Tax Reform Accomplished: How Does the Legislation Affect Investors and Businesses?
"As 2017 drew to a close, Congress passed the Tax Cuts and Jobs Act (the "Act"), tax reform legislation that made sweeping changes to the Internal Revenue Code. When Congress last reformed the tax code in 1986, the legislative process took over two years. This time Congress accomplished the same feat in two months," write Andrew Friedman and Jeff Bush of The Washington Update in their white paper, Tax Reform Accomplished: How Does the Legislation Affect Investors and Business?
Below is a portion of the white paper, as reflects how the changes affect businesses. Unless otherwise noted, changes are effective January 1, 2018. To view the entire white paper, please visit thewashingtonupdate.com.
TAX CHANGES FOR BUSINESSES
Among others, the Act makes the following changes affecting businesses:
- Corporate tax rate: The centerpiece of the Act is a permanent reduction in the tax rate imposed on C corporations from 35% to 21%, beginning January 1, 2018. The Act also repeals the corporate alternative minimum tax (AMT).
U.S. corporations currently pay tax at an average effective rate of 18.6%, lower than the new 21% rate. Washington Post, GOP Tax Plan Delivers Mixed Results for Corporate America (November 2, 2017). Thus, some sectors and companies will benefit from the new rate, while others may receive no benefit or even be hurt. The lower tax rate is particularly helpful to retailers, which claim few deductions and thus pay tax close to the full U.S. rate.
- Business income of pass-through entities: Business income earned by pass-through entities (e.g., partnerships, limited liability companies, and S corporations) flows through to the owners' tax returns, where under prior law it was taxed at ordinary income rates. The Trump Administration, along with the Republican Congressional leadership, sought to reduce that tax to allow smaller businesses to retain more of their profits and grow.
The tax writers realized, however, that individuals could abuse this benefit to save taxes on income that is in fact compensation for their services, which should be taxed at full ordinary income rates. For instance, consider a project manager employed by a large company who earns $150,000 per year, which is taxed as ordinary income. If the tax on pass-through income is reduced, the worker could save taxes by forming a consulting LLC and having his former employer contract with the new LLC for his services—even though he is providing exactly the same services for exactly the same company. To prevent this result, the Act curtails the use of the flow-through benefit by owners who also provide services to the business entity.
The Act provides a deduction equal to 20% of business income received by owners of a non-service business. Combined with the new 37% top individual tax rate, the deduction results in a top tax rate for eligible pass-through business income of 29.6%. The deduction is available only through 2025.
The deduction cannot exceed the greater of (i) 50% of the owner's pro rata share of wages paid by the entity (including wages paid to both employees and owners), or (ii) the sum of 25% of the owner's pro rata share of wages paid by the entity (including wages paid to both employees and owners) plus 2.5% of the initial basis of all depreciable tangible property used by the business.
Owners of a personal service business may claim the deduction if the owner's joint income is less than $315,000. (Such owners also are exempt from the 50% wage limitation.) The ability to claim the deduction is phased out for incomes between $315,000 and $415,000, so that owners of a personal service business who have taxable income over 415,000 may not claim the deduction at all.
The Act defines personal service businesses to include entities providing financial, brokerage, health, law, accounting, actuarial, or consulting services, but excludes engineering and architecture businesses.
Other considerations of the change to pass-through income include:
- Small 401k plans: Small business owners who are eligible to claim the 20% deduction should re-evaluate with their financial professionals the ongoing tax benefits provided by existing 401(k) plans. Contributions into the plans will produce tax savings at a 29.6% rate, but distributions from the plans are likely to be taxed at higher individual rates. Of course this analysis ignores the significant benefits of tax deferral. If owners conclude that the 401(k) plan produces insufficient ongoing tax benefits, they should consider offering a Roth 401(k) option, which will allow business income to be taxed at the lower rate and participants to withdraw earnings tax-free.
- MLPs: Energy and investment master limited partnerships that qualify for pass-through treatment are eligible to claim the 20% deduction, to the extent that the MLP reports taxable income and subject to the limitations on the availability of the deduction described above. Some profitable MLPs might consider operating as C corporations to take advantage of the drop in the corporate tax rate, although there are a number of countervailing factors that go into determining whether such a change in structure is advisable.
- Capital expenditures: The Act permits businesses to deduct immediately capital expenditures they make through 2022, rather than, as under prior law, to claim depreciation deductions over the prescribed life of the asset purchased. The write-off expiration date is phased out, reduced by 20% each year through 2026 (entirely phased out in 2027).
- Small businesses: The Act increases the amount small businesses may expense to $1 million, with the expense deduction phasing out beginning at $2.5 million.
- Interest: Under the Act, a business may no longer deduct net interest expense to the extent it exceeds 30% of the business's income (defined as EBITDA through 2022 and EBIT thereafter). Real estate businesses, and other businesses with gross receipts less than $25 million, are exempt from this disallowance.
- Like kind exchanges: The Act limits tax-deferred "like kind exchange" treatment to exchanges of real property.
- Entertainment expenses: The Act eliminates deductions for business entertainment expenses.
- NOL carryforwards: The Act eliminates net operating loss carrybacks and makes changes to the treatment of loss carryforwards. The Act provides that loss carryforwards may offset only up to 80% of taxable income in any given year. Unused losses may be carried forward indefinitely. Individuals (not corporations) may claim net losses up to $500,000 (joint returns) annually; losses over that amount are subject to the new carryforward rules. The new rules apply to losses arising in 2018 and later years.
- Insurance companies: The Act curtails special tax provisions used by insurance companies to reduce their taxable income.
- Foreign earnings of U.S. multinational companies: Under prior law, a foreign subsidiary's earnings were subject to a 35% U.S. tax when the subsidiary repatriated the earnings to its U.S. parent. To avoid this tax, many U.S. companies left their earnings overseas with their subsidiaries. The Act provides that future earnings of foreign subsidiaries will no longer be subject to tax on repatriation.
Earnings that U.S. companies are currently holding offshore are deemed to be repatriated and subject to U.S. tax at a rate of 15.5% for liquid assets and 8% for illiquid assets, payable over eight years. Existing offshore earnings are taxed regardless of whether foreign subsidiaries actually repatriate those earnings. As a practical matter, once the earnings have been so taxed, the U.S. parent is likely to repatriate them as doing so will incur no additional tax.
- Base erosion: The Act includes provisions aimed at multinational companies that hold valuable intellectual and other intangible property offshore to avoid U.S. tax, an arrangement common in the technology and pharmaceutical sectors. These firms often locate their intangible property in tax haven jurisdictions that impose no or little tax. They then require their U.S. company to pay a royalty or other amount to the foreign affiliate for the domestic use of the intangible property. The group obtained a tax deduction in the U.S. for the payment without owing a corresponding tax on the receipt of that payment in the haven jurisdiction. The Act seeks to thwart this scheme in various ways, such as by imposing a minimum tax on foreign earnings of U.S. multinational companies and by effectively disallowing a full tax deduction for payments made by a U.S. company to a foreign affiliate for the use of intangible and other designated property.
The Tax Cuts and Jobs Act makes sweeping changes that are likely to impact businesses and investor decisions significantly now and in the coming years. The nuances of the Act present a number of potential opportunities and pitfalls. Investors should consult with their professional advisors to determine how the legislation will alter the tax due in their particular situation, both now and in the future when many of the provisions are slated to expire. They also should discuss with their advisors what actions, if any, they might consider to take advantage (or blunt the adverse effects) of the Act's provisions in their cases.
Andrew H. Friedman is the founder and principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He and his colleague Jeff Bush speak regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. They may be reached at www.TheWashingtonUpdate.com.
The authors of this paper are not providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
Copyright Andrew H. Friedman 2018. Reprinted by permission. All rights reserved.