Breaking down the Tax Cuts & Jobs Act

Are you ready for tax reform?

Thanks to the recently passed Tax Cuts & Jobs Act (TCJA), the tax rate for incorporated aggregate businesses will be reduced from 35 percent to 21 percent for the 2018 tax year and thereafter. And, although the business tax cuts are, for the most part, permanent, the tax cuts for individuals are temporary, expiring in 2026.

Unfortunately, while regular C corporations will be taxed at a flat 21 percent tax rate, the majority of small businesses operating as pass-through entities such as partnerships, limited liability companies, S corporations and sole proprietorships, will face new personal tax rates higher than the corporate tax rate.

Pass-through businesses

Pass-through businesses pass their income to their owners who pay tax at the individual rate. The TCJA created a 20 percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by aggregate producers operating as pass-through businesses.

All businesses under the income thresholds can take advantage of the 20 percent deduction. For pass-through income above these new levels, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income.

The TCJA created the 20 percent deduction but only for “business profits,” in essence, limiting the owners’ top effective marginal tax rate to no more than 29.6 percent. Thus, that 20 percent deduction applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner. “Reasonable” compensation had not been defined as of press time.

The corporate alternative minimum tax

Too many deductions and too many otherwise legitimate tax “preferences” shouldn’t mean escaping taxes, at least according to our lawmakers.

Long ago, lawmakers created a unique 20 percent tax rate as part of a parallel system that limited tax benefits to prevent large-scale tax avoidance. Under this system, incorporated businesses were required to calculate both their ordinary tax and the Alternative Minimum Tax (AMT), paying whichever was higher.

Fortunately, the corporate AMT has been eliminated, lowering taxes and eliminating the confusion and uncertainty that surrounded it in the past.

Cost recovery – increased expensing

Unlike in past years when aggregate businesses were required to claim depreciation, spreading the recovery of their equipment costs over several years, many will fully and immediately deduct the cost of certain equipment. What’s more, this provision was made retroactive to Sept. 27, 2017.

Of course, the faster write-off of equipment costs is only temporary. It is at the 100 percent level for expenditures between Sept. 27, 2017, and Jan. 1, 2023. After 2023 and before 2025, the amount deductible drops to 60 percent with a further decrease to 40 percent after 2025 and to 20 percent after 2026. On Jan. 1, 2027, the equipment cost write-off disappears.

Section 179

The differences between bonus depreciation and the tax law’s Section 179, first-year expensing allowance, has narrowed with both offering 100 percent write-offs for new and used property. The immediate write-off, or “expensing” of capital assets under Section 179, remains appealing because, unlike so-called “bonus” depreciation, the use of equipment doesn’t have to begin with the crushed stone, sand or gravel business.

The bottom line: Section 179 allows up to $1 million (up from $500,000 in 2017) of expenditures for business equipment and property to be treated as an expense and immediately deducted. The ceiling after which the Section 179 expensing allowance must be reduced dollar for dollar has also increased from $2 million to $2.5 million.

Interest expenses

In the past, the tax laws have protected the ability of small businesses to write off the interest on loans. In an attempt to “level the playing field” between businesses that capitalize through equity and those that borrow, the TCJA has capped the interest deduction to 30 percent of the adjusted taxable income of the aggregate business.

Exceptions exist for small businesses to protect their ability to write off the interest on loans that help them start or expand a business, hire workers and increase paychecks.

Like-kind exchanges

The tax law’s Section 1031 governing like-kind exchanges currently allows aggregate producers to defer the tax bill on the built-in gains in property by exchanging it for similar property.

Although more a strategy for deferring a tax bill when business assets are lost, sold, abandoned or otherwise disposed of, with multiple exchanges it is possible for gains to be deferred for decades, ultimately escaping taxation entirely.

Under the TCJA, like-kind exchanges will be limited to so-called “real” property, but not for real property held primarily for sale. The provision redefines like-kind exchanges and includes language that would limit Section 1031 exchanges to exchanges of like-kind “real” property. This ensures real estate investors maintain the benefit of deferring capital gains realized on the sale of property.

Leases

Despite largely ignoring leasing, the massive reforms under the TCJA leases, in many cases, remain far more favorable than a loan for acquiring equipment.

Under new U.S. accounting rules, an aggregate business with an operating lease will find the capitalized asset cost is lower when compared to a loan or cash purchase. The reason? Operating leases reflect only the present value of the rents and, as a result, it is still partially off-balance sheet.

While leases remain off-balance sheet transactions, newly adopted international accounting standards will soon require many leases to be reported on an aggregate operation’s balance sheets as a front-end-loaded expense. Surprisingly, however, the result under both standards is that leasing – compared with borrowing to purchase – will be more favorably reflected on many operations’ books.

An aggregate business can, of course, continue to deduct the cost of leased property, and the tax benefits inherent in tax-advantaged leases will get passed along to the lessee through lower pricing. Lessees will also enjoy lower tax rates.

Auto expense

When it comes to cars and light trucks used in an aggregate operation, new limits on the write-off for the cost of so-called luxury automobiles and personal use property were included in the TCJA.

For passenger automobiles and light trucks placed in service after Dec. 31, 2017, where the additional first-year depreciation deduction is not claimed, the maximum amount of allowable depreciation is increased to $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year and $5,760 for the fourth and later years in the recovery period.

For passenger automobiles placed in service after 2018, these dollar limits are indexed for inflation. And for those eligible for bonus first-year depreciation, the maximum first-year depreciation allowance remains at $8,000.

Small business accounting method 
and simplification

Simplifying the rules governing the method of accounting that must be used for tax purposes is a welcome option. Businesses with average annual gross income of less than $25 million may now use the simple cash-basis accounting method.

Under this provision, the current $5 million threshold for corporations and those partnerships with a corporate partner is increased to $25 million, and the requirement that such businesses satisfy the $25 million limits for all prior years has been repealed. Also, under the new law, the average gross receipts test will now be indexed to inflation.

With the cash method of accounting, an aggregate producer may account for inventory as non-incidental materials and supplies. Or, as an alternative, a business with inventories using the cash method of accounting and qualifies would be able to account for its inventories using the method of accounting reflected on its financial statements or its books and records.

NOLs lose

One of the benefits of net operating losses (NOLs) was the fact that they could be carried back to more prosperous years to create a refund of taxes paid in those earlier years, providing an immediate infusion of badly needed cash. Today, the NOL deduction has been severely limited.

The write-off is now limited to 80 percent of taxable income and only in special cases will an NOL carryback be permitted. There is no limit on how far forward NOLs may be carried.

And much more

Obviously, the massive TCJA contains many more changes, including immediate relief from the so-called “death tax” by doubling the estate tax exemption amount; S corporations attempting to convert to regular C corporations will face new rules; Section 199, the deduction for so-called “domestic production activities,” has been repealed; and partnerships will no longer terminate upon the death or exit of a partner.

According to our lawmakers, the TCJA modernizes our international tax systems, making it easier and far less costly for U.S. businesses to bring home foreign earnings. The international provisions of the JCTA also prevent U.S. jobs, headquarters and research from moving overseas by eliminating incentives.

All in all, however, the Tax Cuts & Jobs Act appears to favor businesses over individuals with longer-lived tax savings