As the Tax Cuts and Jobs Act enters its third month, we are finding the more layers we peel back, the more complex it becomes. As taxpayers learn more about the new law, there continues to be confusion for both consumers and businesses alike. My colleague Blake Harrison recently clarified some of the top misconceptions held by individuals. As a follow up to his article, here are five commonly held ideas about business tax reform and why they are not necessarily true:
1.The tax code was simplified.
- This is the largest overhaul of the tax code since 1986. The consequences of tax reform will take a long time for tax professionals and experts to fully appreciate.
- New regulations and case law will be developed over many years to fill in the gaps. The incorporation of these incremental changes will continue to add complexity to the tax code.
- Calculation of the 20% Qualified Business Income (QBI) deduction (discussed below) will substantially increase the required resources needed for pass-through businesses (and their owners) to comply with and take advantage of, the new law.
2. All pass-through entities should convert to a C-Corporation because of the lower corporate rate.
- At a high level, the 21% tax rate makes C-Corporations more competitive with pass-through entities from a tax standpoint, but the second layer of tax on corporate dividends, coupled with the lower overall individual tax rates on ordinary income, could still make pass-throughs a better option.
- By converting to a C-Corporation, you would miss out on the potential 20% top line deduction now available to pass-through owners with QBI. By converting to a C-Corporation, a potential future buyer could miss out on the valuable step-up in the basis of the company’s assets should there be an asset acquisition.
- Individual and business circumstances must be fully weighed prior to making any entity changes. Converting from a pass-through to a C-Corporation is a one-way street. Converting back could come at a significant tax cost (or create a new waiting period to avoid double taxation that includes corporate level taxes).
3. The 20% deduction on qualified business income means all non-corporate business owners will receive a 20% deduction on all business income.
- An owner of a S Corporation, partnership or sole proprietorship may take a deduction equal to the lesser 20% of its “combined qualified business income” earned in a trade or business up to certain limitations or the excess of taxable income minus the sum of any net capital gain.
- The deduction will be limited to either 50% of the business’ W-2 wages allocable to the owner or 20% of the business’ W-2 wages allocable to the owner plus 2.5% of the unadjusted basis of qualified property.
- Complications with the calculation are significant, but without question, only in certain circumstances will the calculation actually net a 20% deduction. In every circumstance, the calculation will increase the compliance cost with pass-through entity tax returns and their owners’ returns. Some of the issues include:
- The definition of a trade or business is not clarified in the code.
- There are multiple definitions (i.e. what is Qualified Business Income, allocable portion of wages, qualified property) each calculated separately.
- There are more nuances associated with the calculation depending on the nature of the business, type of assets held, etc.
- Certain service based businesses earning above a certain threshold aren’t even eligible for the deduction.
- To top it off, the deduction is cumulative at the individual level. Each individual will have to combine all of the pass-through businesses. If you own an interest in 100 pass-through entities that's 101 new calculations.
- This is a huge overhaul to the current pass-through taxation regime. The only certainty provided by this new deduction is that pass-through owners should check in with their tax accountant many times throughout 2018 to be sure they are maximizing the potential tax savings. An additional certainty is that a chunk of whatever savings are created will be used to pay tax accountants for compliance.
4. Meals are no longer deductible.
- Meals that were 50% deductible before the Act are still 50% deductible.
- Entertainment expenses are no longer subject to a 50% deduction and are now excluded as a deduction.
- Taxpayers who keep these expenses in the same account will want to think about separating prior to releasing their financial statements to their tax preparers.
5. The Alternative Minimum Tax has been repealed for all businesses.
- The alternative minimum tax has been repealed for C corporations but not individuals or pass-through entities.
- Some pass-through business income will still be subject to the AMT.
- The 20% QBI deduction discussed above should alleviate some of the AMT burdens on pass-through owners.
- Net Operating Loss deductions are limited to 90% of taxable income, similar to the previous
Understanding tax reform and how the changes will affect your business can be challenging, and inaccurate assumptions can make it even more confounding. Be sure you consult with a tax advisor who has deep expertise in the multifaceted law and all its nuances. Working with a professional who has extensive knowledge of the law will better allow your business take advantage of opportunities resulting from the changes. Investing in a high caliber tax advisor now can save you time and money in the long run.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.