the limit significantly from $500,000 to $1 million and raises the phase out threshold from $2 million to $2.5 million, making this deduction available to more businesses. Businesses who exclusively used bonus depreciation in the past might now be eligible to expense under Section 179.
Pass-Through Income Deduction Update
As we mentioned earlier, pass-through income is generally taxed at the individual owner’s ordinary income tax rate. While the new law did not create a preferential rate for pass through income, it does provide for up to a 20% deduction of qualified business income. We have learned from interpretations of the law that this will include self-employed individuals as well as rental properties that are not held through an entity. With that said we are still waiting for guidance on what qualifies as a service industry and how to calculate the qualified business income deduction. This guidance is expected to be published by the end of June.
Net Operating Losses (NOLs)
When a business finishes a tax year with negative income for the year it generates a net operating loss that, under prior law, could be carried back two years and carried forward 20 years to be used against income. Under the new law, NOLs can no longer be carried back but will now have an indefinite carry forward life. The use of NOLs in any future year will be limited to 80% of taxable income.
Deduction for Net Interest Expense
There had not previously been a limit to the amount of interest expense that a business could deduct. The new law limits the deduction for interest expense to 30% of adjusted taxable income, with an indefinite carryover of disallowed amounts. Small businesses with average gross receipts of $25 million or less are not subject to this restriction.
The new law eliminates the 50% deduction for most entertainment expenses. There is a lack of clarity as to what qualifies as entertainment expenses under the new law, but legislators are expected to provide more details on the deductibility of these expenses at the end of June.
As you can see, the Tax Cuts and Jobs Act introduces many changes to how a business is taxed, and provides tax planning opportunities. It is important to consult your tax advisor before making decisions that will likely have a significant tax impact on your business. If you need assistance interpreting the new tax law changes and analyzing how they will impact your business, please contact your L&B Professional at (858) 558-9200.