The tax reform bill passed by the United States Congress known as the Tax Cuts and Jobs Act, majorly impacts tax rates for corporation and new qualified business deduction for sole proprietorship, partnership and S-Corporation, business deduction, depreciation rates for manufacturing industries and accounting methods. Let’s have a look at these reforms.
New Tax Rates for businesses:
- The tax liability would be calculated parallel using the corporate income tax return and a system called the corporate Alternative Minimum Tax (AMT). The higher of these two taxes were required to be paid. With the reforms, corporations are now required to pay a flat rate of 21% with the corporate AMT being repealed.
- Based on the business structure, businesses may fall under the category of Pass-Through businesses. These businesses include entities such as S-corporation, sole proprietorship or partnership which do not pay corporate tax rates. Instead, owners file the resultant “qualified business income” as a part of their individual income tax returns. With the lower corporate tax rate, pass through business owners can claim a 20% deduction on the “pass-through business income” conditional to certain criteria. This depends on if the taxable income is above or below a threshold amount ($157,500 for individuals and $315,000 for married joint filers):
- When taxable income is below threshold, the deduction is simply 20% of the business income.
- When it is above threshold, limitations on the deduction apply depending on the taxable income, W-2 wages and applicable percentage.
Calculating deductions in certain cases:
Case 1: An individual’s taxable business income is $300,000 and has a W-2 wage share of $200,000.
In this case, the deductible amount will be the lesser amount between (a) 50% of W-2 wage share and (b) 20% of business income share. In this case (a) is $100,000 and (b) is $60,000. Therefore, the amount the person can claim as deduction here is $60,000.
Case 2: An individual’s share in buying property co-owned by 4 is $3 million and his annual rental income is $1 million.
In this case if no W-2 wages are payed, the individual cannot claim a deduction under the former tax policy. The reforms allow the individual to claim a deductible amount that is the lesser between (a) 20% of rental income and (b) 25% of W-2 Wages + 2.5% of property purchase share. In this case (a) is $200,000 and (b) is $75,000. Therefore, the individual’s deduction in this case would be $75,000
Additional Notes: Deductions generally cannot exceed 50% of an individuals W-2 wage share from business. Certain individuals involved in businesses rendering personal services in cases such as accountants or lawyers cannot avail the deduction if their income is above the threshold amount.
Depreciation limits for businesses:
- Bonus depreciation (under Sec 168(k)) was a tax saving tool introduced for businesses to recover from the losses of capital acquisition in the form of property, machinery, etc. They were allowed deduct a substantial percentage of the costs for the first year of the property or equipment acquisition. Under the current policy bonus depreciation was to be phased out over the next 2 years and applied only to new property. The reforms revive and expand this through to 2022 with an eligible 100% deduction on the first year property is acquired and used, and eliminates the “applies only to new property” rule.
- For luxury automobiles (under Sec 280F), depreciation limits have been increased to $10,000 for the first year of service, followed by $16,000, $9,600 and $5,760 for the second, third and fourth years respectively. This applies for automobiles for which bonus depreciation has NOT been claimed.
- Sec 179 expense has also been modified by increasing tax payer expense limit to $1 million and indexing it to inflation. Additionally, the definition of qualified property under this has been expanded to include personal property used for lodging and certain improvements made to nonresidential property.
Accounting Methods for businesses:
- The Act makes it eligible for other businesses aside from pass-through entities grossing $25M or less in 3 prior tax years (Gross Receipts Test) to also use the simpler “accounting by cash” method.
- Businesses satisfying the gross receipts test are also not required under Sec 471., to account for inventories. Additionally, they are also exempt from the uniform capitalization rules under Sec 263A.