The general philosophy of the bill demonstrates the GOP predilection to reward their supporters. As was true for the personal tax situation, HR-1 benefits businesses that thrive in “Red States” (agriculture, manufacturing) and penalizes those that prevail throughout the “Blue States” (finance and media).
As it stands now, corporations- just like individual tax payers- pay different marginal tax rates. Here’s where they’re at right now.
Marginal Tax Rate
< $ 50,000
$ 50,001 to $ 75,000
|$75,001 to $10,000,000||
Moreover, when a company has more than $ 10 million in profits, there is no 25% nor 34% marginal rate. In other words, it is obligated to pay 15% on the first $ 50K and then 35% on the rest. IF the profits exceed $ 15 million, the 34% rate gets phased out until $ 18.33 million, when the only tax rates to pay are the first 15% bracket, with 35% on the rest of business income.
There is a big exception to this rule- personal service corporations. These are firms that provide health services, legal representation, engineering, architecture, accounting, actuary services, performing arts, or consulting. These corporations are always taxed at a straight 35%. (Hmm. Now you know why over the years, these firms now form LLC and NOT corporations!)
The big change HR-1 has wrought? The corporate tax rate would now be 20% across the board. Yes, that means smaller firms are going to be zapped for 5% more taxes. And, those personal service corporations? They save some money, but are still taxed at a special flat rate of 25%.
Then, there’s pass-through companies. Officially, pass-through companies are awarded a 25% income tax rate. And, since they don’t pay any taxes, it means the stakeholders (shareholders or partners) in those companies get to pay those tax rates. BUT… It turns out that only passive owners of those firms will be eligible for that 25% rate. Oops- there are even more exceptions. Those families whose adjusted gross income is less than $ 260K and single folks who make than $ 200K are to be awarded no tax reduction at all.
(That exception covers 10 million or 40% of the total number of pass- throughs. And, pass-throughs garner some 56% of all business income. You should also know that the top 1% income earners receive 70% of all partnership income in the US.)
Active owners (remember- they don’t get the benefit of that reduced tax rate for pass-throughs) who are in the professional services (lawyers, doctors, accountants, etc.) will probably be paying a 39.6% tax rate from now on. Other active owners (such as retailers or manufacturers) will be treated as CEO and investors. As such, 70% of the pass-through income will be taxed at the individual’s tax rate and 30% of the pass-through income will garner that coveted 25% tax rate.
(By the way, you can bet this will change the way the IRS decides what is reasonable compensation for such firms. It will become standard for reasonable compensation to be at least 30% of the potential pass-through revenue, if not at an even higher level.)
Capital and Depreciation
Current law lets businesses “write off” their expenses for qualified property faster than normally. The “qualified property” are those items subject to MACRS (modified accelerated cost recovery system) with a recovery period of 20 years or less. The additional write off is 50% in 2017, 40% in 2018, and 30% in 2019.
The new rules will cover all “qualified property” placed in service between 27 September 2017 and 1 January 2023- and will allow the firm to literally write off the costs. 100% of the cost will be able to be expensed immediately. (You did notice this expires after 5 years, right?)
This is separate and apart from Section 179, the special depreciation rules that have been in force for almost 6 decades now. Any property that costs $ 500K or less can be “expensed” in the calendar year of purchase. Up to $ 2 million can be handled this way- and the only limitation is the amount of profits the firm has. (You can’t create “negative” income via a Section 179 deduction.
Right now, some small businesses are eligible to use “cash accounting”. Cash accounting means the firm recognizes income when it is received and expenses when they are paid. Accrual accounting would mean that income is recognized when a client/customer is billed (regardless of when they pay the tab) and expenses are recognized once the bill is received (even if you have not paid the bill).
Which small businesses are eligible? Partnerships (only those with no corporate partner), sole proprietorships, and S entities. Corporations- whether alone or in a partnership can only use cash accounting if they accrue less than $ 5 million in gross receipts. Farms (corporate entities or in partnership with a corporation) need to abandon cash accounting when their gross receipts exceed $ 1 million.
With one big proviso. If the firm’s business involved inventory, then cash accounting is out once the gross receipts reach $ 1 million. (There are very specialized exceptions which let the cutoff be $ 10 million, but these are pretty specialized.)
If this act passes as it is presently constituted, Cash Accounting will be allowable for all entities, as long as annual gross revenue does not exceed $ 25 million.
There are companies that effect long-term contracts. (Many of our R&D projects involved 3 year terms. That’s the sort of deal we are discussing here.) When these relationships exist, the firm must use the percentage of completion method to account for income and expenses. Unless, for the past three years, gross receipts did not exceed $10 million a year- then percentage of completion can even be used for projects that have a two year time frame or less. The proposed law will raise that exception to $ 25 million.
The Deductibility of Business Interest
As of now, businesses can deduct the costs for interest for items that have been financed. Under the proposed law, only that interest that equals 30% or less of the adjusted taxable income (not counting taxes, depreciation, amortization, and the total amount of interest paid) will be deductible. And, if the entity is a partnership, the rule applies to the entire entity (the one that files an income tax return- not to the individual partners, who will receive their pro-rata share listed on the K-1. (The K-1 is akin to a W-2 for employees; the K-1 explains how corporate revenue and expenses are allocated to the shareholders.) Unless- the entity has a gross income of $ 25 million or less- they can deduct all the interest they pay.
The legislation proposal provides that $ 25 million exception because the House recognizes that smaller businesses are less likely to find investors (who buy stock and, therefore, invest capital in the firm). These smaller entities generally must borrow money for their equipment.
Oh, and commercial real estate firms also have special rules that make this interest deduction rule less onerous on their continued operation. (Yes, those firms have been big supporters of the GOP.)
Net Operating Losses
When a firm generates a loss, it has IRS code permission to carry back that loss to the previous two years (which means an amended tax return is filed) or forward for the next 20 years, until the loss has been extinguished. (This is akin to individual taxpayers dealing with a big stock loss- except that doesn’t get carried backward, just forward, with a maximum capital loss of $ 3K a year allowed.)
The new rules will let one carryback the loss but will now limit that deduction to 90% of the corporation’s profits for the years to which the loss is carried back.
Section 1031 Exchanges
Most of you know this section as it applies to real estate sales. A seller found a property that it can buy that is “similar” [in function, not in size or location] and not pay capital gains on the sale of the property. In essence, the basis is rolled into the new property, which means the IRS doesn’t get to collect taxes for a while (until there is no longer a 1031 exchange made upon the property sale).
But, more things were permitted to have the gain extended forward under Section 1031. No- not stocks, bonds, or partnership shares. (In other words, things that are held primarily to promote a sale of the item in the future to generate a gain.) Except, the new law stipulates that 1031 exchanges will only be allowed for real property from now on.
This one really makes me happy. Right now, businesses cannot deduct the costs of lobbying. (You may now realize why so many of these firms are considered to be “public relations” entities and try to avoid having to register as “lobbyists”.) Except when businesses lobby our local governments, the IRS was required to accept those costs.
That exception evaporates under the new proposed law.
Most of you know that entertainment expenses are only 50% deductible. Just like meals, unless the meals are provided to one’s employees as a means to have them keep working (like overtime, or working lunches). The other half of the expense was not deductible against one’s profits for the calculation of taxes due.
Except the new law outlaws ALL entertainment expenses. No amusement or recreational activities and/or membership dues related to these activities or for social purposes. No transportation fringe benefits or on premises gyms.
And, if this were a non-profit entity, the cost for these activities will now be taxable to the non-profit!
Well, we’ve hit 1550 words. That’s long enough. We’ll finish the business tax changes tomorrow.
The Entire 7 Part Series on the “Tax Reform & Jobs Act”
Personal Taxes, part 1
Personal Taxes, part 2
Grad Students, private colleges
Biz Taxes, part 1
Biz Taxes, part 2
Senate’s version changes