2018 Tax Reform – Effect on Businesses

With the sweeping changes brought to individual taxation from the Tax Cuts and Jobs Act, business taxpayers also face a significant overhaul that will affect 2018 tax planning. The corporate tax cuts will be permanent unlike the personal tax provisions, but items that affect small businesses are subject to more frequent changes although some will expire by 2025 just like the personal tax changes. For professionals operating as sole proprietors, there are many incentives to grow your business and switch to a corporate form but also new benefits for pass-through business entities. Here are the provisions most likely to affect small business taxpayers.

Computers Are No Longer Listed Property

Listed property refers to types of business assets that often have highly personal elements like cars and computers. They were in this category for a long time since they’ve become necessary for daily life but this restriction has been lifted. You no longer have to keep records proving that the computer was used solely for business (such as having no games or personal files on it.)

Changes to Business-Related Meals and Entertainment

In the regular course of business and traveling for work, meals are still 50% deductible if you’re self-employed. If you have employees and provided meals for them because it was for your convenience, this was fully deductible but is now also subject to the 50% limit. This provision is set to expire in 2025 meaning that there will no longer be a deduction for on-site meals.

Business entertainment however, such as taking a client out to a concert, was also subject to the 50% limit and is now no longer deductible. The only entertainment expense that survived the 2018 tax reform is office parties on the premises when you have employees. You can’t deduct off-site recreation anymore or facility rental regardless of whether you have employees or not.

20% Deduction on Pass-Through Profits

95% of all American businesses are pass-through entities, even some very large businesses such as Georgia-Pacific. For many professionals like doctors and attorneys, choosing whether to operate as a pass-through or corporation depends on both legalities in the states where you operate in addition to taxes. There are new benefits to operating as a pass-through like an S corporation, partnership, or sole proprietorship for tax purposes to go hand in hand with the major cuts to corporate tax rates.

This deduction has both an income limit and phaseout range. To be able to take the deduction, your total taxable income needs to be under $315,000 if married filing jointly and less than $157,500 for all other filing statuses. If your income falls below these amounts, you can take a 20% deduction of your business profits. The phaseout range employs the next $50,000 in total taxable income so if your income is above $365,000 for married filing jointly and $207,500 for every other filing status, then you don’t qualify for the deduction. But if your income falls between those two amounts, then you can deduct a percentage of your profit but not the full 20% and there are also two limitations to contend with. The first is your chief product followed by a "required investment" formula.

If your income is higher $315,000 (or $157,500), you cannot be in a line of work where the chief product is your skills or reputation so this excludes most professional-class small business owners with one exception for engineers. You are then limited by the required investment formula. The formula limits your deduction to 25% of employee wages reported on W-2s plus 2.5% of the unadjusted basis of eligible business property (which must be in the 10-year class or greater such as office furniture and fixtures and real estate.) It doesn’t matter when the property was put into service, so long it’s in a 10-year class or longer.

Regardless of whether you qualify for the pass-through deduction or not though, your self-employment tax obligations do not change. This deduction only reduces income tax while only business expenses will reduce your self-employment tax.

Corporate Tax Rates Permanently Reduced

If you plan on reorganizing your business as a C corporation, now may be a good time to do so. The maximum corporate tax rate has been reduced to 21% and this is permanent. For professionals operating as personal service corporations, the House initially proposed a 25% rate but since the new maximum is 21% this is the new rate for personal service corporations.

The bill has sought to make it easier to convert pass-through businesses to C corporations within the next two years in the event that you don’t benefit from the pass-through deduction and/or face a tax increase from other personal and business provisions of the bill.

Net Operating Losses Now Generate Interest

If your pass-through business generated a loss in the past, you could usually always offset both future and past income by carrying net operating losses up to 20 years forward and two years back.

2018 tax reform vastly changed net operating losses in a few ways. First, there is no election to carry back. You can only carry forward now but the 20-year limit is gone so you can carry forward indefinitely. However, your perpetual carryover has another limit: only 80% of business net income can be offset now. If your revenue was low and you had a lot of expenses as is common with starting a new business, you’ll benefit less compared to past calculations which only looked at the big picture and also let you offset other types of income with it. For instance, if you still work at a job or your spouse does, your loss could offset both of your wages and result in significant tax savings. You can’t do this anymore.

While limiting the loss to business income only puts a damper on the massive deductions net operating losses used to bring, there are two new benefits as well. You can carry a net operating loss forward infinitely, so if you decide to save it for a year when you greatly exceed your business goals then you can do so. Additionally, net operating losses are now also treated as if they generated interest over time to preserve the value of what you invested in your business so you’ll get to deduct the "interest".

Given that the provisions of the 2018 tax bill disproportionately benefits business over wage earners, contract workers and self-employed professionals are included with the former. It could be a good time to think about making a career change given that employees can’t deduct business expenses anymore but the self-employed have new benefits.