On Dec. 22, 2017, the Tax Cuts and Jobs Act of 2017 (the act) was signed into law. Hailed as the largest tax reform law since the Reagan Administration, the act makes significant changes to personal income tax rates, deductions and exemptions, while effectively doubling the estate tax exemption. The act further provides many new tax breaks for business owners. However, most of these benefits are temporary and scheduled to expire in 2026, which makes it imperative to evaluate claiming these potential new tax benefits as soon as possible.
Business owners will see a number of important changes in the tax laws and should consult their advisors as soon as possible to maximize these opportunities. The most significant changes include:
1. Maximum Corporate Tax Rate Reduced to 21% from 35%
The maximum federal tax rate for a C corporation has been reduced from 35 percent to 21 percent. C corporations are generally either larger-sized corporations with many shareholders (e.g., publicly traded corporations) or businesses with significant employee fringe-benefit programs. The new tax rate is a huge boon to these companies, and many have announced special employee bonuses or have increased their charitable giving.
2. Pass-Through Deduction for Owners of Small or Family Owned Businesses
Most small businesses in the United States do not elect to be taxed as a C corporation because of the potential for double taxation — first, at the corporate level on profits and then again at the shareholder level for any dividends received. Thus, most small or family owned businesses we see elect to be taxed as a pass-through entity, where the business profits are taxed only once at the owner level. Pass-through entities include S corporations, partnerships, limited liability companies and sole proprietorships.
Under the new law, these pass-through entities may qualify for a deduction of up to 20 percent of qualified business income. For these purposes, qualified business income must be effectively connected with a U.S.-based business and will generally be based on the profits from the business. The deduction would reduce the owner’s taxable income on his personal tax return providing tax savings in his or her marginal income tax bracket.
Qualifying for the pass-through deduction depends on a number of factors, including the taxable income of the owner and whether the business is deemed to be a service business. Service businesses are generally defined to be traditional professional trades (e.g., doctors, lawyers) or any similar business based on the reputation or skill of its owners. Interestingly, under the new law, architectural and engineering firms are specifically excluded from the service businesses definition. For nonservice businesses, the amount of the deduction may also depend on the amount of wages paid and the depreciable tangible property owned by the business.
To understand the deduction, it is important to know the threshold amount, or the amount of the owner’s taxable income from all sources. In 2018, the threshold amount is $315,000 for married taxpayers filing joint returns. For all others, the threshold amount is $157,500. In situations where the owner’s taxable income does not exceed the threshold amount, the pass-through deduction will be 20 percent of qualified business income. For those owners whose income exceeds the threshold amount but does not exceed $415,000 (married filing jointly) or $207,500 (other filers), the deduction is not eliminated but is reduced. Finally, for those owners whose income exceeds $415,000 (married filing jointly) or $207,500 (other filers), there is no deduction for service businesses, but nonservice businesses may still qualify based on wages or tangible depreciable property.
3. Increased Opportunities with Bonus Depreciation and Immediate Expensing for Property and Equipment
Through 2023, the bonus depreciation benefit has been increased to allow for a 100-percent depreciation deduction for property placed in service after September 2017. Also, certain property may qualify for immediate expensing up to a maximum $1 million annual limit. Both of these provisions should help provide significant incentives for owners to invest in the business’ growth.
Planning for these new tax benefits will be a major focus for many business owners and their advisors in 2018, particularly since many of the benefits expire after a few years.
Please contact your tax advisor to better understand the impact of these new rules on your business and personal financial situation.
About the Author
Victor G. Santiago, J.D., LL.M.
Senior Vice President, Business & Financial Planning Strategist
Victor Santiago is the business transition planning strategist for the Florida and Northern Pennsylvania regions. A former practicing tax attorney, Victor holds a Master of Laws degree in taxation from Villanova University and has advised families and business owners for more than 20 years.