How Will Tax Reform Affect You?

April 2, 2018

The latest attempt by Congress to reform the evil tax code, the Tax Cuts and Jobs Act of 2017 is a very mixed bag of changes that eliminates or modifies a host of tax deductions and credits, lowers tax rates, increases the estate exemption, and actually adds a lot of complexity to the already complicated the Internal Revenue Code (IRC).

The most compelling provision of the act is a reduction of the top corporate tax rate from 35 percent to 21 percent. Earlier versions of the act, prior to the conference committee, contained a large reduction in tax rates for pass-through entities, such as partnerships, LLCs, and S corporations. The final language of the conference report has reduced this relief greatly (potentially 20 percent of the income is excludable), so that in many cases, taxation of C corporations may be lower than taxation of pass-through entities. This is going to be the key decision that most small businesses will have to make in response to the act. However, since a C corporation is still a double tax entity, S corporation taxation may still be the same or less. It all depends on the size of the dividend being taken by the shareholders. Let’s look at the following example:

The ABC Corp. has $2 million in taxable income before bonuses or dividends to the shareholders. Here’s how this might look under 2017 law and adopted 2018 law:

This analysis assumes that ABC will distribute the net income, and therein lies the issue. In an S corporation (or other pass-through) the owners pay tax on the entity’s net income, and all of it is distributable tax-free when cash flow permits. In real life, these distributions may come in a future year, or may never come, and will be used as basis when and if the shareholder sells his interest. In a C corporation, the dividend is still taxable whenever the shareholder takes it, and the undistributed amounts do not constitute basis for the shareholder. As you can see from the above example, assuming the money will eventually be distributed or used as basis in a sale, the spread in the tax rates from S to C remains approximately 10 percent both prior to and after the law change—assuming that you get the 20 percent exclusion.

Key Planning Point

An S election can be revoked at any time, but to have the revocation be effective at the beginning of the tax year, it must be done within two months and 15 days of the beginning of the current tax year. In order to elect S status again, the entity must wait five tax years. A partnership or LLC can be converted to a C corporation at any time, and an S election can be made at any time, but it must be made within the first two months and 15 days of a tax year for it to be effective for that year. Anyone who is considering a sale in the next few years would probably be foolish to revoke an S election or incorporate a partnership. However, a corporation that is in growth mode and will not be in a position to declare dividends for the foreseeable future may benefit from the 21 percent tax rate, which will allow it to build up equity more cheaply.

Let’s take a look at the rest of the key provisions of the act and determine whether or not there is any action to be taken:

To further muddy the waters on C corporation vs. S corporation, the act contains a provision that says that if an S corporation converts to a C corporation within two years of the enactment date, 50 percent of the distributions that it makes for the next six years will be deemed to be made from C corporation retained earnings and not S corporation retained earnings, which will make them taxable subject to the 20 percent maximum rate. They are clearly trying to discourage S corporation revocations.
Pass-through income will be reduced by 20 percent, subject to a limitation based on either 50 percent of the entity’s W-2 salary expense or 25 percent of the entity’s salary expense increased by 2.5 percent of the original cost of tangible property. Companies that operate through multiple entities, some of which do not have significant payroll, may want to revisit their corporate structures as soon as possible to make sure that all pass-through income gets the full 20 percent. This does not apply to most service entities (doctors, lawyers, accountants, etc.).
100 percent cost recovery for property placed in service after September 27, 2017, and before January 1, 2024—the threshold is 50 percent for assets placed in service from January 1, 2017, to September 27, 2017. For most machinery and equipment, under the IRC, placed in service means “when it is first placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income. …” The following three elements must be proved: readiness, availability, and capability to perform intended function. This may be a year when equipment installed in the summer may not have fully met these three elements prior to September 27, 2017. It is also important to note that this provision covers new and used equipment.
State and local tax deductions will be limited to $10,000 after 2017; therefore, you should prepay whatever you think you will owe for the 2017 year, unless you are sure that you will be subject to the alternative minimum tax, which does not allow any deduction of state and local taxes. The act contains a provision that says that you cannot prepay taxes for a future year and get a tax deduction.
New-car depreciation—cars placed in service after December 31, 2017, will be allowed $10,000 of depreciation in year one, $16,000 in year two, $9,600 in year three, and $5,760 per year thereafter.
Computers and peripherals are no longer considered listed property after 2017.
Recovery periods for real property are down from 40 years to 30 years, and the rules have been liberalized with respect to qualified leasehold improvements, qualified restaurants, and qualified retail property for assets placed in service after December 31, 2017. So, if you can push a closing on a piece of property or take the position that an improvement is placed in service next year, you may reap some benefits.
Like-kind exchange treatment repealed for non-real estate transactions. Open trades, in which the taxpayer has disposed of the relinquished property or acquired the replacement property before December 31, 2017, are grandfathered in. If you are in the middle of a transaction in which you are trading in an older piece of equipment, get the paperwork done as soon as possible, so you can say that the transaction is grandfathered in. If you wait, the credit that you receive for the trade will be taxable.
Business entertainment is nondeductible after December 31, 2017, although business meals still are (subject to the 50 percent disallowance).
No deduction is available for amounts paid to settle sexual harassment claims subject to a nondisclosure agreement.
Code Section 263A, which requires nonfactory overhead costs to be capitalized into inventory, is repealed for any converter or reseller with less than $25 million in gross receipts. Finally, some relief for small business. I would suggest a conservative calculation for 2017, since it will be reversed in the following year.
Technical termination of partnerships, in which more than 50 percent of the equity changes hands in a 12-month period, is repealed. This should help many family-owned smaller partnerships facilitate business succession planning without having to worry about the tax effects of a technical termination.
The corporate alternative minimum tax (AMT) is repealed, and the exemption amount for the individual AMT is increased to $109,400 (married joint)—currently, 60 percent of households with income between $200,000 and $500,000 pay AMT. Medical expense threshold for 2018 is reduced to 7.5 percent of income, and medical expenses are not deductible for AMT. Another planning point may be to defer paying medical expenses until 2018, when they have a greater chance of being deductible and not causing AMT.
New mortgages are limited to $750,000.
Miscellaneous itemized deductions are suspended.

The following is a list of changes in the act, which are for information purposes, as I do not believe there is any current action to be taken with respect to them:

A comparison of married/joint tax rates.
Section 179 deduction increased to $1 million and the phase-out threshold is increased to $2.5 million.
Disallowance for interest expense in excess of 30 percent of taxable income (EBITDA)—not applicable to businesses with less than $25 million in gross income, and certain real estate entities can elect out by changing their depreciation methods.
Net operating losses can no longer be carried back and are limited to 80 percent of taxable income going forward.
Domestic activities production deduction is repealed. This was a nice break for domestic manufacturers.
Standard deduction increased to $24,000 for married joint filers and $12,000 for single filers.
Personal exemptions are suspended (they phased out for high-income taxpayers, anyway).
The “kiddie tax” has been modified to tax unearned income of children based upon the estate and trust rates, rather than the rates paid by their parents. This may save money for some and will speed up processing tax returns, since the children will not have to wait for their parents’ returns to be finalized.
Disallowance of business losses in excess of $500,000 (for married taxpayers; $250,000 for individual taxpayers). This means that if you invest in an activity that you actively participate in, and it shows a loss greater than these limits (after netting it with all of your other active trades and businesses), then the excess is carried over to a future tax year.
The deduction for casualty and theft losses is suspended.
Child credit is increased to $2,000 per child, with $1,400 refundable even if there is no tax. This phases out at $400,000 of income for married taxpayers.
Charitable deduction for college athletic seating licenses where the donor receives the right to purchase tickets is revoked.
Alimony deduction (and income to the spouse) is suspended.
Moving expense deduction and exclusion is suspended.
The “Obamacare” individual mandate is repealed.
Expanded use of Section 529 plans for elementary and secondary private schools, including religious schools.
New deferral available for certain grants of stock options.
Estate tax exemption is doubled (approximately $22.4 million for a married couple).