Tax reform offers savings opportunities for businesses
We live in an age of instant news and information. The availability of 24-hour cable news, social media, the internet, in addition to traditional information sources, has allowed more access to information than at any other time in history. My high school-aged children look at me with blank faces when I describe my childhood that included three television channels and afternoon delivery of an evening newspaper as my primary sources of news and entrainment.
For many of us, that is how life was in the 1960s and 1970s as we were growing up. The technology and information changes also have changed access to news and developments in tax, finance and business. These developments have made my daily routine easier and more complicated at the same time. The need to be current is more relevant than ever before.
The recent tax reform has provided many tax-planning opportunities for business. It now has been more than two months since H.R 1, also known as the Tax Cuts and Jobs Act (TCJA), was enacted into law. Much of the recent press coverage with respect to the TCJA has revolved around the tax treatment of multinational businesses and their international operations. This includes the immediate impact of the transition tax on previously undistributed offshore earnings.
In addition, provisions dealing with global intangible low taxed income (GILTI), base erosion alternative tax (BEAT) and foreign-derived intangible income (FDII) also have garnered much attention. Many of these provisions don’t impact in any material way many small- and medium-sized businesses. In the discussion that follows, I don’t plan to give these provisions much attention, though they may have relevance to some businesses. I will focus on some other provisions in the TCJA.
The TCJA did provide other opportunities that don’t necessarily involve multinationals and their offshore cash or earnings. There was plenty of room in the hundreds of pages of the tax legislation documents that provided other tax changes for businesses.
Tax rates were adjusted under the TCJA. For C corporations, the top federal tax rate was reduced from 35 percent to 21 percent. For individuals, the top federal ordinary income tax rate was dropped from 39.6 percent to 37 percent. However, other tax law changes may impact the actual effective tax rate of taxpayers.
Many businesses use debt to finance their operations. One provision that in prior years primarily impacted foreign-owned U.S. operations was a provision that limited interest expense deductions on payments of interest from a U.S. business to a related foreign party. This limitation applied when a debt-to-equity ratio of the U.S. business exceeded 1.5 to 1.
In such cases, interest expense was allowable in a given year if it did not exceed 50 percent of a business’ adjusted taxable income (ATI). ATI was essentially taxable income with interest and depreciation and amortization being added back to taxable income with some other minor modifications. As with any tax provision, there were some technical requirements with respect to definitions and the actual mechanics of the calculation.
Fast forward to 2018. The specific code section — 163(j) — was repealed for tax years beginning after 2017 with the TCJA and replaced with a new version of the same section that now generally applies to any U.S. business with more than $25 million in average gross receipts for the prior three years. Thus, interest expense limitations were expanded to a wider group of businesses other than foreign-owned U.S. businesses.
No grandfathering of existing debt was included in the TCJA. Many businesses that previously had no limitation on their interest deductions found themselves in a situation where a potential limitation on their annual interest expense deduction may result. This limitation includes interest paid to third parties, including banks. Certain floor plan interest for inventory of certain motor vehicle-related businesses is subject to an exception. An exception also exists for certain real estate-related businesses if a special election is made that also limits certain depreciation deductions.
The new interest limitation provision also uses a different ratio of adjusted taxable income in determining the amount of interest currently deductible. As mentioned earlier, under prior law it was limited to 50 percent of ATI. Under the TCJA changes, the limitation ratio was lowered to 30 percent of ATI. In addition, beginning in 2022, the definition of ATI will be modified as the depreciation and amortization adjustment will be eliminated from the calculation.
Most U.S. businesses are organized in some pass-through or fiscally transparent form. Whether, a sole proprietorship, partnership (including many limited liability companies or LLCs), or S corporation, the tax liability of these entities is taxed at the tax rate of its owner or owners. Thus, the reduction in C corporate tax rates doesn’t impact individual owners of pass-through entities.
In an effort to provide additional business tax savings for pass-through income that individuals earn, the TCJA does include a provision that provides for a deduction of 20 percent of the lesser of the pass-through qualified business income or 20 percent of taxable income. This provision is included in the new section 199A of the tax code and there are a number of specific rules with respect to the actual mechanics of the deduction.
The specific rules have some complexity on the actual calculation and on what income actually is subject to the benefit of the deduction. For an individual whose only taxable income is qualified business income from a pass-through entity, the effective federal tax rate for the qualified business income for an individual in the 37 percent marginal tax bracket income is approximately 29.6 percent on the income that qualifies for the deduction.
A host of other provisions may also impact most businesses. These provisions impact many items and include such business provisions as 100 percent expensing of certain qualified business fixed asset purchases and entertainment expense deduction limitations. Working with a tax professional to fully understand the impact of all the TCJA changes is a prerequisite for any business.
Many of the tax provisions included in the TCJA require some additional guidance from the Treasury Department and the Internal Revenue Service. The issuance of such guidance may take many weeks or months before it is provided. In the meantime, taxpayers will need to determine what provisions of the TCJA may apply to their facts and circumstances and make any adjustments in their business and income tax planning.
Tax reform in 2017 with TCJA did change the tax landscape. The tax simplification that was advertised with the enactment of the Tax Reform of 1986 it is not. However, there are opportunities to take advantage of potential tax savings for many businesses. Working through the tax algebra is the task at hand. Hopefully, most taxpayers will master this tax math and earn a passing grade.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.