HOW SMALL BUSINESSES CAN TAKE ADVANTAGE OF TAX REFORM; THE TAX CUTS AND JOBS ACT (TCJA) OF 2017
The Tax Cuts and Jobs Act (TCJA) of 2017 created substantial new tax breaks for companies of all sizes, but owners of smaller businesses in particular may still be reviewing how much their tax burden could change under the new legislation. The deductions individual business owners can take advantage of and the value of these tax breaks will vary considerably depending on the nature of their business activities, their income levels, and other factors that they may be able to adjust to maximize their tax benefits.
Under the TCJA, the corporate tax rate was cut to 21% from a previous top rate of 35%. But because relatively few smaller firms are organized as C-corporations, most small business owners will be interested in determining whether they are eligible for the new 20% business income deduction that applies to partnerships, sole proprietorships, LLCs, Scorporations, and other pass-through entities. But in addition to variations depending on the type of business and the total income of the owners, the size of the deduction a business is eligible to receive may depend on how much the firm pays its employees and how much property it owns.
Generally, all business owners with a qualified business income (QBI) of below $157,500 if single or $315,000 if married and filing jointly qualify for the full 20% deduction. Above these income levels, the deduction phases out on a pro rata basis for businesses that are engaged in a “specified service trade or business,” such as health, law, accounting, performing arts, consulting, athletics, financial services, and brokerage services. Owners of professional service businesses no longer qualify for the deduction if their QBI exceeds $207,500 for singles or $415,000 for married couples.
Moreover, pass-through businesses that are not professional service firms but have a QBI that exceeds the threshold limits outlined above may find that their deduction is reduced by other factors. Generally, the deduction is limited to the greater of either 50% of the W-2 wages the business pays or the sum of 25% of wages plus 2.5% of the basis of the business’ qualified property.
Business owners who are close to qualifying for the pass-through deduction may be able to do so by reducing their QBI below the threshold using various strategies, such as maximizing contributions to retirement plans or a health savings account (HSA), or making large charitable donations. Some pass-through businesses may also consider converting to Ccorporation status to take advantage of the lower corporate tax rate. It is also important to keep in mind that unlike the change to the corporate tax rate, which is permanent, the pass-through deduction expires at the end of 2025.
However, even pass-through entities that do not qualify for the 20% deduction may be able to take advantage of other provisions in the TCJA, including provisions that allow businesses to write off a large share of their equipment purchases up front, instead of depreciating these investments over a number of years. The TCJA raised bonus depreciation to 100% from 50% previously for qualifying property placed in service between September 27, 2017, and January 1, 2023, followed by a phase-down period ending in 0% on January 1, 2027. The deduction has also been expanded to include purchases of used equipment. Moreover, the legislation enhances the Section 179 expensing amount for small businesses starting in 2018, raising it to $1 million with a $2.5 million phaseout threshold.
In addition, the TCJA allows more companies to take advantage of the cash method of accounting, rather than the accrual method. Generally, manufacturing businesses are required to use the accrual method, but the new tax plan raises the annual revenue threshold from $5 million to $25 million. Thus, a greater number of small businesses will now be able to deduct inventory at the time of purchase, rather than having to wait until the inventory has been sold.
The TCJA also provides a new credit for wages paid for family or medical leave that can be claimed in tax years 2018 and 2019. The tax credit is intended to incentivize employers to continue to pay their employees when taking leave. Depending on the share of wages paid, the tax credit can range from 12.5% to 25%.
At the same time, however, small business owners should be aware of changes to the tax code included in the TCJA that could increase their tax burden. The legislation repeals for most businesses the Section 199 that allowed manufacturers to take a 9% deduction on income from qualified production activities; and caps the deduction for net interest expenses at 30% of earnings before interest, taxes, depreciation, and amortization for businesses with average gross receipts in excess of $25 million. It also eliminates business deductions for most entertainment expenses; limits the deductibility of employee meals provided on business premises to 50% (with a total repeal of this deduction in 2025); and repeals business deductions for the cost of providing employee transportation fringe benefits, such as parking, mass transit passes, and van pooling services.