Recent tax reforms have the potential to impact every aspect of your business. Here are a tax deductions and tax savings to focus on.
On Dec. 20, 2017, Congress approved a sweeping $1.5 trillion tax bill that changed income tax rates for corporations, provided new breaks for private businesses and reorganized the individual tax code. The reform was the biggest overhaul of the U.S. tax system since 1986. For owners of small- and medium-size businesses, it was cause for celebration—mixed, perhaps, with a certain amount of head-scratching.
Many tax savings benefits for businesses were immediately apparent. The federal corporate tax rate dropped from 35% to 21%. There’s a new 20% deduction for pass-through income. And rates for many taxpayers decreased, potentially benefiting business owners and employees alike.
But some tax changes are not so advantageous. For example, under the new law many deductions have been reduced or eliminated. Other changes are buried deep in the tax code, or hold implications that won’t be fully understood until a period of trial and error has passed. As Daniel Hoverman, Managing Director of Regions Securities, says, “The new tax bill has a lot of nice, shiny perks for businesses. But it’s not a cohesive act of regulation.”
To get a handle on this monster of a bill, it helps to identify the most significant tax changes for small- and medium-size businesses.
The New Pass-Through Deduction
Fully 95% of U.S. businesses are so-called pass-through entities, according to 2014 Treasury Department data. These companies include most of those organized as sole proprietorships, S corporations, LLCs and partnerships, and their profits are taxed according to the owners’ personal rate. Under the new tax plan, their owners save money on taxes because they can deduct 20% of pass-through income, providing they meet certain requirements. Consequently, the maximum individual tax rate on pass-through income decreases from 37% to 29.6%.
“That leaves a lot of extra cash for business owners to invest in new employees, higher salaries, more benefits and equipment upgrades,” says Hoverman. There are some limitations to the new deduction rule, though. “The biggest winners are smaller sole proprietorships and employee-driven businesses of all sizes,” says Robert Ricketts, a professor of accounting at Texas Tech University’s Rawls College of Business. That’s because the full 20% deduction is available only to single taxpayers with an income of $157,000 or less, and to married couples with a joint income of $315,000 or less. For businesses that bring in more money than that, eligibility—and the amount of the deduction—depends on a combination of income level and the type of business you own. Legislators tried to favor job creators, so businesses with W-2 wages or assets are generally better positioned for a pass-through deduction. The rules are complicated, though, so make sure to consult a professional.
The New Corporate Tax Rate
Under the new tax law, the corporate tax rate on profits plunges from 35% to 21%. On the one hand, it opens up opportunities for growth for all C corporations. On the other hand, the 20% pass-through deduction—combined with other changes for pass-through businesses—gives many pass-through businesses greater net tax benefits. Accordingly, some companies may want to consider restructuring.
“It will be interesting to see how this plays out,” says Hoverman. “A lot of it depends on how long you plan to keep money in the corporate entity.” Time horizon is key here because, while the corporate rate cut is permanent, the pass-through deductions phase out in 2025 (barring further changes to the law). If you’re unsure about which business structure is most advantageous, says Hoverman, be sure to model out various scenarios with a financial professional.
Property Savings
The number 179 is important to remember. That’s because Section 179 of the tax code has significantly changed under the new law. Before, businesses could deduct up to $500,000 of equipment. The new Section 179 law ups that limit to $1 million. For businesses with large, expensive equipment, these deductions could result in substantial savings that could lead to expansion.
Even more significant—at least for the next five years—may be new bonus depreciation provisions. Under the new law, businesses can take 100% bonus depreciation—with no one-dollar cap—on qualified property bought between Sept. 17, 2017, and Jan. 1, 2023, after which the provision will be phased out. Moreover, bonus depreciation can now be used for both used and new property.
“For most purchases made until 2023, bonus depreciation will save more money than Section 179,” says Ricketts. “Let’s say I pay 20% down on a machine for my business and finance the rest of it. With bonus depreciation, there’s a good chance my immediate tax benefits will exceed the down payment. That positive cash flow in the year I make the purchase should provide a huge incentive to expand.”
Ricketts notes that the cap in Section 179 necessarily limits the benefit—$1,000,000 is the maximum deduction. But with bonus depreciation, there is no cap, so it has the potential to save much more money.
The bottom line? Both the revised Section 179 and the new bonus depreciation rules will allow small and midsize companies to make more purchases and save money doing it.
Changes to Certain Deductions
The new tax changes aren’t all good news, however. The elimination of certain individual tax deductions include business expenses like travel costs and membership dues for professional organizations. And the deductibility of state and local taxes is now limited to $10,000.
An even more consequential change could be new rules about the deductibility of interest on debt payments. Previously, businesses could deduct any and all interest on debt; but starting this year, a business can only deduct interest on debt up to 30% of its EBITDA—that is, its earnings before interest, taxes, depreciation and amortization. And in 2022, it will be capped at 30% of earnings before interest and taxes but after depreciation and amortization—resulting in smaller deductions.
“For a long time, financing with debt has been worthwhile for businesses because the interest deduction shields that cash flow from tax,” says Hoverman. “Now a lot of companies are going to ask: If you can’t deduct the interest, why have it in the first place?” In addition to many businesses being cautious about incurring leverage, he says, some business owners may be more tempted to sell equity in their companies rather than creating financial leverage in traditional debt-driven buyout transactions.
Other Considerations
Other changes to the tax law are more specific and will affect fewer companies. For example, some benefits are targeted toward farmers, while others are aimed at other industries. And businesses with profits overseas will face a territorial tax system with potentially higher rates than they currently pay. Manufacturers with plants in Mexico, for example, likely have to pay more under the new rules.
Discovering the nooks and crannies of the tax code that affect your business is a hard but necessary task. Work with financial and tax professionals to identify tax deductions, find ways to save money on taxes and determine how best to position your business with regard to the new regulations. And with much of the law phasing out in a few years, be sure to have both a short- and a long-term plan.
“This is a work in progress for most businesses,” says Hoverman. “Lawyers and accountants are scrambling to figure out just what the new law will mean. But no one will know until a tax year or two has gone by.” Until then, he says, take advantage of the clear benefits and try to minimize any drawbacks.
Speak to your commercial banker about:
- What changes you should consider implementing in your daily processes to respond to the changing tax code
- What long-term business strategies need to be reexamined in light of the tax reforms
- How you might adjust your company’s financial practices to benefit from the changes to tax deductions
