Tax reform enacted at the end of 2017 included a number of issues that small businesses should be aware of to ensure the best tax outcome when filing their 2018 tax returns. These include new tax benefits but also the loss of some deductions that have been available for as long as many younger business owners can remember. Plus, there are still some unanswered questions related to the new tax law that need to be resolved.
Let’s start by looking at several of the new benefits and how they might be used to your advantage.
New Sec 199A Deduction – As part of tax reform Congress reduced the tax rate for C corporations to a flat 21%. To compensate for that significant rate reduction with other forms of businesses, Congress added the Sec 199A deduction, otherwise heralded as the 20% pass-through deduction, that allows taxpayers a deduction on their individual Form 1040 returns equal to 20% of the income from their sole proprietorships (Schedule C), farming activities (Schedule F), rentals (Schedule E), K-1 pass-through income from partnerships and S corporations, REIT dividends, and publicly traded partnerships. Such pass-through income is referred to as qualified business income (QBI). However, as with everything related, there are limitations and complications, and this deduction takes the prize for being the most complicated tax provision ever created.
Qualified Business Income - QBI is defined as the net amount of income, gains, deductions, and losses with respect to trades or businesses that are conducted within the United States. QBI, among other things, does not include capital gains or losses, interest income, dividends or payments in lieu of dividends, the trade or business of being an employee, reasonable compensation from an S corporation, or guaranteed payments from a partnership.
The pass-through deduction is not a business deduction, as it is deducted after a taxpayer’s adjusted gross income has been determined. It can be taken regardless of whether or not the taxpayer claims the standard deduction or itemizes deductions. Since it is not a business deduction, it does not affect the computation of self-employment tax. Where QBI is less than zero, it is treated as a loss from a qualified business on the next year’s taxes.
Threshold – When determining the 20% of QBI deduction for each entity, the deductible amount may be reduced, phased-out, or phased-in based on that year’s taxable income (without regard to the deduction itself). The thresholds for each limitation are $157,500 for individuals and $315,000 for joint filers. The maximum of any phase-out or phase-in is $50,000 more than the threshold for individuals and $100,000 more for joint filers, so the ranges top out at $207,500 for individuals and $415,000 for joint filers.
Specified Service Business – Special rules apply to specified service businesses, which are generally businesses that rely on the skill and reputation of the owners or employees. These include businesses focusing on health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and so on. This category specifically does not include engineering or architecture businesses and trades or businesses whose services consist of investment-type activities. For specified service businesses, if the taxable income is equal to or below the threshold, the deductible amount for that entity is the full 20% of QBI. When the taxable income is above the threshold, the deduction is pro rata phased out between the threshold and the cap. Thus, a specified service business entity has no deduction when the taxable income exceeds $207,500 for individuals or $415,000 for joint filers.
Wage Limit – Before learning how the deduction is determined for other business entities, one must understand the wage limit and how it is determined. An entity’s deduction is limited to the lesser of 25% of QBI or the wage limit. The wage limit is the greater of
Other Businesses – Computing the deduction for other entities gets significantly more complicated depending upon the taxpayer’s taxable income. The computations fall into three categories:
Income Below the Threshold – The entity’s deductible amount is the full 20% of QBI.
Income Above the Threshold But Less Than the Cap – This is the most complicated computation because the wage limit is phased-in between the threshold and the cap; it only applies to a pro rata portion of the deduction.
Income Above the Cap – The deduction is equal to the lesser of the wage limit or 20% of QBI.
Example: A single taxpayer has a taxable income of $125,000. He runs a small car-repair business that has a net profit (QBI) of $100,000. Because his taxable income is below the threshold, his deduction for the business entity is $20,000 (20% of $100,000).
Example: A married taxpayer with a taxable income of $500,000 is a shareholder in an S corporation. The K-1 from the S corporation shows pass-through income (QBI) of $300,000. The taxpayer’s pro rata share of wages that were paid by the S corporation is $100,000, and the taxpayer’s pro rata share of the S corporation’s qualified business property is $75,000. These amounts are also provided by the S corporation on the K-1.
Because the taxable income is above the cap, the deduction for this business entity is the lesser of the wage limitation or 20% of the QBI. The wage limitation is the greater of $50,000 (50% of the $100,000 in wages) or $26,875 (25% of the $100,000 in wages plus 2.5% of the $75,000 in qualified business property). Thus, the wage limitation is $50,000. This is less than $60,000 (20% of the $300,000 in QBI), so the taxpayer’s deduction for this business is limited to $50,000.
Aggregating Amounts – Once the deductions have been determined for each of a taxpayer’s business entities, they are combined in a rather complicated computation. First, the total deduction is added to 20% of the taxpayer’s REIT dividends and all of the taxpayer’s publicly traded partnership income and cooperative dividends (after limitations). The final step is to compare this combined deduction amount to the taxpayer’s adjusted taxable income (i.e., taxable income minus capital gains); the lesser of the two becomes the actual deductible amount.
S Corporations – These provide a unique complication. The less compensation (wages) taken by a shareholder, the greater the pass-through income and the greater the QBI, which will produce a larger 199A deduction (20% of QBI). At the same time, reducing wages in favor of generating a larger 199A deduction will reduce the wage limit and, if the taxpayer’s taxable income is above the threshold, the 199A deduction will be restricted by the wage limitation. Thus, stockholders must be aware of and adjust for this conflicting issue, as well as keep in mind the requirement that shareholders working in the business should be paid a reasonable compensation.
Expensing and Retirement Plans – If a taxpayer’s taxable income is above the threshold, the taxpayer may be able to reduce taxable income to below the threshold and maximize the 199A deduction by taking advantage of the new liberal asset expensing allowances, increased auto depreciation rates, or deductible pension contributions. On the other hand, utilizing the increased expensing allowances will also reduce the QBI and thus reduce the 199A deduction itself.
As you can see, this deduction provides a great tax benefit for business owners, but it can be quite complicated and in many cases may require advance planning. If you have questions consult your tax advisor.
Bonus Depreciation – Under the old law, the bonus depreciation provision was being phased out and had been reduced to a 40% rate for 2018. Tax reform restored bonus depreciation to the full 100% for years 2018 through 2022, after which it again begins to phase out. This means you can literally write off the cost of most tangible assets with a depreciable life of 20 years or less in the year the asset is placed in service. In addition, under the old rules bonus depreciation was only allowed for new assets, but under tax reform 100% first-year depreciation applies to new or used business assets.
Whether to utilize bonus depreciation depends upon your need to reduce your current taxable income as opposed to spreading the deduction over the normal depreciable life of the property. Its impact on the new 199A deduction also needs to be considered.
Caution: There is an unanswered question related to whether or not the bonus depreciation applies to leasehold improvements, restaurant property, and retail property. Tax reform was to have designated these items as being 15-year life property qualifying for the bonus depreciation. However, due to a drafting error in the final bill, the 15-year recovery provision was not included in IRC Sec 168(e)(3)(E), which spells out which property is 15-year MACRS property.
This means that unless Congress passes a technical correction assigning the intended 15-year recovery period to qualified improvement property placed in service after 2017, this type of property will have a 39-year recovery period and will not qualify for the bonus depreciation. Concerned about this glitch, several industry associations have asked the IRS for clarification, stating it is causing a delay in some store and restaurant remodeling projects, as well as prompting some retailers to decline opportunities to purchase or lease new store locations that would require substantial improvements.
Sec 179 Expensing – Under prior law, a taxpayer could expense up to $510,000 of the cost of Section 179 property, with the deduction phasing out when the costs of eligible property exceed $2,030,000. Under tax reform, the deduction limit has been increased to $1 million, and the phase-out begins at $2.5 million.
Property eligible for this deduction is generally defined as tangible depreciable property, such as equipment, office furniture, computers, etc., but as part of tax reform, the definition of Sec 179 property has been modified to include:
Business Entertainment – Under the old law, when taxpayers established that an item was directly related to the active conduct of their trade or business, they could deduct 50% of the cost of business entertainment. Under tax reform, no deduction is allowed for entertainment, amusement or recreation activities, facilities, or membership dues relating to such activities or other social purposes. Meals provided to employees at the office or reimbursed for travel away from home are still deductible subject to the 50% limitation.
However, it is uncertain whether business meals where a businessperson takes a client or customer out for a meal will be classified as nondeductible entertainment or still as deductible. Until guidance is provided by the IRS, taxpayers are cautioned to retain the required documentation should meal expenses be allowed as a deduction.
Tax Deferred Exchanges – Under prior law, gain from the exchange of most business or investment property can be tax-deferred when the property is exchanged for like-kind property. Under tax reform, tax-deferred exchanges are only allowed for real property after 2017.
Under prior law, it was good tax strategy to trade in a business vehicle that would result in a gain, thus deferring the gain into the replacement vehicle and avoiding the tax on the gain. On the flipside, it was good practice to sell a vehicle if that sale would result in a loss and take advantage of the tax loss. Unfortunately, tax reform no longer allows tax-deferred exchanges for anything but real estate. This does away with the aforementioned strategies, and now all sales and trade-ins of business vehicles and equipment are treated as sales, with any gain being taxable and any loss being deductible.
Net Operating Loss (NOL) – Tax reform generally repealed carryback of NOLs arising after 2017. The carryforward period, which was previously limited to 20 years, is now indefinite, and for losses incurred in 2018 or later years, the loss deductible in any carryforward or carryback year is limited to 80% of that year’s taxable income (figured without the NOL deduction).
Vehicle Depreciation - The so-called “luxury auto” rules limit the annual deduction for depreciation. Tax reform substantially increased these limits providing much larger first and second-year deductions for more expensive vehicles. The table below displays the limits that apply to vehicles placed in service in 2017 and 2018 and shows the substantial increase for 2018. These rates will be inflation adjusted in subsequent years.
Tax reform also includes 100% bonus depreciation, which, at the election of the taxpayer, can be added to the first-year luxury auto rates (see the amounts for “first year with bonus” in the table below).
However, as mentioned earlier, it may not always be beneficial to claim an excessive write-off and, in the current year and future year, taxable incomes should be considered as well as the impact on the 199A deduction.
Excess Business Loss – Applicable to all businesses except C corporations, tax reform imposes a limit on business losses by creating what is termed as an “excess business loss.” An excess business deduction loss is the excess (if any) of the taxpayer’s aggregate trade or business deductions for the tax year that are attributable to trades or businesses of the taxpayer (determined without regard to whether or not the deductions are disallowed for that tax year) over the sum of:
(i) the taxpayer's aggregate gross income or gain for the tax year, which is attributable to those trades or businesses, plus
(ii) $250,000 (200% of that amount for a joint return; i.e., $500,000). This amount will be adjusted for inflation after 2018.
For partnerships and S corporations, the limit is figured at the partner or shareholder level.
Example: A single taxpayer in 2018 has business deductions of $500,000 from a Schedule C business. The taxpayer’s gross income from the business is $200,000. The deductible loss would have been $300,000 prior to the TCJA tax reform change (provided the business was not a passive activity). The excess business loss under TCJA tax reform is $50,000: $500,000 – ($200,000 + $250,000). Thus the taxpayer’s deductible business loss for 2018 is $250,000, and the excess business loss of $50,000 is treated as an NOL carried forward to the next year.
The foregoing only includes the major changes that affect small businesses, and there are numerous other details not covered. If you have questions or concerns about these new provisions, contact a five star reviewed tax consultant.
About Lee Reams, BSME, EA
Besides his role at ClientWhys as an educator and speaker to thousands of accountants nationwide, Lee manages a technical research service for a large group of tax accountants which sharpens his technical skills. Lee served on the Board of Blackline Systems, is a former Board of Director for the California Tax Education Council, is a Past President of the San Fernando Valley Chapter of Enrolled Agents, Member and Past Director for the California Society of Enrolled Agents.
