Last week, I reflected on my growing popularity as we reviewed some of the most significant aspects of individual income tax reform under the Tax Cuts and Jobs Act (P.L. 115-97). This week, uneasy lies the head that wears a crown of tax reform popularity as we examine the business aspects of tax reform.
Business Tax Reform
Corporation Income Tax Brackets: Under prior law, net income of corporations taxed under Subchapter C of the Internal Revenue Code (C corporations) was subject to taxation under four brackets.
Taxable Income Rate
Up to 50,000: 15 percent
50,001 – 75,000: 25 percent
75,001 – 10,000,000: 34 percent
10,000,000 +: 35 percent
Once a C corporation’s taxable income exceeded $100,000, however, the lower two brackets were phased out so that C corporations effectively paid a flat tax of 34 percent on the first $75,000 of taxable income. Meanwhile, under prior law “personal service” corporations (i.e., those providing health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) paid a flat 35 percent tax on taxable income.
Effective for 2018, The Tax Cuts and Jobs Act eliminates the corporate income tax brackets and instead imposes a flat 21 percent rate on all corporate taxable income, including personal service corporation income. Unlike the individual income tax rates, which expire after 2025, the corporate rate change is permanent. The corporate rate changes should cause businesses currently taxed as C corporations and personal service corporations to review their salary and distribution practices to minimize income and employment taxes. Businesses not currently organized as a C corporations may want to consider whether a conversion will be tax beneficial.
Accelerated Cost Recovery: Under prior law, businesses could elect to expense the first $500,000 of certain property (Section 179 property), subject to a phaseout limitation. The Tax Cuts and Jobs Act increases the expense amount from $500,000 to $1,000,000, increases the phaseout limitation by $500,000, and adds certain qualifying real property to the definition of Section 179 Property.
Under prior law, businesses were also permitted a bonus depreciation deduction equal to 50 percent of the adjusted basis of qualifying property. The Tax Cuts and Jobs Act increases the bonus depreciation deduction for qualifying property to 100 percent for tax years 2018 through 2022, and then phases out the deduction by 20 percent each year between 2023 and 2027. The ability for taxpayers to fully deduct the cost of capital acquisitions is expected to drastically increase the capital expenditures by businesses over the next 5 years.
Deduction for Qualified Business Income: Unlike C corporations, other business entities, including partnerships (and limited liability companies taxed as partnerships), corporations taxed under Subchapter S of the Internal Revenue Code (S corporations), and sole proprietorships, are generally not taxed separately on income at the business entity level. Instead, the business income “passes through” to the owners, who each pay tax based on the owner’s applicable individual tax rate. In light of the corporate tax reductions, the Tax Cuts and Jobs Act provides a 20 percent deduction for certain qualified business income in order to treat corporate and non-corporate business income similarly. Unlike the corporate tax reductions, the 20 percent deduction is not permanent. Instead, the deduction is scheduled to expire at the end of 2025 with the individual tax reform provisions of the Tax Cuts and Jobs Act.
The deduction is calculated as the lesser of the combined qualified business income of the taxpayer, or 20 percent of the excess of taxable income over the sum of any net capital gain, plus the lesser of 20 percent of qualified cooperative dividends, or taxable income less net capital gain. If the taxpayer’s taxable income exceeds certain levels, the deduction is limited by the greater of 50 percent of the taxpayer’s allocable W-2 wages paid by the business or 25 percent of the taxpayer’s allocable W-2 wages paid by the business, plus 2.5 percent of the taxpayer’s allocable share of the unadjusted basis immediately after acquisition of all “qualified property” of the business. Got it? Said another way, certain qualifying taxable income earned by owners of non-corporate businesses will qualify for a 20 percent deduction, subject to certain limitations. To better understand which taxpayers, types of income, and activities qualify for the deduction, let’s review a few of the more important aspects of the deduction below.
- Who is a taxpayer? The 20 percent deduction is available to any taxpayer that is not a corporation. This includes partners in partnerships, members of limited liability companies taxed as partnerships or disregarded for tax purposes, shareholders of S corporations, and sole proprietors. But, as we’ll below, excludes employee wage income.
- What is “qualified business income”? The Tax Cuts and Jobs Act defines “qualified business income” as the income, gain, deduction, and loss from any “qualified trade or business” of the taxpayer, excluding certain real estate investment trust (REIT) and cooperative qualified dividends and publicly traded partnership income.
- What is a “qualified trade or business”? The Tax Cuts and Jobs Act defines a “qualified trade or business” as any trade or business that is not a “specified service trade or business” or employee services. The Tax Cuts and Jobs Act fails to define “trade or business” for the purpose of the deduction. So, at this point, you may rightly be wondering if your hobby, sole proprietorship, or side hustle qualifies as a trade or business. Well, courts have traditionally applied variations of a facts and circumstance test to determine whether a taxpayer’s activities are considerable, regular, and continuous and conducted with a sufficient profit-motive to qualify as a trade or business. In other words, the answer is: it depends.
Digging even further into “qualified trade or business” definition, we learn that a “specified service trade or business” includes the provision of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, investing or investment management, and in cases where the business’s principal asset is the “reputation and skill of one or more of its employees or owners.” If you are a taxpayer with business income from a “specified service,” and your income exceeds certain thresholds ($315,000 married filing jointly, $157,500 single), then your 20 percent deduction will be reduced or entirely eliminated. Finally, because employee services are not considered derived from a qualified trade or business, an employee’s W-2 wage income will not qualify for the 20 percent deduction. Accordingly, the worker classification between employee and independent contractor, and the IRS’s multi-factor test to determine appropriate classification, will continue to cause headaches for employees and employers.