For most taxpayers, the 2017 Tax Cuts and Jobs Act (TCJA) should provide a welcome reduction to their tax bills. Taxpayers should see the act’s immediate impact on their tax bills as they work to finalize and file their 2018 tax returns.
Some of the new savings — such as rate decreases for individuals and corporations, increased standard deduction amounts, increased child tax credits, and so on — require little or no advance tax planning by taxpayers. However, other changes implemented by the Act require additional thought and advance planning to take full advantage of the act’s benefits. This article discusses bonus depreciation, the new pass-through entity deduction, and choice-of-entity considerations after the TCJA, three of the most significant items which businesses may utilize to take advantage of the act’s changes to the Internal Revenue Code (IRC).
Bonus depreciation, under Section 168(k) of the IRC, provides a 100 percent deduction for certain property that a taxpayer acquires and puts into use within its business. To qualify, the property generally must be tangible personal property, such as furniture and equipment. The TCJA modified the IRC to make bonus depreciation applicable to both new and used property (under prior law bonus depreciation was available only on new property). This 100 percent deduction, in conjunction with the deduction under Section 179 of the IRC (which covers substantially the same types of property as bonus depreciation, but with certain restrictions), provides taxpayers with an opportunity to acquire property necessary for their businesses and reap substantial tax benefits at the same time.
The TCJA also established new Section 199A of the IRC which, generally, provides a 20 percent deduction on qualified business income (QBI) of certain pass-through businesses (i.e., a sole proprietorship, partnership, or S corporation (but not a C corporation)).
At first, it seems too good to be true — is the IRS really having a 20 percent off sale? Not so fast – much like other provisions of the IRC, Section 199A has a host of restrictions that taxpayers must navigate to qualify for the deduction. For instance, QBI does not include active income such as wages or guaranteed payments to a partner in a partnership. Also, restrictions exist for taxpayers with taxable income of greater than $157,500 ($315,000 for joint returns) which reduces or eliminates the 20 percent deduction if certain wage and property limitations are not met. Finally, the statute does not allow a 20 percent deduction for taxpayers in certain service businesses (e.g., health care, legal, accounting, etc.) unless such taxpayers are under the threshold noted above. Assuming the foregoing restrictions can be met, though, the 20 percent deduction ultimately reduces the top tax rate on income of pass-through businesses to 29.6 percent.
Speaking of lower rates, the Act reduced the income tax rate applicable to C corporations to 21 percent from a former top tax rate of 35 percent. The primary drawback to operating as a C corporation is double taxation — one tax on corporate income and a separate tax on dividend income when shareholders extract capital from the corporation. Under prior law, with a corporate rate as high as 35 percent and a dividend tax that reached 23.8 percent (factoring in the 3.8 percent tax on net investment income under Section 1411 of the IRC), this double-tax system mostly eliminated the C corporation as a viable choice of entity for many businesses. Now, however, with a 21 percent income tax rate, the C corporation presents a viable option for business owners that plan to reinvest most of their profits back into the business (because shareholders will not pay the extra 23.8 percent tax until they begin taking dividends out of the corporation). The rate reduction also presents a tax-savings opportunity for businesses that pay their owners large salaries to reduce their C corporation’s tax burden.
In either situation, the rate reduction can, with proper planning, provide a business more after-tax dollars which can be used to grow its business. Whether the benefits of being a C corporation exceed the advantages that Section 199A offers depends on your particular business situation and certainly should be reviewed as significant tax benefits may be available.
These three features of the TCJA represent opportunities for business owners to strategically structure their businesses to expand in a tax-efficient manner.
The information is written by Attorney E. Conner McNair who is a tax attorney in the Mergers & Acquisitions Group of Friday, Eldredge & Clark, LLP. Conner focuses his practice on advising clients through mergers, acquisitions, divestitures and real estate transactions and providing advice and counsel regarding general corporate and partnership tax matters for small to mid-sized businesses.
This is not a substitute for legal advice and should be considered for general guidance only. For more information or if you have further questions, please contact one of our Mergers and Acquisitions Attorneys.