The new federal tax legislation signed into law in late December 2017 triggers a massive overhaul of the U.S. tax regime. The Tax Cuts and Jobs Act (TCJA) has been widely heralded as business-friendly, and that description is no joke. If you own a business, you’re likely to enjoy substantial tax cuts, even if you don’t benefit from the new 21% corporate tax. Here are some of the most significant changes.
Reduced taxes for pass-throughs
Owners of businesses operating as partnerships, limited liability companies, S corporations and sole proprietorships report net income on their individual tax returns. Until now, they’ve paid taxes on that income at ordinary income tax rates as high as 39.6%. Beginning in 2018, the TCJA cuts the highest individual tax rate to 37%. And it raises the threshold for that rate to $500,000 in taxable income for single filers and $600,000 for joint filers.
More important, the law establishes a generous new deduction that will slash taxable income from pass-through entities. Beginning in 2018, the qualified business income (QBI) deduction generally allows taxpayers to deduct 20% of QBI (not salary) from a pass-through entity. Combined with the lower top tax rate on ordinary income, the deduction translates to a 29.6% top rate on pass-through income.
Once taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a “wage limit” begins phasing in. The wage limit phases in completely at $207,500 for single filers and $415,000 for joint filers. At that point, taxpayers generally will deduct the lesser of:
- 20% of QBI, or
- The greater of 1) 50% of the W-2 wages paid by the business or 2) 25% of the wages paid plus 2½% of the unadjusted basis (meaning the purchase price) of tangible depreciable property (for example, real estate).
Notably, the QBI deduction is reduced and eventually eliminated for “specified service businesses” (such as law or accounting firms, consultants, or any business whose principal asset is the reputation or skill of one or more employees) above a threshold amount of taxable income. Specifically, the deduction begins to be reduced when an owner’s taxable income exceeds $157,500 for single filers and $315,000 for joint filers. And it’s eliminated when taxable income exceeds $207,500 and $415,000, respectively.
Be aware that the reduced tax rates and QBI deduction will expire after 2025 without congressional action.
Accelerated depreciation deductions
The TCJA extends and modifies bonus depreciation for qualifying property (for example, office furniture, software and qualified improvement property). For qualified property placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain property with longer production periods), businesses generally can expense 100% of the cost of such property (both new and used) in the year the property is placed in service. Beginning in 2023, the amount of the allowable deduction will drop, shrinking 20 percentage points each year for four years and disappearing in 2027, absent congressional action.
The TCJA also expands the immediate expensing of equipment under Section 179 — permanently. For 2018, it increases the maximum deduction for qualifying property to $1 million (from $510,000) and raises the phaseout threshold to $2½ million (from $2.03 million). The definition of qualified real property now includes several improvements to nonresidential real property (for example, roofs; heating, ventilation and air conditioning; and alarm and security systems).
Limited interest expense deduction
The TCJA isn’t all good news, though. Many businesses will be disappointed to learn that it might increase their cost of borrowing by limiting the amount of interest expense they can deduct beginning in 2018.
The law generally restricts the deduction to 30% of adjusted taxable income, although it allows an indefinite carryforward for unused interest expense (with special rules for partnerships). Companies whose average annual gross receipts don’t exceed $25 million are exempt. Real estate businesses can elect out of the limit, but with some negative consequences in regard to their depreciation deductions. There are also exceptions for certain other types of businesses.
And much, much more
The provisions discussed above only skim the surface. The TCJA also makes changes related to, among other things, foreign income, net operating losses, like-kind exchanges, the domestic production activities deduction, research and experimentation expensing, excessive compensation and the deductibility of entertainment expenses and employee fringe benefits. Your CPA can help you wade through it all to minimize your tax liability.