As I’m sure you’re aware, the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted at the end of last year. It’s the largest tax overhaul since the 1986 Tax Reform Act and will affect almost every business in the United States. In light of all the changes that took effect this year, I think it would be appropriate for us to meet as early as possible to discuss how these changes might affect your 2018 business tax return and to nail down any actions that may need to be taken before the end of the year.
Here’s a quick recap of the new rules, followed by some thoughts on steps we can take to reduce your 2018 tax liability.
I. New Business-Related Tax Rules for 2018
The business-related provisions in the TCJA are permanent and generally take effect beginning with 2018 tax years. For businesses, highlights of the new law include: (1) an increase in amounts that may be expensed under Section 179 and an increase in the bonus depreciation deduction; (2) a 21 percent flat corporate tax rate; (3) a new business deduction for sole proprietorships and pass-through entities; (4) the elimination of the corporate alternative minimum tax (AMT); (5) modifications of rules relating to accounting methods; and (6) several changes involving partnerships and S corporations. As a result of these changes, many businesses are rethinking their entity choice. Whether this would be appropriate in your situation depends on several factors which we should evaluate together. The following is a brief overview of some of the more significant aspects of the new tax law that may affect your business.
Section 179 Deduction. For 2018, businesses can write off up to $1,000,000 of qualifying property under Section 179. The theory is that the money a business saves on taxes, as a result of deducting the full amount of equipment and other business property, can be reinvested back into the business. Additionally, writing off an asset in the year it is purchased, saves you the time and money it takes to keep track of the remaining basis of an asset after its yearly depreciation. The $1,000,000 amount is reduced (but not below zero) by the amount by which the cost of the qualifying property placed in service during the tax year exceeds $2,500,000.
In addition, the definition of property that qualifies for the Section 179 deduction has been expanded to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging, as well as any of the following improvements to nonresidential real property: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
Bonus Depreciation Deduction. The new tax law extended and modified the additional first-year (i.e., “bonus”) depreciation deduction, which had generally been scheduled to end in 2019. An enhanced bonus depreciation deduction is now available, generally, through 2026. Under the new rules, the 50-percent additional depreciation allowance that was previously allowed is increased to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023, as well as for specified plants planted or grafted after September 27, 2017, and before January 1, 2023. These deadlines are extended for certain longer production period property and certain aircraft.
The 100-percent allowance is phased down by 20 percent per calendar year in tax years beginning after 2022 (after 2023 for longer production period property and certain aircraft).
Another new provision removes the requirement that, in order to qualify for bonus depreciation, the original use of qualified property must begin with the taxpayer. Thus, the bonus depreciation deduction applies to purchases of used as well as new items.
TCJA also expands the definition of qualified property eligible for bonus depreciation to include qualified film, television and live theatrical productions, effective for productions placed in service before January 1, 2023.
Additional Depreciation on ‘Luxury’ Automobiles and Certain Personal Use Property. Another benefit of the new tax law is that it increases the depreciation limitations that apply to certain “listed” property such as vehicles with a gross unloaded weight of 6,000 lbs or less (known as “luxury” automobiles). For luxury automobiles placed in service after 2017, an additional $8,000 deduction is available, thus making the write-off for the first year $18,000. The deduction is $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. In addition, computer or peripheral equipment has been removed from the definition of listed property, which means that such property is not subject to the heightened substantiation requirements that previously applied.
New Deduction for Qualified Business Income. This is one of the bigger changes in the new tax law, which amounts to an attempt to even out business tax rates by allowing a deduction of up to 20% of qualified business income to passthrough entity owners. For a detailed look at this new deduction, read my post explaining the details.
Carryover of Business Losses Is Now Limited. Beginning in 2018, excess business losses of a taxpayer other than a corporation are not allowed for the tax year. Under this excess business loss limitation, your loss from a non-passive trade or business is limited to $500,000 (married filing jointly) or $250,000 (all other taxpayers). Thus, such losses cannot be used to offset other income. Instead, if your business incurs such excess losses, you must carry them forward and treat them as part of your net operating loss carryforward in subsequent tax years.
New Interest Deduction Limitations. You may have heard about a new limitation on the deduction of interest expense. Effective for 2018, the deduction for business interest is limited to the sum of business interest income plus 30 percent of adjusted taxable income for the tax year. However, there is an exception to this limitation for certain small taxpayers, certain real estate businesses that make an election to be exempt from this rule, businesses with floor plan financing (i.e., a specialized type of financing used by car dealerships), and for certain regulated utilities.
The new law exempts from the interest expense limitation taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. Further, at the taxpayer’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation does not apply to such trades or businesses.
Elimination of Entertainment Deduction. The new tax law also eliminated business deductions for entertainment. As a result, no deduction is allowed with respect to: (1) an activity generally considered to be entertainment, amusement or recreation; (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes; or (3) a facility or portion thereof used in connection with any of the above items. Under prior law, there was an exception to this rule for entertainment, amusement, or recreation directly related to (or, in certain cases, associated with) the active conduct of a trade or business. This is no longer the case.
In addition, no deduction is allowed for expenses associated with providing any qualified transportation fringe benefits to your employees, except as necessary for ensuring the safety of an employee, including any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
A business may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees during work travel). If meals are combined with entertainment, the meal portion needs to be separately stated in order for the business to deduct the meal expense.
Employer Credit for Paid Family and Medical Leave. For 2018 and 2019, eligible employers can claim a general business credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave if the rate of payment under the program is 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent.
Given the cost of implementing such a policy and complying with reporting requirements, the credit may be impractical for many employers to pursue during the short period it’s available. For businesses that already have a qualifying family and medical leave plan in place, however, the credit may provide a nice windfall.
Changes to Partnership Rules. Several changes were made to the partnership tax rules. First, gain or loss from the sale or exchange of a partnership interest is treated as effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership is allocated to interests in the partnership in the same manner as nonseparately stated income and loss.
Second, the transferee of a partnership interest must withhold 10 percent of the amount realized on the sale or exchange of the partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Third, the definition of a substantial built-in loss has been modified so that a substantial built-in loss is considered to exist if the transferee of a partnership interest would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all of the partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest. This could necessitate the adjustment of the basis of partnership property.
Fourth, TCJA modifies the basis limitation on partner losses to provide that a partner’s distributive share of items that are not deductible in computing the partnership’s taxable income, and not properly chargeable to capital account, are allowed only to the extent of the partner’s adjusted basis in the partner’s partnership interest at the end of the partnership tax year in which an expenditure occurs. Thus, the basis limitation on partner losses applies to a partner’s distributive share of charitable contributions and foreign taxes.
Lastly, the rule providing for technical terminations of partnerships has been repealed.
Changes to S Corporation Rules. Several changes were also made to the tax rules involving S corporations. First, income that must be taken into account when an S corporation revokes its S corporation election is taken into account ratably over six years, rather than the four years under prior law. Second, a nonresident alien individual can be a potential current beneficiary of an electing small business trust (ESBT). Third, the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.
II. Year-End Tax Planning.
Section 179 Expensing and Bonus Depreciation. As discussed above, the Section 179 expensing and bonus depreciation rules have been generously enhanced under TCJA. These changes may create new opportunities to reduce current year tax liabilities through the acquisition of qualifying property – including property placed in service between now and the end of the year.
Vehicle-Related Deductions and Substantiation of Deductions. Expenses relating to business vehicles can add up to major deductions. If your business could use a large passenger vehicle, consider purchasing a sport utility vehicle weighing more than 6,000 pounds. Vehicles under that weight limit are considered listed property and deductions are more limited. However, if the vehicle is more than 6,000 pounds, up to $25,000 of the cost of the vehicle can be immediately expensed.
Vehicle expense deductions are generally calculated using one of two methods: the standard mileage rate method or the actual expense method. If the standard mileage rate is used, parking fees and tolls incurred for business purposes can be added to the total amount calculated.
Since the IRS tends to focus on vehicle expenses in an audit and disallow them if they are not property substantiated, you should ensure that your mileage is recorded properly. Read my past blog post on properly recording business mileage.
Retirement Plans and Other Fringe Benefits. Benefits are very attractive to employees. If you haven’t done so already, you may want to consider using benefits rather than higher wages to attract employees. While your business is not required to have a retirement plan, there are many advantages to having one. By starting a retirement savings plan, you not only help your employees save for the future, you can also use such a plan to attract and retain qualified employees. Retaining employees longer can impact your bottom line as well by reducing training costs. In addition, as a business owner, you can take advantage of the plan yourself, and so can your spouse. If your spouse is not currently on the payroll, you may want to consider adding him or her and paying a salary up to the maximum amount that can be deferred into a retirement plan. So, for example, if your spouse is 50 years old or over and receives a salary of $24,500, all of it could go into a 401(k), leaving your spouse with a retirement account but no taxable income.
By offering a retirement plan, you also generate tax savings to your business because employer contributions are deductible and the assets in the retirement plan grow tax free. Additionally, a tax credit is available to certain small employers for the costs of starting a retirement plan. Please let me know if this is an option you would like to discuss further.
De Minimis Safe Harbor Election. It may be advantageous to elect the annual de minimis safe harbor election for amounts paid to acquire or produce tangible property. By making this election, and as long as the items purchased don’t have to be capitalized under the uniform capitalization rules and are expensed for financial accounting purposes or in your books and records, you can deduct up to $2,500 per invoice or item (or up to $5,000 if you have an applicable financial statement).
S Corporation Shareholder Salaries. For any business operating as an S corporation, it’s important to ensure that shareholders involved in running the business are paid an amount that is commensurate with their workload. The IRS scrutinizes S corporations which distribute profits instead of paying compensation subject to employment taxes. Failing to pay arm’s length salaries can lead not only to tax deficiencies, but penalties and interest on those deficiencies as well. The key to establishing reasonable compensation is being able to show that the compensation paid for the type of work an owner-employee does for the S corporation is similar to what other corporations would pay for similar work. If you are in this situation, we need to document the factors that support the salary you are being paid.
As you can see, a lot is going on with respect to business income and taxes for 2018. The new tax law provisions are quite extensive and also quite complicated.