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By: Clifton Teague, CPA – Shareholder Doeren Mayhew
The Tax Cuts and Jobs Act was signed into law in December 2017, making it one of the most significant revisions to the Internal Revenue Code in more than 30 years. A tax reform of this magnitude will have broad implications on businesses, so we’ve outlined 19 key changes impacting them under the new tax law:
Generally, a taxpayer’s deductible QBI is the lesser of 20 percent of the QBI or the wage limitation. The wage limitation is 50 percent of the Form W-2 wage expense related to the business. Taxpayers then combines the deductible QBI from each business and applies an overall limitation equal to 20 percent of taxable income computed without net capital gains (and other less common adjustments). The wage limitation does not apply to taxpayers with taxable incomes below $315,000 (MFJ) and is phased-out for incomes between $315,000 and $415,000.
An alternative wage limitation is available for capital intensive businesses, which is 25 percent of wages plus 2.5 percent of the cost basis of depreciable assets. This excludes older assets as an asset can only be included in the computation if its depreciable period has not ended. The depreciable period is the lesser of 10 years or its tax depreciation recovery period (as determined in IRC Section 168(c)). Again, this limitation applies separately to each activity to determine the deductible QBI.
If a loss results from combining the QBI of each activity, then there is no allowed deduction. Further, the combined loss is included as an activity in the QBI deduction computation for the following year (again clarification is needed, but it appears that the combined loss is treated as a separate activity in the following year).
QBI generally does not include portfolio income/loss amounts and is reduced by employee wages, reasonable wages paid to the taxpayer, payments to partners for services rendered, and other guaranteed payments to partners. The impact of the “wage” component into this computation appears to create disparity between sole proprietorships, S corporations and partnerships. For example, guaranteed payments to partners reduce both the QBI amount as well as the 50 percent of wage limitation; a payment of salary to an S Corporation shareholder reduces QBI but is included in the wage limitation. This disparity may be corrected in future technical corrections made to the Tax Act.
The above rules are actually more complicated than presented above, but those complications should be narrowly applicable to taxpayers.
2. Tax Rate Reduction for Corporate Businesses: The new corporate tax rate has been reduced to 21 percent, plus Alternative Minimum Tax (AMT) has been eliminated. Businesses with AMT credit carryovers may offset 100 percent of their regular corporate income tax in years 2018 through 2020. For those years, corporations may also obtain a refund for 50 percent of the excess credit in each of those years. Any remaining credit will be refunded in 2021.
3. S Corporation Conversion: S corporations that convert to C status during the period Dec. 22, 2016, through Dec. 22, 2018, have six years to distribute their cumulative S Corporation earnings tax free. This provides taxpayer’s with an opportunity to replace capital invested at individual income tax rates with lower-taxed corporate equity by distributing prospective corporate earnings tax-free to the extent of the S corporation’s Accumulated Adjustments Account (AAA) balance.
4. Excess Business Losses: For individual taxpayers, aggregate losses from business activities (including flow-through losses) will be limited to $500,000 for MFJ. Excess losses will be considered a net operating loss and be carried forward subject to the new NOL limitations.
5. Net Operating Losses: New net operating losses will be limited to 80 percent of taxable income and cannot be carried back. However, they can be carried forward indefinitely.
6. Cash Method of Accounting: The cash method of accounting can now be used by both pass-through and C corporation taxpayers whose prior three-year gross receipts average is under $25 million. The new law reverses certain specific prohibitions and increases the prior overall ceiling of $5 million. For businesses with sales in excess of $25 million, pass-through entities that are not required to account for inventories (basically, service entities) as well as personal service corporations can continue to use the cash method of accounting. As C corporations having sales in excess of the $25 million ceiling will continue to be prohibited from using the cash method, there remains a benefit for larger service providers to use a pass-through status. Businesses must apply for an accounting method change to adopt the cash method.
The accounting method change will allow the taxpayer to currently deduct the excess of its accrued revenue over accrued expenses and payables.
7. Inventory Accounting: Businesses whose prior three-year gross receipts average under $25 million may now characterize inventories as materials and supplies. Capitalization rules for materials and supplies are contained in Treasury Regulation Section 1.162-3 for which IRS Notice 2015-82 provides that the de-minimis safe harbor for capitalization is $2,500 (per item or invoice). Materials and supplies not capitalized can be currently expensed. To apply this provision to inventory purchases, businesses must apply for an accounting method change. The accounting method change will allow the taxpayer to currently deduct capitalized inventory in excess of the Section 1.162-3 capitalization requirements. Please note, for taxpayers with audited financial statements, the $2,500 is increased to $5,000.
8. Uniform Capitalization of Inventory: Section 263A provisions generally capitalize indirect costs related to purchasing and carrying inventory not captured by financial accounting. Businesses whose prior three-year gross receipts average under $25 million are now exempt from applying IRC Section 263A. The law increased the $10 million ceiling to $25 million, but made no changes to the underlying IRC Section 263A provisions. To apply this provision to inventory purchases, businesses must apply for an accounting method change. The method change will allow the taxpayer to currently deduct its cumulative prior-year tax adjustments.
9. Long-term Construction Contracts: Businesses whose prior three-year gross receipts average under $25 million may now use the completed contract method for recognizing revenue for construction contracts completed within two years. The law increases the prior overall ceiling of $5 million and applies to both pass-through entities and corporations.
Taxpayers wishing to apply the completed contract method may do so using a cut-off method for contracts entered after 2017. To change to the completed contract method, businesses must apply for an accounting method change; however, there is no benefit for contracts started before 2018. Please note, there are rules that may provide for a beneficial determination as to when a contract began.
10. Bonus Depreciation: Businesses can now expense 100 percent (previously 50 percent) of acquisition costs of most assets acquired after Sept. 27, 2017, and before Jan. 1, 2023 (the 100 percent deduction is phased-out from 2013 through 2016). Previously, the depreciation deduction applied only to new property, but it now includes to new and used property.
The new law changes which business assets are subject to the bonus depreciation deduction. However, it made no change to the 2015 definition of qualified improvement property that included improvements to the interiors of nonresidential buildings, so long as such improvements were made after the building was placed in service and did not enlarge the building, improve its structural integrity, or include expenditures for elevators and escalators.
Applying bonus depreciation provisions will not require an accounting method change, but these rules apply by default and an election to omit the benefit from a return must be made. Omitting bonus depreciation without an election risks losing this tax deduction.
Now that new bonus depreciation rules apply to used property and has an effective date of Sept. 28, 2017, businesses should apply additional diligence when preparing 2017 income tax returns.
11. Section 179 Expensing: Businesses can now annually expense up to $1 million of business property it places in service after 2017. The intent of Section 179 is to provide an additional benefit to small taxpayers, so the deduction is phased-out between $2.5 million and $3.5 million.
Like the new bonus depreciation rules, Section 179 expensing applies to both new and used property. However, Section 179 now applies to certain exterior improvements to real estate for which bonus depreciation is not allowed (specifically, roofs, A/C, heating, ventilation, alarms and security systems). Given that Section 179 can be phased out as a result of other asset additions for which bonus depreciation can be taken, businesses should plan the timing of asset additions that include the above assets.
12. Depreciation of Automobiles: The automobile depreciation deduction has been increased for assets placed in service after 2017. This allows a $10,000 deduction the first year and an additional $37,000 of deductions in years two through five. Expensing options for heavy SUV and pick-up purchases are not impacted, and they can be recovered using the new 100 percent bonus depreciation allowance (heavy SUV’s and pickups will have a gross vehicle weight in excess of 6,000 pounds).
13. Meals and Entertainment: Beginning in 2018, entertainment expenditures are no longer deductible. Deductions for meals provided by the employer for its own convenience (e.g., overtime, cafeteria and training) is now limited to 50 percent of the expenditure until 2025, at which time no deduction will be allowed.
A full deduction is still allowed for recreational and social events where employees are the primary beneficiary (e.g., holiday parties and employee outings). An employer’s best practice would be to break out trial balance accounts and modify expense reporting forms by:
14. Interest Expense: Business interest expense will be limited to 30 percent of taxable income, plus interest income and interest on floor plan financing. The floor plan financing exception is specifically limited to interest on motor vehicles held in inventory. Small businesses (the recurring $25 million gross receipts) will be exempt from the limitation. Real estate businesses can also elect out of the interest expense limitation, but it will impact their recovery method on qualified improvement property.
The real estate business exemption applies to business activities in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerages. For businesses in real estate activities, the Act is more lenient than proposals that would have allowed either depreciation on debt financed property or an interest deduction on debt financed property.
15. Qualified Improvement Property: After technical amendments, the Tax Act is expected to allow improvements to the interior of a building to be recovered over a 10-year life, unless the business has elected out of applying interest expense limitations using the real estate business exception. The recovery period for electing real estate business taxpayers will be 20 years.
The real estate business exception will apply to taxpayer activities in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerages. The new qualified improvement property that generally covers improvements to the interior of a commercial building replaces the categories for qualified leasehold property, qualified restaurant property and qualified retail improvement property.
16. Domestic Production Deduction: The 9 percent special deduction for production activities has been eliminated beginning in 2018.
17. Carried and Profits Interests: Partnership interests granted to employees for services remain capital assets, but they must now be held for three years to receive beneficial long-term capital gains rates from either the sale of the interest or the partnerships underlying assets. The new three-year requirement applies to investment partnerships (commodities, derivatives, investment real estate, etc.), and the rules will not impact partnerships with business operations.
18. Self-Created Assets: Gains from self-created patents, inventions, models or designs, or secret formulae or processes is recognized as ordinary income under the Tax Act, but it does not include customer lists and goodwill as specified assets. However, the inclusion of models, designs and processes provides the service the opportunity to allocate a portion of the proceeds from a business sale to items that will generate ordinary gains.
Taxpayers selling a business should document the allocation of purchase price between intangible assets starting in 2018. Intangibles related to goodwill, customers, trademarks, workforce and suppliers should still obtain capital gain treatment.
19. Research Expenditures: Beginning in 2022, businesses will be required to amortize research expenditures over a five-year period. Please note, the Tax Act refers to IRC Section 174 expenditures, which has a broader application than the expenditures included in a R&D credit computation. Section 174 includes software development activities as well as some software implementation expenditures. Given the reference to Section 174, claiming research credits should not impact applying the capitalization requirement.
Doeren Mayhew’s tax advisors continue reading through the new legislation to interpret its impact on businesses. For assistance navigating the new tax law, contact us today.
Clifton Teague brings more than 25 years’ experience providing consultative tax services in his role as shareholder at Doeren Mayhew. He is based in the firm’s Houston office and can be reached at 713.860.0271 or at teague@doeren.com.
For more articles related to tax reform, visit Doeren Mayhew’s Tax Reform Resource Center. Additional articles related to tax compliance and planning can be viewed here.
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