Of the 100+ provisions in the Tax Cuts and Jobs Act (TCJA, or the Act) that take effect this year, there are specifically 3 new tax reform changes most likely to impact your small business clients. As a certified tax preparer, you’re probably already familiarizing yourself with many provisions in the TCJA. However, have you been talking to small business clients about them?
These are three of the most important things (and potentially the most impactful) from the new tax reform law to talk to small business clients about.
Changing their business entity to take advantage of the lower corporate tax rate
The lower corporate tax rate of 21 percent (down from the old rate of 35 percent) has some businesses thinking that it might be advantageous to incorporate as a C corporation. That reduced rate can look pretty enticing, especially since many small business owners have their business income taxed at the personal tax rate. So, for example, if you make between $38,701 and $82,500 (which would be a pretty humble small business or startup), your tax rate is 22% – about even with the corporate tax rate. However, the rate climbs from there. If you’re the owner of a pass-through and you have to file married/separate, it only takes $300,000 in business income to be taxed at the new highest rate of 37 percent – even higher than the old corporate tax rate.
So, for some pass-through entities, being able to claim that lower tax rate could save some money.
However, there are other factors to consider:
- As a corporation, when you pay dividends to stakeholders, they are taxed on that income at the individual rate, leading to a double taxation situation (since the profits are taxed first at the entity level and again when they’re paid out or distributed). An alternative option could be to pay stakeholders a salary instead of paying out dividends. Sometimes that arrangement can be more favorable tax-wise. However, you have to crunch the numbers to compare.
- If everything lines up right, non-C corp entities may be able to claim a 20 percent business deduction on their business income. Depending on the situation, this deduction could be enough to make it worth it not to go through the trouble of changing entity. It won’t make up for the full difference in tax rate in many cases, but sometimes you have to look at other costs, such as the time, energy, and money it takes to make such a change. You also have to consider other tax rules that would suddenly apply to you as a C corp. It’s not as simple as just lowering your tax rate and changing which deductions you can take.
- You could always reinvest profits into your corporation rather than distributing them. However, if you end up accumulating a lot of assets, you could get hit with the accumulated earnings tax – also known as a personal holding company tax. This rule kicks in if the amount of your accumulated assets exceeds the reasonable needs of your organization.
- Another big risk is that if your C corp holds assets that go up in value (such as real estate), if you sell any of these assets and make a substantial gain, getting these profits out of your corporation without double taxation will be extremely difficult.
- If you’re a C corp and distribute assets to shareholders, the corporation pays taxes on the difference of the fair market value and the assessed value of that asset. (For example, if a used car assesses at $5,000 but the fair market value is $8,200, the corporation will pay taxes on the difference of $3,200.) The shareholder will additionally pay taxes on the fair market value of the asset he or she is receiving. In contrast, a limited liability corporation (LLC) doesn’t have to pay taxes on assets distributed to shareholders, which saves a step and some money.
In other words, given the many variables that can affect the outcome of a particular tax situation, your clients really need to meet with you to run the numbers both ways – and through a number of scenarios -before a decision is made to change their choice of business entity. But checking it out may be worth it if it can save thousands of dollars and open up some new options for them.
Time to make those capital expense purchases
New rules under section 179 lets businesses write off the entire cost of qualifying property purchases in the same year they make them (versus having to write-off the cost little by little through a depreciation schedule). So, for example, under the old rules, when you purchased qualifying property to the tune of $100,000, you could write off around 20 percent of the cost each year over five years. (This is just an example – actual details will differ based on each individual tax situation.) Under the new rules, if everything lines up, businesses can claim 100 percent of that $100,000.
The deduction for each individual purchase is capped at $1 million (up from $510,000 in 2017). The overall cap for all purchases claimed is $2.5 million (up from $2.03 million in 2017). After that $2.5 million limit, there’s a dollar-for-dollar phase-out so that there’s essentially no deduction beyond $3.5 million in purchases.
The definition of qualifying property has been expanded, too. In addition to tangible property, including off-the-shelf software, the TCJA added certain tangible personal property that couldn’t be deducted before. The property has to be used predominantly to furnish lodgings and to improve nonresidential real property, such as roofs, HVAC, fire protection systems, alarm systems, and security systems.
In addition to the section 179 deduction, the TCJA also permits a business to claim first-year bonus depreciation – as much as a 100 percent deduction in the first year. In order to qualify for this deduction, the qualified property has to be acquired and placed into service after September 27, 2017, and before January 1, 2023 (or January 1, 2024, if the property in question has a longer production period).
Another new development is that the property can be new or used, as long as it’s new to you. The old rules insisted that the property being purchased was brand new. This bonus depreciation is scheduled to phase down between 2023 and 2026.
For a more thorough explanation of section 179 rules and applications, a great resource is Section179.org. (That’s right! This section of the tax law has its own nonprofit org and fan club!)
Are they using the best accounting method?
Many small businesses like to use the cash method of accounting, because it’s simple. Now, under the TCJA, the cash method has been expanded. Any entity that isn’t a tax shelter can use this method, as long as the three-year average of their annual gross receipts is $25 million or less. The purchase, production or sale of merchandise to produce income is no longer a determining factor.
If old limits kept them from using the cash accounting method, it might be worth looking to see if they qualify now and if it would hold any tax advantages.
Make sure to review these three areas of the tax law with small business clients during the fall prep season, to ensure clients are getting the most out of these new tax reforms.