Businesses may need to adjust their tax strategies
The Tax Cuts and Jobs Act (TCJA) included a multitude of business-related provisions, most of which went into effect last year. Although the changes are no longer brand new, the TCJA’s complexities mean that businesses are still figuring out the exact impact — and how to adjust their tax strategies accordingly.
Income taxation and owner liability are the main factors that differentiate one business structure from another. Many businesses choose entities that combine pass-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. But TCJA changes warrant revisiting the tax consequences of business structure.
The now-flat corporate rate (21%) is significantly lower than the top individual rate (37%), providing significant tax benefits to C corporations and helping to mitigate the impact of double taxation for their owners. In addition, the corporate alternative minimum tax (AMT) has been repealed, while the individual AMT remains (though it will affect far fewer taxpayers). But, the TCJA also introduced a powerful deduction for owners of pass-through entities.
For tax or other reasons, a structure change may be beneficial in certain situations. But there also may be unwelcome tax consequences that effectively prevent such a change.
Sec. 199A deduction for pass-through businesses
Through 2025, the TCJA provides the Sec. 199A deduction for sole proprietorships and owners of pass-through business entities, such as partnerships, S corporations, and LLCs that are treated as sole proprietorships, partnerships or S corporations for tax purposes. The deduction generally equals 20% of qualified business income (QBI), subject to limitations that can begin to apply if taxable income exceeds the applicable threshold — $160,700 or if married filing jointly, $321,400 ($160,725 for separate filers). The limits fully apply when taxable income exceeds $210,700 and $421,400 ($210,725), respectively.
QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business, or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.
The 199A deduction isn’t allowed in calculating the owner’s adjusted gross income, but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction (though you don’t have to itemize to claim it).
When the income-based limit applies to owners of pass-through entities, the 199A deduction generally can’t exceed the greater of the owner’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year-end and used by the business at any point during the tax year to produce qualified business income. Additional rules apply.
Another limitation for taxpayers subject to the income-based limit is that the 199A deduction generally isn’t available for income from “specified service businesses.” Examples include businesses that involve investment-type services and most professional practices (other than engineering and architecture).
The W-2 wage and property limitations and the service business limitation don’t apply if your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% deduction.
Projecting your business’s income for this year and next can allow you to time income and deductions to your advantage. It’s generally — but not always — better to defer tax, so consider:
Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for products or services at year-end. If you use the accrual method, you can delay shipping products or delivering services.
Accelerating deductible expenses into the current year. If you’re a cash-basis taxpayer, you may pay business expenses by Dec. 31, so you can deduct them this year rather than next. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of
when the credit card bill is paid.
Warning: Don’t let tax considerations get in the way of sound business decisions. For example, the negative impact of these strategies on your cash flow or customers may not be worth the potential tax benefit.
Taking the opposite approach. If your business is a flow-through entity and it’s likely you’ll be in a higher tax bracket next year, accelerating income and deferring deductible expenses may save you more tax over the two-year period.
For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases, the Modified Accelerated Cost Recovery System (MACRS) will be preferable to other methods because you’ll get larger deductions in the early years of an asset’s life.
But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. Careful planning can help you maximize depreciation deductions in the year of purchase.
Other depreciation-related breaks and strategies may be available and, in many cases, have been enhanced by the TCJA:
Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) the cost of purchasing eligible new or used assets, such as equipment, furniture, off-the-shelf computer software, and, under the TCJA, qualified improvement property, certain depreciable tangible personal property used predominantly to furnish lodging, and the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.
For qualifying property placed in service in 2019, the expensing limit is $1.02 million. The break begins to phase out dollar for dollar when asset acquisitions for the year exceed $2.55 million. (These amounts are annually adjusted for inflation.)
Bonus depreciation. This additional first-year depreciation is available for qualified assets, which include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software, and water utility property. But due to a drafting error in the TCJA, qualified improvement property will be eligible for bonus depreciation only if a technical correction is issued. (Check with your tax advisor for the latest information.)
Under the TCJA, through Dec. 31, 2026, the definition has been expanded to include used property and qualified film, television and live theatrical productions. For qualified assets placed in service through Dec. 31, 2022, bonus depreciation is 100%. For 2023 through 2026, bonus depreciation is scheduled to be gradually reduced. For certain property with longer production periods, these reductions are delayed by one year.
Case Study: De-mystifying Vehicle-Related Deductions
Julia is considering buying some new vehicles for her business this year. She wants to know how the tax breaks available to her might be affected by the type of vehicle she buys or how the vehicle is used. So she consults her tax advisor.
He tells Julia that purchases of new or used vehicles may be eligible for Sec. 179 expensing, and she may want to buy a large truck or SUV to maximize her deduction. The normal Sec. 179 expensing limit (see page 16) generally applies to vehicles with a gross vehicle weight rating of more than 14,000 pounds. A $25,000 limit applies to vehicles (typically SUVs) rated at more than 6,000 pounds, but no more than 14,000 pounds.
But even if Julia prefers to buy a smaller vehicle, she can still potentially enjoy a valuable first-year deduction. Vehicles rated at 6,000 pounds or less are subject to the passenger vehicle limits, and for 2019 the first-year depreciation limit is $18,000 ($10,000 plus $8,000 bonus depreciation). Julia’s advisor also explained that, if she uses a vehicle for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. He also warns her that, if business use is 50% or less, she won’t be able to use Sec. 179 expensing or the accelerated regular
MACRS; she’ll have to use the straight-line method.
Warning: Under the TCJA, in some cases, a business may not be eligible for bonus depreciation. Examples include real estate businesses that elect to deduct 100% of their business interest and dealerships with floor-plan financing if they have average annual gross receipts of more than $25 million for the three previous tax years.
Offering a variety of benefits not only can help you attract and retain the best employees but also may save tax because you generally can deduct your contributions:
Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You take a tax deduction for your contributions to employees’ accounts. Certain small employers may also be eligible for a credit when setting up a plan.
HSAs and FSAs. If you provide employees with a qualified high-deductible health plan (HDHP), you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you can offer Flexible Spending Accounts for health care. If you have employees who incur daycare expenses, consider offering FSAs for child and dependent care.
HRAs. A Health Reimbursement Account reimburses an employee for medical expenses up to a maximum dollar amount. Unlike an HSA, no HDHP is required. Unlike an FSA, any unused portion can be carried forward to the next year. But only the employer can contribute to an HRA.
Fringe benefits. Certain fringe benefits aren’t included in employee income, yet the employer can still deduct the portion, if any, that it pays and typically also avoid payroll taxes. Examples are employee discounts, group term-life insurance (up to $50,000 per person) and health insurance.
Warning: You might be penalized for not offering health insurance. The Affordable Care Act (ACA) can in some cases impose a penalty on “large” employers if they don’t offer full-time employees “minimum essential coverage” or if the coverage offered is “unaffordable” or doesn’t provide “minimum value.”
Interest expense deduction
Generally, under the TCJA, interest paid or accrued by a business is deductible up to 30% of “adjusted taxable income.” Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years are exempt from the interest expense deduction limitation.
Some other taxpayers are also exempt. For example, real property businesses can elect to fully deduct their interest but then would be required to use the alternative depreciation system for real property used in the business.
A loss occurs when a business’s expenses and other deductions for the year exceed its revenues. Tax treatment differs based on whether the business is a C corporation or a pass-through entity, and the TCJA made changes to the tax treatment of both types of losses:
C corporation net operating losses (NOLs). For NOLs that arise in tax years starting after Dec. 31, 2017, the maximum amount of taxable income that can be offset with NOL deductions is generally reduced from 100% to 80%. In addition, NOLs incurred in tax years ending after Dec. 31, 2017, generally can’t be carried back to an earlier tax year but can be carried forward indefinitely (as opposed to the 20-year limit under pre-TCJA law). Congress might make
a technical correction to address the difference in effective dates. Check with your tax advisor for the latest information.
Pass-through entity “excess” business losses. Through 2025, a limit applies to deductions for current-year business losses incurred by noncorporate taxpayers: Such losses generally can’t offset more than $255,000 (for 2019) of income from other sources, such as salary, self-employment income, interest, dividends, and capital gains. The 2019 limit is $510,000 for a married couple filing jointly. Disallowed losses are carried forward to later tax years and can then be deducted under the NOL rules.
Tax credits reduce tax liability dollar for dollar, making them particularly beneficial:
Research credit. The research credit (often called the “research and development” credit) gives businesses an incentive to step up their investments in research. Certain start-ups (in general, those with less than $5 million in gross receipts) can, alternatively, use the credit against their payroll tax. While the credit is complicated to compute, the tax savings can prove significant.
Work Opportunity credit. This credit is designed to encourage hiring from certain disadvantaged groups, such as certain veterans, ex-felons, the long-term unemployed and food stamp recipients. The maximum credit is generally $2,400 per hire but can be higher for members of certain target groups — up to $9,600 for certain veterans. The credit is scheduled to expire on Dec. 31, 2019. Warning: Certification from your State Workforce Agency generally must be
requested within 28 days after the employee begins work.
Case Study: Deduction for the Self-Employed
Nicole left her full-time job earlier this year to join the gig economy and had to begin making estimated tax payments for the first time in her life. To be sure she was doing everything correctly, she visited her tax advisor.
He let Nicole know that along with the extra tax-paying responsibilities come some additional tax deductions. First, while she has to pay both the employee and employer portions of employment taxes on her self-employment income, the employer portion (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible “above the line,” which means she doesn’t have to itemize to claim the deduction.
In addition, Nicole can deduct 100% of health insurance costs for herself, and if she were married or had children, she could deduct these costs for them, too. This above-the-line deduction is limited to net self-employment income. Nicole also can take an above-the-line deduction for contributions to a retirement plan and,
if she’s eligible, an HSA for herself.
Nicole asks whether she can deduct her home office expenses. Her advisor explains that, if her home office is her principal place of business (or used substantially and regularly to conduct business) and that’s the only use of the space, she probably can deduct home office expenses from her self-employment income.
New Markets credit. This gives investors who make “qualified equity investments” in certain low-income communities a 39% credit over a seven-year period. The credit is scheduled to expire on Dec. 31, 2019.
Retirement plan credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified start-up costs.
Small-business health care credit. The maximum credit is 50% of group health coverage premiums paid by the employer, provided it contributes at least 50% of the total premium or of a benchmark premium. For 2019, the full credit is potentially available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $27,100 per employee. Partial credits may be available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $54,200. Warning: The credit can be taken for only two years, and they must be consecutive.
Family medical leave credit. For 2018 and 2019, the TCJA has created a tax credit for qualifying employers that begin providing paid family and medical leave to their employees. The credit is equal to a minimum of 12.5% of the employee’s wages paid during that leave (up to 12 weeks per year) and can be as much as 25%
of wages paid. Ordinary paid leave that employees are already entitled to doesn’t qualify. Additional rules and limits apply.
Sale or acquisition
Whether you’re selling your business or acquiring another company, the tax consequences can have a major impact on the transaction’s success or failure. Consider installment sales, for example. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount
based on the business’s performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years. This could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate. But an installment sale can backfire on the seller. For example:
- Depreciation recapture must be reported as gain in the year
of sale, no matter how much cash the seller receives.
- If tax rates increase, the overall tax could wind up being more.
With a corporation, a key consideration is whether the deal should be structured as an asset sale or a stock sale. If a stock sale is chosen, another important question is whether it should be a tax-deferred transaction or a taxable sale.