The Tax Cuts and Jobs Act, recently passed under the direction of President Trump was, without question, a significant and sweeping tax reform. It will have a substantial and lasting impact on many aspects of our economy and on individual taxpayers and businesses alike. This new tax code was intended to provide benefits for the middle-income class and the business owner as well as to make the United States more attractive to very large corporations. While its effectiveness (or lack thereof) remains largely to be seen, discussion of its potential impact is already widespread.
If you are a business owner, you may likely already be experiencing some of these impacts. Although you may not be able to calculate the precise impact of the reforms on your business until you sit down and review your financials with your tax team, a broad look at the changes and their likely implications can be helpful.
New Deduction for Pass-Through Businesses.
One of the most significant changes brought about by the Act is the new deduction applicable to pass-through businesses. Companies like S corporations, partnerships, and sole proprietorships are often referred to as pass-through businesses. This is so because their expenses and revenues are “passed through” to the owner’s personal tax returns at individual rates, as opposed to larger corporations like C-class corporations. Pass-through companies account for about 95% of U.S. businesses.
If you are a business owner, and particularly a small business owner, one of the changes in the bill that will likely have the most impact upon your business is the new deductible rate of 20% for all pass-through businesses. Thus, if a business’s annual income is $100,000 per year, for example, the IRS only taxes $80,0000 of it. Taking the deduction does not lower adjusted gross income nor is required to be itemized on a tax return. The 20% deduction is ultimately applied to either qualified business income or taxable income minus capital gains, whichever is lower.
So, although the reforms have eliminated previously used deductions such as the 199 deduction, the business interest deduction, and deductions for things like employee meals, entertainment, and transportation expenses, this new deduction is intended to serve as a broad and sweeping benefit to American small businesses by lowering the business’s taxable income. The reasoning is to allow the small business the opportunity to take the money saved and reinvest it into the business by buying new equipment, hiring new workers, or expanding operations.
It is important, however, to note that married individuals who own service-based businesses, like law and accounting firms, can only receive the 20% deduction if they make under $315,000 per year (or $157,500 if single).
Reduced Corporate Tax Rate
In addition to creating a new deduction for pass-through businesses, the Tax Cuts and Jobs Act also cut the corporate tax rate for larger C-corporations. A C-corp is a corporation that is a separate legal entity from its owners. A C-corp makes profits, is taxed separately, and can be held legally liability as an entity in and of itself. As distinguished from LLCs, partnerships, and/or sole proprietorships, C-corps are taxed both at the corporate level and then again at the personal income tax level if corporate income or payments are distributed to the shareholders of that company.
The act lowered the corporate tax rate from 35 to 21 percent. This is based upon the theory that, in doing so, the United States would be seen as a haven for larger corporations to establish headquarters and create economic growth.
The bill’s main event was cutting the corporate tax rate. By lowering the corporate tax rate from 35 to 21 percent, lawmakers aimed for the United States to be a place for larger corporations to set up shop and create economic growth. Certainly, lower tax rates are attractive for corporations because of profitability
In addition to the two large-scale changes mentioned above, it should also be noted that the new tax plan includes some other changes that will affect businesses as well. One of these is the ability to write off a larger portion of large equipment purchases up front, instead of depreciating them over a number of years. Prior to the new plan, businesses were only able to deduct up to $510,000 in equipment purchases. The new cap is now $1 million. In addition to increasing the percentage of value that is deductible, the new law also allows businesses to take the deduction over five years. Previously, the deduction was only eligible in the year the asset was placed in service.
The new tax plan also allows more companies to take advantage of using the cash method of accounting as opposed to the accrual method. By utilizing the cash method of accounting, revenue is recorded as soon as the payment is received from customers, and expenses are recorded as soon as they are paid to employees and suppliers. Under the accrual method, by contrast, revenue is recorded when earned and expenses are only recorded when consumed.
In a practical sense, the accrual method of accounting often means that business owners find themselves waiting until inventory is sold to deduce its cost, rather than being able to do so when the purchase is initially made. While manufacturing businesses are usually required to use the accrual method, the new tax plan raised the annual revenue threshold from $5 million to $25 million, which has drastically increased the number of businesses that qualify for an exemption from that rule.
Lastly, we would note that, through 2019, the new tax plan also creates a new credit for wages that are paid for family or medical leave. This portion of the plan is intended to encourage employers to pay when their employees need leave, which is normally a benefit that is difficult for small businesses to provide. Depending on the amount of wages paid out, the tax credit can range from 12.5% to 25%.
Contact an Attorney For Additional Questions
While this is a brief overview of some of the significant impacts anticipated as a result of the new tax reforms, there are, of course, many other provisions that may also impact your particular business. If you have specific questions regarding your business and how the reforms might affect it, it is always wise to consult with an attorney who is knowledgeable and experienced in tax law and who can advise you as to your unique circumstances.