Tax Reform Includes Tax Breaks for Businesses
The Tax Cuts and Jobs Act (TCJA), which was signed into law Dec. 22, contains a treasure trove of tax breaks for businesses. Overall, most companies and business owners will come out ahead under the new tax law, but some tax breaks were eliminated or reduced to make room for other beneficial revisions. Here are the most important changes in the new law that will affect businesses and their owners.
New 21 percent corporate tax rate
Under pre-TCJA law, C corporations paid graduated federal income tax rates of 15 percent on taxable income of $0 to $50,000; 25 percent on taxable income of $50,001 to $75,000; 34 percent on taxable income of $75,001 to $10 million; and 35 percent on taxable income over $10 million. Personal service corporations (PSCs) paid a flat 35 percent rate.
For tax years beginning in 2018, the TCJA establishes a flat 21 percent corporate rate, and that rate also applies to PSCs.
Reduced corporate dividends deduction
Under pre-TCJA law, C corporations that received dividends from other corporations were entitled to partially deduct those dividends. If the corporation owned at least 20 percent of the stock of another corporation, an 80 percent deduction applied. Otherwise, the deduction was 70 percent of dividends received.
For tax years beginning in 2018, the TCJA reduces the 80 percent deduction to 65 percent and the 70 percent deduction to 50 percent. These reductions are part of the price businesses pay for the new 21 percent corporate rate.
Corporate alternative minimum tax repealed
Prior to the TCJA, the corporate alternative minimum tax (AMT) was imposed at a 20 percent rate. However, corporations with average annual gross receipts of less than $7.5 million for the preceding three tax years were exempt. For tax years beginning in 2018, the new law repeals the corporate AMT. For corporations that paid the corporate AMT in earlier years, an AMT credit was allowed under prior law. The new law allows corporations to fully use their AMT credit carryovers in their 2018-21 tax years.
New deduction for pass-through businesses
Under prior law, net taxable income from pass-through business entities (such as sole proprietorships, partnerships, S corporations and LLCs that are treated as sole proprietorships or as partnerships for tax purposes) was simply passed through to owners. It was then taxed at the owners’ standard rates. In other words, no special treatment applied to pass-through income recognized by business owners.
For tax years beginning in 2018, the TCJA establishes a new deduction based on a non-corporate owner’s qualified business income (QBI). This new tax break is available to individuals, estates and trusts that own interests in pass-through business entities. The deduction generally equals 20 percent of QBI, subject to restrictions that can apply at higher income levels.
QBI is generally defined as the net of qualified items of income, gain, deduction and loss from any qualified business of the non-corporate owner. For this purpose, qualified items are income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.
The QBI deduction isn’t allowed in calculating the non-corporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction.
W-2 wage limitation
For pass-through entities other than sole proprietorships, the QBI deduction generally can’t exceed the greater of the non-corporate owner’s share of:
- 50 percent of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25 percent of W-2 wages plus 2.5 percent of the cost of qualified property.
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of the year’s end and used by the business at any point during the tax year for the production of qualified business income.
Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Above those income levels, the W-2 wage limitation is phased in over a $50,000 range ($100,000 range for joint filers).
Service business limitation
Finally, the QBI deduction generally isn’t available for income from specified service businesses (such as most professional practices other than engineering and architecture and businesses that involve investment-type services such as brokerage and investment advisory services). Under an exception, the service business limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Above those income levels, the service business limitation is phased in over a $50,000 phase-in range ($100,000 range for joint filers).
The W-2 wage limitation and the service business limitation don’t apply if your taxable income is under the applicable threshold. In that case, you should qualify for the full 20 percent QBI deduction.
New limits on business interest deductions
Subject to some restrictions and exceptions, prior law stated that interest paid or accrued by a business generally is fully deductible. Under the TCJA, affected corporate and non-corporate businesses generally can’t deduct interest expenses more than 30 percent of “adjusted taxable income,” starting with tax years in 2018. For S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, this limit is applied at the entity level rather than at the owner level.
For tax years beginning in 2018 through 2021, adjusted taxable income is calculated by adding back allowable deductions for depreciation, amortization and depletion. After that, these amounts aren’t added back in calculating adjusted taxable income.
Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that cannot be deducted in the current year can generally be carried forward indefinitely.
Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years are exempt from the interest deduction limitation. Some other taxpayers are also exempt. For example, real property businesses that elect to use a slower depreciation method for their real property with a normal depreciation period of 10 years or more are exempt. Another exemption applies to interest expense from dealer floor plan financing (for example, financing by dealers to acquire motor vehicles, boats or farm machinery that will be sold or leased to customers).
Reduced or eliminated employer deductions for business-related meals and entertainment
Prior to the TCJA, taxpayers generally could deduct 50 percent of expenses for business-related meals and entertainment. Meals provided to an employee for the convenience of the employer on the employer’s business premises were 100 percent deductible by the employer and tax-free to the recipient employee. Various other employer-provided fringe benefits were also deductible by the employer and tax-free to the recipient employee.
Under the new law, for amounts paid or incurred after Dec. 31, 2017, deductions for business-related entertainment expenses are disallowed. Meal expenses incurred while traveling on business are still 50 percent deductible, but the 50 percent disallowance rule will now also apply to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises will be nondeductible.
Changes to some employee fringe benefits
The new law disallows employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety.
It also eliminates employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking allowances, mass transit passes and van pooling), but those benefits are still tax-free to recipient employees.
Foreign tax provisions
The TCJA includes a bevy of changes that will affect taxpayers who conduct foreign operations. In conjunction with the reduced corporate tax rate, the changes are intended to encourage multinational companies to conduct more operations in the United States, with the resulting increased investments and job creation in this country.
Here are some of the other business-related changes in the TCJA:
- For business net operating losses (NOLs) that arise in tax years ending after Dec. 31, 2017, the maximum amount of taxable income that can be offset with NOL deductions is generally reduced from 100 percent to 80 percent. In addition, NOLs incurred in those years can no longer be carried back to an earlier tax year (except for certain farming losses). Affected NOLs can be carried forward indefinitely.
- More generous business asset expensing and depreciation tax breaks are available. The maximum Section 179 deduction increases to $1 million, and the phaseout threshold amount is increased to $2.5 million (from $510,000 and $2.03 million respectively). There are also much better first-year bonus depreciation rules.
- The Section 199 deduction, also commonly referred to as the domestic production activities deduction or manufacturers’ deduction, is eliminated for tax years beginning after Dec. 31, 2017, for noncorporate taxpayers and for tax years beginning after Dec. 31, 2018, for C corporation taxpayers.
- A new limitation applies to deductions for “excess business losses” incurred by noncorporate taxpayers. Losses that are disallowed under this rule are carried forward to later tax years and can then be deducted under the rules that apply to NOLs. This new limit kicks in after applying the passive activity loss rules. However, it applies to an individual taxpayer only if the excess business loss exceeds the applicable threshold.
- The eligibility rules to use the more-flexible cash method of accounting are liberalized to make them available to many more medium-size businesses. Also, eligible businesses are excused from the chore of doing inventory accounting for tax purposes.
- The Section 1031 rules that allow tax-deferred exchanges of appreciated like-kind property is allowed only for real estate for exchanges completed after Dec. 31, 2017. Beginning in 2018, there are no more like-kind exchanges for personal property assets. However, the prior-law rules still apply if one leg of an exchange has been completed as of Dec. 31, 2017, but one leg remains open on that date.
- Faster depreciation is allowed for eligible farming assets.
- Compensation deductions for amounts paid to principal executive officers generally cannot exceed $1 million per year, subject to a transition rule for amounts paid under binding contracts that were in effect as of Nov. 2, 2017.
- Specified R&D expenses must be capitalized and amortized over five years, or 15 years if the R&D is conducted outside the United States instead of being deducted currently. This begins with tax years beginning after Dec. 31, 2021.
The TCJA is the largest overhaul of the tax code in more than 30 years, and we’ve covered only the highlights of the business-related tax provisions here. Please contact your tax advisor if you have questions about how they may affect your business.
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