Most of the changes enacted by the Tax Cuts and Jobs Act took effect in tax year 2018. So the current tax-filing season is the first season in which businesses will file their returns based on the new law.
Following is a look at three tax reform provisions that are likely to have the biggest impact on many businesses this tax-filing season.
Lower Corporate Tax Rate and QBI Deduction
The centerpiece of corporate tax reform was a permanent reduction of the corporate tax rate, which was lowered from a top rate of 35 percent to a flat rate of 21 percent . In addition, the 20 percent corporate Alternative Minimum Tax (AMT) was repealed.
However, these lower rates only apply to C corporations, not pass-through entities like S corps, partnerships, and LLCs, where income flows through the business directly to the owner’s personal return. To help these businesses benefit from tax reform, the law includes a new 20 percent deduction for qualified business income (QBI) under Internal Revenue Code (IRC) Section 199A.
To claim the deduction, pass-through business owners will subtract 20 percent of QBI from their total income. This effectively lowers the top tax rate for pass-through entities from 39.6 percent before tax reform to 29.6 percent.
The legislation placed limits on the new deduction to prevent high-earning professional service providers (like doctors and lawyers) and owners of some service businesses from claiming the deduction for what is essentially their own labor income. The deduction will phase out for these owners once their taxable income exceeds $160,725 for single taxpayers and $321,400 for married taxpayers filing jointly in 2019.
For other types of businesses, the deduction will be reduced or eliminated if it exceeds 50 percent of W-2 wages paid, or 25 percent of wages paid plus 2.5 percent of the business’s tangible depreciable property.
Bonus Depreciation Expanded
Another beneficial provision of tax reform for businesses is the expansion of first-year bonus depreciation under IRC Section 168(k). Businesses can now immediately expense 100 percent of the cost of qualifying assets placed in service between September 27, 2017 and December 31, 2022.
Doubling the amount of asset purchases that can be depreciated and expensed immediately should help strengthen the economy and job creation by accelerating business investment and boosting productivity. A wide range of business assets qualifies for bonus depreciation, including machinery and equipment, office furniture, computers and computer software, business vehicles, and telecommunication systems.
Bonus depreciation will be reduced starting in 2023 by 20 percent per year until it is phased out completely in 2027. Therefore, you should encourage borrowers to plan future equipment acquisitions with this in mind.
The IRS recently issued proposed regulations that clarify some of the questions business owners had about bonus depreciation. For example, used property is now eligible for first-year bonus depreciation if it wasn’t used by the business or a predecessor at any time prior to its acquisition.
The regs also stipulate that property must be of a specified type to qualify for bonus depreciation. For example, it must be depreciated under the Modified Accelerated Cost Recovery System (MACRS) with a recovery period of 20 years or less. Also, qualified improvement property (QIP) no longer qualifies for first-year bonus depreciation if the property is acquired and placed in service after December 31, 2017.
Interest Deductions Capped
Businesses have long been able to deduct the interest they pay on loans, but tax reform placed limits on these deductions for mid-sized and larger firms. Companies with average gross receipts of $25 million or more for the preceding three years can only deduct net interest costs up to 30 percent of their earnings before interest, taxes, depreciation, and amortization (EBITDA).
In 2022, the 30 percent limit will apply to earnings before interest and taxes, not EBITDA. This will result in more businesses being impacted. Keep in mind that the provision doesn’t apply to floorplan interest assumed by car dealers or to farmers and many real estate firms.
No exception is made for debt that was assumed before tax reform was enacted, so this provision hit many borrowers immediately. It could have an impact on loan demand going forward, so it’s worth paying especially close attention.
Give us a call if you have questions about these or any other provisions of tax reform that could affect your borrowers.