*** Last Updated: 12/6/2017
The U.S. Congress is currently in the midst of attempting to pass sweeping tax reforms for businesses of all sizes.
Our coverage is primarily focused on how the new tax bill will affect small businesses, LLCs, S Corps, and startups, including service-based businesses.
The Latest Events: Where Things Are Now
- December 2, 2017 – The Senate has successfully passed the new tax bill, Tax Cut and Jobs Act, H.R. 1, by a vote of 51-49
- Currently Pending: Conference committee is gathering to reconcile the House tax bill and the Senate tax bill and reach a version that both will agree to.
- 12/6/2017 – House Speaker Paul Ryan says they are going to try to finish committee work before the end of this week.
Current Summary: How the New Tax Bill Affects Small Business, Startups, LLCs, S-Corps and Professional Services
There are various features of the 12/2/2017 Senate-approved tax bill that differs from the original version presented for vote as well as the House version that was approved earlier in the year.
NEW INDIVIDUAL TAX BRACKETS:
There are going to be new tax brackets, as follows:
– 10% (income up to $9,525 for individuals; up to $19,050 for married couples filing jointly)
– 12% (over $9,525 to $38,700; over $19,050 to $77,400 for couples)
– 22% (over $38,700 to $70,000; over $77,400 to $140,000 for couples)
– 24% (over $70,000 to $160,000; over $140,000 to $320,000 for couples)
– 32% (over $160,000 to $200,000; over $320,000 to $400,000 for couples)
– 35% (over $200,000 to $500,000; over $400,000 to $1 million for couples
– 38.5% (over $500,000; over $1 million for couples)
- New tax rate of 20% for corporate taxes. This would cut corporate taxes from 35% to 20%, which is the lowest in nearly 100 years. The 20% rate will take effect starting 2019.
- Expensing rules: Corporations can deduct the cost of new equipment immediately and for five years; then phrase-outs apply thereafter. The rate will phase out at 80%/60%/40%/20% rates over the ensuing four years.
LLCS AND S CORPS:
- General Structure. The new tax bill is set up to allow LLCs and S Corps to deduct a certain percentage from the business’s qualified business income or taxable income, up to a maximum of 50% of the “wages” paid to the business owner, and then all remaining excess amounts are declared as income subject to taxes on the filer’s individual return. LLCs and S Corps will be able to deduct 17.4% of their income, up to a max of 50% of the W-2 wages paid (H.R.1 , page 24.); and then the rest will be subject to taxation.
- 23% Deduction for Non-Service Businesses. For businesses that are NOT service based, additional deductions will be permitted, up to 23% of qualified business income or taxable income.
- W-2 Rule. To prevent business owenrs from recharacterizing their wage income as business profits, to increase the pass-through deductions, the deduction is limited to only 50% of W-2 wages of the pass-through entity; except that this rule will not apply if the business owner’s taxable income is under $250,000 (single) / $500,000 (married).
- LLC Guaranteed Payments. The Senate Tax Bill makes it clear that, when calculating business income of the LLC, guaranteed payments are not included. (H.R. 1, p. 29-30).
- Reasonable Compensation. In the S Corp context, the Senate Tax Bill states that the calculation of business income should also not include “reasonable compensation” paid to an owner for services.
SOLE PROPRIETORSHIPS (DBAS)
- Given that all miscellaneous itemized deductions are being suspended, it is not clear the extent to which business owners who are sole proprietors (DBAs) will be able to deduct some or most of their deductions.
- Because of the lack of clarity on this topic, it is not clear the extent to which sole proprietorships will still be able to take deductions for business expenses.
PROFESSIONAL SERVICE PROVIDERS (Lawyers, accountants, etc.)
- Straight 17.4% Deductions. Professional service providers are NOT permitted to take advantage of the higher deduction rate (23%) against business income. They are limited to 17.4% deduction from business income. The remainder earned (82.6%) must be subject to taxation.
- No Deduction of Contingency Fee Expenses. The new tax bill prohibits lawyers from deducting any expenses during the course of representing clients in any case in which the lawyer/law firm is compensated primarily on a contingent basis, until the case concludes (H.R.1, p. 189.)
SPECIAL RULES FOR PARTNERSHIPS AND S CORPS.
- According to the Senate Tax Bill, the share of income, gain, deduction, and losses of a partner or shareholder of a partnership or S Corp. is treated as having received W-2 wages for that amount (H.R.1, p. 34.)
- These amounts are supposed to be set off against the income and to which the deduction percentages do not apply.
- Multinational businesses will now be taxed on a territorial system.
- Companies will be paying a 14.5% tax on overseas profits constituting cash assets; and 7.5% on non-cash assets (i.e., equipment).
Provisions Relating to Entertainment (Film/TV) Productions
The new tax bill has special provisions for qualified film and television and life theatrical productions (H.R.1, p. 130). According to the new Senate tax bill, film and entertainment productions are the subject of specific tax reform provisions:
- There will now be expensing of 100% of the cost of domestic film, television, and theatrical projects, and these expenses can be deducted at the time of release or first performance.
- The new provisions will apply to all provisions after September 27, 2017.
- The 100% expensing provision will replace I.R.C. Section 181, which previously allowed companies to deduct the first $15 million of certain types of TV and film production costs. One of the problems with this code section was that it was not a perennial deduction, and had to be renewed every year.
General Accounting Provisions
- Net Operating Losses. NOLs carrybacks will be eliminated; while NOL carryforwards are reduced to 80% of taxable income. (H.R.1, p. 166)
- Cash Accounting. The threshold for businesses eligible for cash accounting are increased from $5 million to $15 million. (H.R.1, p. 113-114)
- Limits in Interest Deductions. Deductions for business interest are going to be limited to no greater than the amount of interest income plus 30% of AGI of the taxable year (H.R.1, p. 156)
Provisions on Section 1031 Exchanges of Real Property
- The new tax bill amends the Section 1031 Exchange of Real Property rules. (H.R.1, p. 172-173)
- The new 1031 Exchange rules will be limited to real estate only. This will effectively bar the use of 1031 exchange for cryptocurrency, which was a hot topic in the weeks leading up to the vote.
Non-Deduction of Certain type of Lawsuit Settlements
- The new tax bill is disallowing deductions for any settlement or payments of lawsuits alleging sexual harassment or sexual abuse if the agreement is confidential, as well as attorneys’ fees for such proceeding (H.R.1, p. 189).
Employer Credit for Paid Family and Medical Leave
- The new Senate tax bill makes provisions for employers paying paid family and medical leave.
- Companies will receive a tax credit equal to 25 percent of an employee’s earnings during their leave for offering two weeks of paid family leave to their workers.
Other Key Points of the Tax Bill Regarding Individual Taxpayer Obligations
- Personal exemptions are eliminated (H.R. page 75)
- Property taxes only deductible up to $10K
- Mortgage deduction will still exist, up to $1 million; however, NO deductions for interest paid on home equity loans.
- Tax-free receipts for selling your house. You will have to live in a new home for 5 years (increased from 2) out of the last eight (8) years, before you can sell it tax-free.
- AMT will still exist.
- Estate tax will be doubled to $11 million for individuals, and approximately $22 million for couples.
- Teacher deduction: teachers buying supplies for classrooms will be permitted up to $500.00 of deductions
- Health expenses: Will be deductible if over 7.5% in 2017 and 2018
- Individual mandate for health insurance: repealed
- The tax breaks for individuals will sunset in 2025; the tax breaks for corporations are permanent.
List of Deductions that Are Eliminated
- Personal exemptions (H.R. 1, page 75)
- Personal casualty losses – severely cut back unless occuring in a Federally declared disaster. (H.R.1, p. 83)
- Unreimbursed business expenses
- State/local income taxes (H.R. 1, page 81)
- Tax preparation fees
- No more moving expense deductions (H.R. 1, page 86) unless filer is in the Armed Forces on active duty who moves pursuant to military order
- Interest paid for home equity loans (H.R. 1, page 82)
- All miscellaneous itemized deductions – all suspended (H.R. 1 , p. 84)
- No bicycle commuting reimbursement (H.R.1., p. 85)
- Wagering loss deductions limited (H.R.1., p. 88.)
So how should pass-through entities be calculating their potential tax increase or decrease as a result of the Senate tax bill?
The 17.4% deduction to businesses is calculated by determining qualified business income (QBI), or modified taxable income, whichever is less.
Modified taxable income is taxable income excluding long-term capital gains and qualified dividend income.
Of these two amounts (modified taxable income and QBI), the “lower” amount should be used when calculating the 17.5% deduction.
In addition, the deduction cannot be greater than 50% of the W-2 wages paid in the pass-through entity, so depending on what wages have been paid, the deduction may be very minimal.
In addition, the 50% wage limitation does not apply to any filer that has a taxable income under $500,000 married / $250,000 others.
So for example:
Service based S Corp.
Gross Income: $300,000
Wages (W-2 Paid): $50,000
Net Income: $150,000
In this scenario:
- The 50% wage limitation does not apply because the net income of the business is $150,000 (less than $250,000 single / $500,000 married)
- No investment items to exclude from ABI
- Taxable income would be $200,000 ($150,000 net income + $50,000 wages)
The deduction would be 17.4% x $200,000.
Special Interest Provisions
- Oil & gas company tax rates. Oil and gas firms can take advantage of lower tax rates on pass-through businesses (provision added by Sen. John Cornyn (R-Texas), who received more than a million dollars in contributions from oil/gas in 2013.
- Drilling in the Arctic. The Arctic National Wildlife Refuge will be open to drilling (added by Sen. Lisa Murkowski (R-Alaska).
- Car dealer floor price financing. Sen. Rand Paul (R-Kentucky) insisted that car dealers receive 100 percent deduction on “motor vehicle floor price financing.” This refers to the interest that car dealers pay on inventory / cars that sit on their lots.
- Sinai Peninsula Armed Forces. Significant provisions are made for any member of the U.S. Armed Forces located in the Sinai Peninsula subject to “hostile fire or imminent danger.” They will receive a major tax break enjoyed by military personnel serving in a combat zone.
- Small craft breweries. The new senate tax bill cuts taxes on beer produced in the U.S. by small breweries, from $7 for the first 60,000 barrels down to $3.50; and from $18 on the first 6 million barrels, down to $16 per barrel.
- Citrus growers. Certain citrus growers growing citrus produce in certain areas affected by national disasters are given tax breaks.
Sole Proprietors. Consider incorporating your business activities into a C Corp, LLC, or S Corp. to take advantage the ability to deduct business expenses in categories that are being phased out.
S Corps. and LLCs. Consider the possibility to conversion into C Corp status, in the event the deduction percentages offered by the new tax plan are lower than your business’s current expense-to-income ratios.
Tiered Business Structures. For businesses that have excessive deductions that are beyond what the new tax bill will permit you to deduct, mult-tiered business structures might be necessary.
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