By Miranda Aavatsmark
It’s 11:00 p.m. on New Year’s Eve, 2017 and I’m ready for a relaxing evening. My day started with checking my email and fretting that something was left undone after having had a frantic Friday at the office. We worked diligently sending last minute estimate vouchers to clients, before the UofL vs. UK game started and, of course, Lexington, KY would be completely shut down.
But back to New Year’s Eve night. I sent my husband out for ice cream, a plain vanilla sundae with caramel. Simple right? It turns out all the fast food restaurants closed early tonight so he decided to go to Walmart. He comes home with several bags full of items. He is so proud as he takes out the “vanilla” ice cream that, as it turns out, is “No Sugar Added” Butter Pecan flavored. In addition, he bought a wire basket that he thought I might like, burritos, milk and deodorant.
When I think about Tax Reform this year it reminds me of my husband’s all too usual trips to the store. I send him out for something simple and he comes back with a bunch of random things and not exactly what I wanted. However, it’s late, I want ice cream, nothing is open, and so I must eat this no-sugar butter pecan stuff. As it is with the new tax bill, tax reform is here, even if it is not exactly what we wanted or asked for.
We know all too well in the accounting industry, when Congress talks of simplifying the tax code, be prepared to navigate the labyrinth of rules, exceptions, limitations and special circumstance that are sure to ensue. That’s why, as soon as the final bill was released, CPAs dove right in, trying to understand the deduction for pass-through businesses. Many CPAs work with business owners of pass-through entities and we want to be prepared to answer their questions.
Starting in 2018, business owners will potentially be allowed a deduction of 20% of their qualified business income from pass-through entities (including Schedule C, E and F businesses) when calculating taxable income. The deduction is calculated separately for each of the taxpayer’s businesses. Qualified business income is defined as the “net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” Note that shareholder wages and guaranteed payments are not included in the calculation of qualified business income. Here are the details and exceptions in simplified terms:
All businesses other than Professional Service Business:
All business owners, other than professional service businesses, can take the full 20% deduction if their taxable income is less than $315,000 married filing jointly or $157,500 single/head of household/married filing separately. Business owners whose taxable income is over $315,000 married filing jointly or $157,500 single/head of household/married filing separately may potentially be entitled to a deduction, however, it may be limited based on wages paid in the business and tangible property owned.
Professional Service Businesses:
Professional services businesses, (accountants, lawyers, doctors, etc.), can take the full 20% deduction if their taxable income is less than $315,000 married filing jointly or $157,500 single/head of household/married filing separately. Professionals whose taxable income is between $315,000 – $415,000 married filing jointly or $157,500 – $257,500 single/head of household/married filing separately may potentially be entitled to a deduction, however, it may be limited based on wages paid in the business, tangible property owned and other factors. If taxable income of a professional is over $415,000 married filing jointly or $257,500 single/head of household/married filing separately then no deduction is allowed.
Wage and tangible property limitation:
A taxpayer whose taxable income falls in the range where the wage and tangible property limitations apply will have to do a few extra calculations. The pass-through deduction will be limited to the lesser of:
- 20% of pass-through business income or
- The greater of:
- 50% of W2 wages paid by the business or
- 25% of W2 wages paid by the business plus 2.5% of qualified tangible property owned by the business
The wages and qualified property for each business is allocated to the individual owner based on his/her respective ownership percentage. Qualified tangible property is defined as the unadjusted basis of assets for a period no longer than the longer of the asset’s useful life or 10 years.
I imagine this upcoming tax season to be much different than any others we CPAs have worked through thus far. We have the task of preparing 2017 returns, under the old law, while keeping in mind the new law and how that will affect our clients starting in 2018. Below are just a few ideas for the upcoming year:
Slow down the depreciation!
This may sound counterintuitive, but many business owners do not differentiate between cash flow and net profit, for tax purposes. As a result, often businesses are not prepared to write a check on April 15th to pay their tax bill. However, given the pass-through deduction for businesses and lower rates, accelerated depreciation may not be as desirable. Sure, it is great to take a large deduction all in one year, but what about all those years afterwards cash is used to pay down an asset loan without a corresponding deduction? This is a great opportunity to create income and expense matching for business owners.
Contribute to retirement and/or Health Savings Account (HSA).
Taxpayers, especially business owners, will probably have more disposable income to invest in their retirement or HSA account. Additionally, contributions to retirement accounts and HSAs could reduce taxable income for those taxpayers whose income is near or over the limitations. For example, suppose Bob is a single filer self-employed attorney whose taxable income is $175,000 before calculating the pass-through deduction. If Bob contributed $17,500 or more to a retirement account he would be eligible to deduct the full 20 percent pass-through business deduction on his tax return.
We cannot forget that S-Corporations must continue to pay “reasonable compensation” to their shareholders who provide services to the business. However, there is still an opportunity to think about how we structure the pay of business owners, other than for purposes of reducing payroll taxes. This could apply not only for S-Corporations but Partnerships as well. Shifting income from guaranteed payments to ordinary income will give partners the benefit of a deduction, assuming all limitations allow it.
Invest in assets.
Do you or a business owner who is renting an office building have an opportunity to purchase it? As we have learned, property ownership can potentially be a factor in calculating the pass-through deduction. The building may be home to other business tenants that pay rent, which would increase cash flow. The business owner would also be entitled to the pass-through deduction on the rental income as well.
Invest in employees.
Suppose a doctor is providing services at capacity and would like to slow down or take time to manage the business. We could suggest they hire another doctor to help with the overflow and take over some of the patient care. Yes, the additional wages and benefits will be an expense of the business, but what if the additional expenses reduced the doctor’s income enough to reap the pass-through business deduction? This may or may not create a huge tax savings, but the benefits could be more intangible in nature. We also may be able to justify a lower salary for the doctor (if S-Corporation) if he/she is providing fewer personal services.
Hire your Spouse/Children.
What better way to shift income, reduce taxable income and create higher wages (for purposes of the W2 limitation)? We should be careful to communicate to our clients that the spouse/child needs to be a legitimate employee. Other benefits of hiring spouses and children is the ability to contribute to an employer-sponsored plan or an IRA, (if they didn’t have earned income from another source).
Re-evaluate how your entity is taxed.
This is as good a time as ever to analyze a businesses’ entity choice. Does it perhaps now make sense for an S-Corporation to change to a partnership or C-Corporation? Should a Schedule C business convert to a different type of entity? Across the board, the tax savings may not be significantly different but depending on the business there could be reasons to change.
Plan for succession.
Business owners who are near retirement or have an interest in selling their business may now have many succession opportunities. The purchase of a business may be even more attractive to potential buyers as they may see the tax benefits and lower rates as an opportunity to take over a business that they may not have been able to afford in the past. The sale could be to a key employee or competitor or relative. This is also a good time for owners to have an appraisal or business valuation performed.
Taxpayers with high-interest loans or unfavorable contracts may have a chance to refinance or re-negotiate terms. Once businesses begin to realize tax savings they should start showing a much healthier balance sheet in the way of increased cash, investments, and equity and decreased debt. This may give them more leverage to negotiate more favorable terms.
Innovate and expand:
An increase in cash flow, equity and borrowing ability could translate into turning ideas and plans into reality. Business owners and executives have probably bounced around the idea of adding additional locations, expanding a product line or developing a new idea for years. Now the funds and resources may be available to make it happen.
In closing, tax reform brings new challenges to CPAs, business owners and others in the financial community, but it also provides opportunities. We can use these opportunities to maximize tax savings and take full advantage of the deductions available under the 2017 Tax Cuts and Jobs Act.