The sweeping tax reform bill known as the Tax Cuts and Jobs Act will overhaul the way the tax code treats businesses – whether small businesses or large multinational corporations. While it is not possible to gauge the exact ways different provisions will impact small businesses, it is very likely that the overall tax burden will be reduced for the majority of small businesses.
Strategic tax planning for businesses has never been more important. Here are several major changes that could affect the way small businesses operate:
The largest change in the tax code affecting small businesses will likely be the reduced tax burden on business entities that utilize pass-through taxation. Pass-through taxation is common in the business entities usually favored by small business, such as partnerships, proprietorships, limited liability companies, and S-Corporations. Business entities utilizing pass-through taxation account for 40.6 percent of all net income in 2014 and represented 95 of all American businesses in 2012.
Unlike corporations which are required to pay corporate tax on profits, pass-through taxation allows a business to distribute its profits to the owners, partners, or shareholders without taxation at the business entity level. Then, those that receive the distributions are required to pay personal taxes on the business profit. Because of the historically high corporate tax rate and the relatively lower individual tax rates, many small businesses have chosen entity forms that allow for pass-through taxation.
Under the new tax reform bill, taxpayers receiving profits from a pass-through entity will now be allowed to deduct up to 20 percent of the proceeds. There are two important caveats to the new tax deduction. Notably, the deduction phases out for high earners – beginning at $157,000 for individual filers and $315,000 for married couples filing jointly.
Lowered Corporate Tax Rates
For small businesses that are organized as a C-corporation, the tax rates under the Tax Cuts and Jobs Act will be significantly lower. The profit of a corporation will be taxed at a maximum rate of 21 percent, a full 14 percent below the current rate. For small businesses organized with pass-through taxation, the vastly lowered rates for corporations may now provide a more favorable tax structure for their business.
Changed Small Business Deductions and Expenses
There have been a slew of changes to business deductions.
Business interest deduction
Businesses will no longer be able to fully deduct the interest on business loans. Under the tax reform bill, the business interest deduction will be capped at 30 percent of income. The new 30 percent cap will not include depreciation.
New investment purchases
Currently, when a business purchases an asset it must follow a complex regulatory scheme and deduct the investment over the course of several years. The deductible amount and timing of the deductions depend on numerous factors including the type of investment and the industry which the business operates. This unnecessarily complex formula will be simplified by the new tax reform bill. Under the new bill, a business will be able to fully expense the investment the year it was purchased.
Section 179 Expensing
For many small business owners, Internal Revenue Code Section 179 can significantly reduce their tax liability. Section 179 allows small businesses to fully expense the cost of any capital equipment purchased during the year. Currently, small businesses may not deduct more than $500,000 in capital expenditures each year. The new tax reform bill increases this limit to $1 million.
Research and Development Tax Breaks
Currently, research and development expenditures can be immediately deducted. Under the new tax reform bill, these deductions would be spread out several years. This could potentially increase the tax burden for small businesses that rely heavily on research and development.
Net Operating Losses
Under the Tax Cuts and Jobs Act, net operating losses will also be treated differently. Currently, when a business has a net operating loss then it can either “carry-forward” or “carry-back” the loss by applying that operating loss to different years. Consequently, under the current tax structure, a business with a net operating loss can apply the loss retroactively to the previous year and, depending on the size of the previous year’s profit, qualify for a tax refund. Further, the business can also “carry-forward” the loss and apply it to any future year when it is most advantageous.
Like most other parts of the new tax reform bill, the treatment of net operating losses is simplified. Under the Tax Cuts and Jobs Act, businesses will only be able to deduct up to 80 percent of a net operating loss. Further, the business will only be able to “carry-forward” the loss.
The two most notable changes for how the new tax bill will change how small business operate include the lowered tax rates and the new accounting standards. Whether you are running a corporation, which will see its effective tax rate drop 14 percent, or a small business with pass-through taxation, which for many businesses will now be 20 percent deductible from personal income, the tax burden on small businesses is about to significantly drop.
If you have questions about how the new tax bill will affect your company, schedule a consult with taxation attorney Stephen Thienel today. Mr. Thienel has decades of experience assisting clients with their tax planning needs throughout, Maryland, Virginia, and the District of Columbia.
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