March, 2018
Castle Wealth Advisors, LLC

In our last tax article, we discussed how the 2017 “Tax Cuts and Jobs Act” (TCJA) brought many changes to individual income tax filers. This article is an attempt to discuss a number of the tax changes to businesses.

 While the changes made in the TCJA were intended to help simplify the tax code and provide tax relief to business owners, only the later objective seems to have been met. Interpreting and using all this information will be challenging and will require new tax planning for most businesses.

We encourage you to use this information to speak with your tax accounting professional about how these changes apply to you and how you can best take advantage of those changes in your circumstances in the coming year. To begin, we have tried to tackle the most complicated change, the new tax deduction for pass-through entities.

Pass-through Entities – S Corporations, Limited Liability Companies, Partnerships, Sole Proprietorships, Real Estate investor (Schedule E), Trusts and Estates

Old Law - 2017 New Law - 2018 Planning Comments
Income earned by businesses was passed directly through to the owner(s) of the business. It was then taxed at each owner’s personal income tax level.

All pass-through income is still taxable at each owner’s personal income tax level.

There is now a new deduction of up to 20% of business income (referred to as (QBI) - Qualified Business Income). The deduction is referred to as the “Section 199A deduction”.

The chart and example scenarios listed below provide some general guidance on how the new law affects business owners in different ways.

Businesses that are considered part of the Specified Service Trade or Business (SSTB) category have greater phase-out of the deduction.

All owners of S corporations and other pass-through entities have access to this deduction. But, the deduction favors business owners that are not in “professional services” type industries.

For owners with pass-through businesses that can qualify for the new 199A deduction, it is important to review the deduction phase-out limits, the ratio of shareholder wages to total (QBI) income, and the other aspects of the new law to maximize the deduction.

Owners, partners, and stockholders that have a minority ownership, and/or have lower taxable income, may have a much better chance to take advantage of the 20% deduction. Because of this, there may be a significant incentive for family-owned businesses. If the owners are selling to the next generation then dividing up (QBI) among two or more stockholders could be beneficial.

The deduction for section 199A is outlined as follows . . .

The determination of deductible amounts for each trade or business, is the amount determined under this paragraph with respect to any qualified trade or business is the lesser of - 

  1. 20% of tax payers qualified business income with respect to the qualified trade or business, or
  2. The greater of -

           i.  50% of the W-2 wages with respect to the qualified trade or business or,
           ii. The sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis
                immediately after acquisition of all qualified property. 

The deduction not only applies to the income that business owners earn from their pass-through companies, but can also be applied to other specific types of income that a business owner may have interest in including income from cooperative dividends, REITS and publicly traded partnerships. Our discussion will focus mainly on Qualified Business Income (QBI), and how it would apply to small business owners.

The following chart outlines the thresholds and how they apply to service businesses, such as healthcare, law, accounting, performing arts, consulting, financial services, and athletics. Non-service businesses would include all retail and wholesale companies, manufacturers, agriculture, and other industries that manufacture or sell products.

2018 Personal Taxable Income (TI) Thresholds Specified Service Businesses All other businesses
Less than $157,000 single/$315,000 married filing jointly. Generally eligible for the 20% deduction, not subject to the W-2 limit. Generally eligible for the 20% deduction, not subject to the W-2 limit.
Between $157,500 - $207,500 single/ $315,000 - $415,000 married filing jointly. Generally eligible for the 20% deduction; subject to income.
Phase-out and phase-in of W-2 limit.
Generally eligible for the 20% deduction subject to phase-in of W-2 limit.
More than $207,500 single/$415,000 married filing jointly. Not eligible for the 20% deduction. Generally eligible for the 20% deduction, subject to W-2 limit.

The following are examples to help illustrate the thresholds associated with the new pass-through deduction. Please keep in mind, the new law still has some ambiguity on certain definitions of income and business type. It could take several months for the IRS to provide guidance on these uncertain areas of the new tax law.

Here are some examples:

  • Scott owns a manufacturing company and has a net profit of $2,000,000 in 2018 and pays $500,000 in wages to his employees during the year. The stockholders would only be able to take the qualified business income deduction of $250,000 since 50% of total employee wages ($500,000 x 50% = $250,000), are less than 20% of the net income (QBI) of the business ($2,000,000 x 20% = $400,000).

        This creates another gray area because it seems that the additional calculation is triggered by the taxable income of each individual
        stockholder, but the calculation is based on the total profitability and wages paid by the company. For the owners that require this
        special calculation for exceeding the threshold, how is their portion of the lower deduction amount allocated?

  • Maxine makes $100,000 in net business income from her catering business, which is a sole proprietorship, but also deducts $5,000 of self-employment health insurance, $7,000 for self-employment taxes and $10,000 for a SEP IRA. These are not business deductions – they are adjustments on form 1040 to calculate adjusted gross income. Her deduction is the lesser of 20% of $100,000, (her net business income), or 20% of her taxable income which could be less (See Cathy below). This may change as we get more clarification from the IRS.
  • Cathy earns $100,000, but reports $80,000 of taxable income on her tax return due to other deductions such as her itemized deductions. Her section 199A deduction would be $16,000 because it is limited by the lesser of 20% of $100,000 or 20% of $80,000 which is her taxable income.
  • Kent owns three rentals with net incomes of $20,000 and $5,000, with one losing $8,000 annually. These are aggregated to be $17,000. He would deduct 20% of $17,000. 

        Kent has passive losses that are carried forward and are released because he now has net rental income, those passive losses are
        taken first. With using the same example above with $10,000 in passive loss carry forward, Kent’s deduction would equal
        $17,000 less $10,000 in passive loss which would equal 20% of $7,000 (which is $1,400).

  • Darren operates an on-line retail S corporation which pays $100,000 in W-2 wages and earns $400,000 in net qualified business income. Because his income exceeds the income limits, his deduction is limited to 50% of the W-2 or $50,000 which is less than 20% of $400,000.

        If Darren instead operates as a sole proprietor and earns $500,000, but does not pay any W-2 wages, his deduction is the lesser of
        50% of the W-2 wages (or $0 in this example) or 20% of the $500,000. If he paid out $200,000
 in wages and had $300,000 in net
        business income, his section 199A deduction would be the lesser of 50% of $200,000 or 20% of $300,000. In other words, he
        would deduct $60,000. He should probably consider creating an S corporation and pay out W-2 wages to maximize his section
        199A deduction. 

         If Darren instead operates as a specified service or consulting business, he would completely phase out of the section 199A
         deduction by exceeding the income limit of $207,500 for a single individual and $415,000 for a married individual.

  • Bruce is a single business owner and owns 100% of a retail hardware store which is organized as an S corporation. His business income is $190,000 in 2018. He also has $32,000 of itemized deductions bringing his taxable income down to $157,000. Since his total taxable income is less than the threshold exclusion which starts at $157,500, he qualifies for the full pass-through income deduction. The deduction is the lesser of 20% of his qualified business income (QBI) or 20% of his taxable income which would be 20% of $157,000 or $31,400.
  • Cindy is a single business owner and owns 100% of a retail flooring store which is organized as an S corporation. Her (QBI) is $400,000 in 2018. The company had $100,000 of W-2 wages paid that year. The business has very few fixed assets. In this case, the deduction is limited to 50% of the W-2 wages or $50,000 since the owner’s personal taxable income has exceeded the $207,500 maximum threshold. If Cindy had owned an accounting firm under the same circumstances, her deduction would have been totally phased out.

C Corporation Tax Rate

Old Law - 2017 New Law - 2018 Planning Comments
15%, 25%, 34%, and 35% rate brackets.   Flat 21% rate                  

C corporations that were attempting to keep their taxable income at or below the 15% rate will now be subject to
a 21% rate. Businesses that generate high income and may have many locations may consider establishing a new
C corporation to take advantage of both tax entities and find ways to allocate income to take advantage of lower
tax rates between the two. We are working on several planning techniques in this area.

C corporations still have many problems. For example, the stockholder’s basis does not increase as you leave profits
in the business. If you plan on selling the company and retiring in the next few years you would be subject to a corporate tax on selling the business, as well as a personal tax when you distribute the sales proceeds out of the company.

Net Operating Loss

Old Law - 2017 New Law - 2018 Planning Comments
Able to carry back a Net Operating Loss (NOL) (Active Income) up to two years.
NOL carryforward can be used up to twenty future years.
Cannot carry back a NOL to a previous tax year. NOL carryforward can be used into future years, indefinitely. When used in future years, the NOL can only be used up to 80% of pre-NOL taxable income.

If you have or anticipate carry over losses, be sure to plan out their use in the future.

Be careful to avoid the forfeit of losses if you anticipate selling your business in the future.

Depreciation - Section 179 Election

Old Law - 2017 New Law - 2018 Planning Comments
Allowed up to $510K of property and equipment to be expensed (depreciated) in a single year. The limit is reduced if the cost of the property is approximately $2M+.

Allows up to $1M of deprecation in a single year. The phaseout of the ability to take the deduction was raised to $2.5M+.

Expanded to include “furnish lodging” capital improvements for residential property.

Expanded to include certain capital improvements for commercial: roofing, HVAC, alarm, security.

Good for the buyer of a new company, or someone who is expanding. You can depreciate more assets at a faster pace.

Depreciation - Capital Improvement

Old Law - 2017 New Law - 2018 Planning Comments

15 year depreciation for leasehold, retail, and restaurant property improvements.

39 year depreciation for qualified improvement property (for everything else that isn’t lease, retail or restaurant).

No separate requirement for leasehold improvement property or restaurant property.

15 year depreciation for all of these categories of capital improvement.

Good for the buyer of a new retail store. You can depreciate more assets at a faster pace which will be important for future income tax planning.

Depreciation - Bonus - 100% of Qualified Business Assets (Section 168(k))

Old Law - 2017 New Law - 2018 Planning Comments

50% deprecation on qualified business assets.

Only new property could elect for the bonus depreciation.

100% deprecation on qualified business assets.

Used property can get the 100% depreciation.

Provides more flexibility on future depreciation.

Entertainment Expenses

Old Law - 2017 New Law - 2018 Planning Comments
Old law permits businesses to claim deductions for 50% of entertainment expenses directly related to the business. TCJA will limit these rules starting in 2018 by barring any deduction for “an activity generally considered to be entertainment, amusement, or recreation” (even if they directly relate to, or are associated with the business). Although the 50% deduction for food and beverage expenses associated with the business remains. Be careful on when and how these types of expenses can be taken.

 Like Kind Exchanges

Old Law - 2017 New Law - 2018 Planning Comments
1031 Exchange could be for real estate as well as other property held for investment. 1031 exchanges are now only for real estate (real property). The major change to section 1031 is the complete repeal of personal property exchanges. The new code section now refers exclusively to real estate assets.

 Business Interest Expense

Old Law - 2017 New Law - 2018 Planning Comments
All business interest expense was potentially deductible. Starting in tax year 2018, businesses will generally not be able to deduct business interest expenses, which is considered any interest paid or accrued on indebtedness properly allocable to a trade or business, exceeding the sum of the following:
          • Business interest income
          • 30% of the adjusted taxable income of the business
          • The floor-plan financing interest of the business

The new business interest expense limitation will not apply to businesses with average annual gross receipts (revenue) of $25 million dollars or less.
Note that the interest limitation applies to net interest expense, which means the business may use their annual interest income, if they have any, to offset their annual interest expense, before they apply the 30% restriction.

Impact on Farming and Agriculture - a few examples:

  • The new section 179 election will allow farmers to immediately write off capital purchases such as breeding stock, farm equipment and single purpose structures such as milking parlors, up to $1,000,000. The phase out on this expensing provision is set at $2.5 million.

  • Bonus depreciation will allow farmers to write off 100% of qualified property purchased after September 27, 2017 through December 2022. The new law expands bonus depreciation to include new and used property purchased or constructed and to plants bearing fruits and nuts.

  • Machinery and equipment (other than grain bins, fence, or other land improvement structure) will be able to be depreciated over five years as long as the original use of the asset begins with the taxpayer.

  • The federal estate tax exemption rates have doubled to $11.2 million per individual ($22.4 million for married couples) in 2018. This will help tremendously with the transition of agriculture businesses and farmland to the next generation in the family. This law sunsets in 2025.

  • A provision was added at the last minute to the new tax law which gives growers of crops a better deal at tax time if they sell their agricultural products to co-ops rather than other types of companies. This provision may be changed in the near future.

Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.