Ask a CPA: How the Recent Tax Reform Affects Small Businesses
Since Congress passed the new tax reform bill at the end of 2017, many business owners have been trying to determine just how the legislation will affect them going forward. We took a few of the top questions our clients are asking and posed them to Jason Newman, a CPA with RH2 CPAs.
First off, on a high level, is this reform going to make the lives of small business owners easier or harder?
Generally speaking, the tax reform isn’t going to necessarily impact the day to day operations of a small business owner, but it will provide them with some favorable deductions as a small business owner.
I’ve heard that owners of a pass-through entity can now deduct a certain percentage of their pass-through income. Why? What does that include?
The new deduction is available to taxpayers that are not corporations, and is based on pass-through income. In this case, pass-through income includes not only income from a partnership or S-corporation, but also income from any unincorporated trade or business operated by the taxpayer.
These taxpayers can deduct up to 20% of their qualified business income, subject to certain limitations. A few of the notable limitations include:
- Wages received as employees aren’t considered qualified business income.
- The deduction cannot exceed the sum of 50% of wages and 2.5% of the unadjusted basis of certain assets.
- The deduction for certain types of service businesses (including accountants, financial advisors, brokers, and lawyers to name a few) is, in addition to the ceiling above, phased out for taxpayers whose taxable income is above a certain amount ($315,000 for married couples filing jointly, $157,500 for all others).
Generally speaking, if you do not own a service business and you pay employees wages, this is going to be a huge benefit to you as owner of a pass-through business entity.
Is depreciation really going away?
No. The changes to depreciation are actually favorable, in that they raise the limits on what you can fully expense in the first year after purchase or acquisition of the asset under section 179, and expand bonus depreciation (which can allow expensing of up to 100% of the asset in the first year after purchase or acquisition). In fact, the depreciable asset may not even need to be brand new—it only needs to be new to the purchaser for the taxpayer to obtain these favorable deductions.
I understand small C-corporations may be able to use the cash method of accounting now. What are the benefits of switching over?
Correct. C-Corporations with less than $25 million of revenue can now utilize the cash basis of accounting. This may be favorable if collection of revenue for product sales or services typically lags behind payment of expenses (such as product costs or employee wages).
Under the accrual method, a company recognizes revenue when it sells a product is sold or renders a service, not when the customer makes a payment. This means a business can pay taxes on income it may not have yet received.
Under the cash method, however, the company recognizes expenses when it spends cash, and recognizes revenue when it receives cash. What this means is that if you typically spend cash to provide goods or services to customers before you receive payment from those customers, you will benefit by using the cash method. Since most small businesses pay employees (or pay for products) prior to invoicing and receiving cash, they would benefit by being cash basis, as they would have expenses (and a tax benefit) prior to having income. Practically speaking, this may allow businesses to (1) front load deductions for expenses by paying them early, and (2) delay paying tax on revenues until they actually receive cash. Combined, this effectively lowers taxable income and reduces the tax expense.
What about deducting certain business expenses, like fringe benefits to employees, entertainment and meal expenses, and business interest? What has changed?
The tax reform act generally caps the deduction for net business interest expenses at 30 percent of adjusted taxable income, among other changes. This cap did not exist prior to Congress passing the new act.
The act also eliminates the deduction for entertainment expenses, and further limits deductions for meal expenses. For example, office snacks or coffee may have been 100% deductible in the past, but now are likely to be subject to a 50% limitation on the deduction. The days of taking a client to a baseball game and expensing it as entertainment are now gone.
Fringe benefits, which were previously deductible by the employer but not taxable to the employee, are now taxable to the employee. For example, the cost of bus passes or parking must now be included on the employee’s W-2 and are subject to payroll expenses.
Are there other provisions of the new tax reform law that will impact small businesses that haven’t been getting much discussion?
Under the act, excess business losses of noncorporate taxpayers will not be allowed for tax years beginning after December 31, 2017, and before January 1, 2026. The result of this provision is that an individual taxpayer is limited to offsetting a maximum of $250,000 of business loss against their other income for the tax year. Any excess business loss above $250,000 is disallowed in the current year and treated as part of the taxpayer’s net operating loss (NOL) carryover to the following tax year. Noncorporate taxpayers must apply this rule after applying the passive activity loss rules. For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level.
What can business owners do in 2018 to maximize the positives of the new law, and minimize the negatives?
Reach out to your tax advisor now to implement a strategy to maximize the benefits and minimize the negatives of the tax reform act. A few examples:
- Do certain accounting elections, such as switching to the cash basis of accounting, need to be made?
- Consider upcoming capital expenditures: Can they be made in the same year to maximize deductions? Or should you make these purchases in a year expected to have high profits, where a larger deduction will benefit you? Should these assets be financed with the new interest limitation or purchased outright?
- Is there a potential to hire new employees and increase the amount of the pass-through deduction, effectively reducing the cost of hiring the employee by up to 50% (subject to certain limitations)?
- Examine your company’s capital structure: With the new interest expense limitation, does it make sense to replace debt with shareholder equity?
- Instead of obtaining a home equity line of credit, should you obtain a second mortgage, or refinance the existing mortgage and pull cash out to obtain your full interest expense deduction?
- If you’ve typically had large unreimbursed business expenses in the past, should you speak with your employer about changing pay structure, duties, and control to become a 1099 contractor? (Unreimbursed business expenses are no longer allowed under the new act.)
- Be sure to factor in new limitations on offsetting business losses against other income—some of the tax benefits of losses in business acquisitions may need to be reevaluated.
If you want to get advice from Jason or the folks at RH2 on how the recent changes are going to impact you, you can give them a call at 425-658-1400.