Tax Reform for your Small Business

Tax Cuts and Jobs Act for Small Businesses

On November 2, 2017, Congress released full details of 2018 tax reform proposals. Included in the proposals are changes for individuals and businesses. It passed 227-205 in the house on November 16, 2017. The Senate has variations to this bill. I noted some of them in the text below, but this article is primarily focused on the bill that passed.

Earlier I summarized the year-end planning points for individuals, which included a lot of changes. In this edition, I included a summary for entrepreneurs.

Individual year-end planning points are much more straightforward and actionable. My suggested plan of action included an “if this, then that” scenario analysis. This type of analysis is suggested because what we have today are PROPOSALS, not laws.

Understanding the proposals is important because it gives us a guide on what is on the horizon. There needs to be an expectation that this won’t be the final look for the new tax law. Yet, there will be key aspects of this proposal that will end up in the law.

Since it’s November and the earliest expected date these proposals will become law isn’t until December makes we’re left with an “if this, then that” path to planning.

Business changes will require a review of your overall tax strategy. What was standard protocol under the old law doesn’t appear to be standard protocol under the new law.

Before we get into the proposals, there are some minimum requirements for year-end planning that all business owners need to do before they are able to do the “if this, then that” scenario analysis.

Minimum requirements

Listed below are 5 minimum requirements you must have out of the way before you can plan for tax reform. If these aren’t complete, then planning for tax reform is more like throwing darts.

#1: Clean up your accounting records

Accurate bookkeeping is the cornerstone of tax planning. Without accurate books, you are at a disadvantage in terms of information. Time spent making your books accurate is absolutely necessary to identify your deductions and projected tax rate.

What does cleaning up your bookkeeping mean?

  • All transactions for year-to-date are recorded in your accounting software
  • Cash is reconciled
  • All balance sheet accounts are reconciled
    • Example: if you have a loan balance then on your BS then that should agree to the loan statement received from the lender.
  • Review your profit & loss statement for reasonableness
    • How does it compare to the prior year? Does the change seem reasonable?
    • You’re not an expert, but this base level review can catch blatant errors
#2: Identify entity changes

Did you start or end an entity? Add or subtract partners or shareholders? These changes play a significant role in your tax rate and tax return preparation

#3: Identify major purchases or sales of property

Purchasing real estate, equipment, vehicles, and other assets weighs heavy in your tax calculation. Understanding the details of the transaction is absolutely necessary before any tax advice can be provided. The same goes for sales of any of these assets.

#4: Gather up your documentation

Poor documentation is the sign of somebody who overpays taxes. The number one way not to lose a tax audit is to have good documentation.

Your CPA may not want your shoebox of receipts, but you need to have your shoebox ready. If you’re handing your QuickBooks file to your CPA in November and they ask you about a purchase in February are you going to remember the details? Probably not, so have your documentation in an easy to navigate filing system so you can get the necessary details.

Good documentation also adds more assurance that you won’t miss a deduction.

Documentation may include:

  • Receipts
  • Meeting minutes for your businesses/entities
  • Loan documents between you and your businesses/entities
  • Agreements between you and your businesses/entities
  • Mileage logs
  • Business activity logs
#5: Make a list of your questions

Your CPA can’t read minds, so a simple list of questions can go a long way into your tax planning.

Throughout the year, write down questions that come to your mind. It is amazing how often a question you ask can save you big money.

Tax Cuts and Jobs Act

With your minimum requirements complete, you are positioned to succeed in planning for tax reform.

Listed below are some of the changes and how they may impact our thinking going forward.

Accelerate Deductions and Defer Income

The tax year 2017 will be like any other year… Accelerate Deductions and Defer Income.

The general idea is that a dollar of tax saved today is worth more than a dollar saved tomorrow. There is truth behind this as long as there isn’t a big gap between the tax rate you’re receiving the deduction at today versus your tax rate tomorrow.

For example, you could buy a $1,000 widget on December 31st or January 1st. On December 31st you’re expecting to be in the 15% tax bracket, which is $150 of tax savings. If on January 1st you are expected to be in the 25% tax bracket, your deduction is worth $250. In this example, a deduction today is not worth more than a deduction tomorrow.

As we look at December 31, 2017, versus January 1, 2018, all signs are pointing towards higher tax rates today and lower tax rates tomorrow. This combination falls right in line with “accelerate deductions and defer income.”

Let’s dig into what to expect in 2018.

Choose your entity wisely

After good accounting records, entity selection might be the most important step in protecting you from overpaying taxes.

Entities also provide a layer of protection between you and the entity. At a basic level, it is an insurance policy.

Entities also have favorable tax characteristics. Tax characteristics that are projected to change.

Expected tax rate for Partnerships, S Corporations, and LLCs

Under the current system, Partnerships, S Corporations, and LLCs are taxed at the individual ordinary tax rate. There are different rules for each entity type, but in the end, all profits from the business are taxed at individual ordinary rates.

At the individual taxpayer level, you are required to declare the income as either:

  1. Passive
  2. Active

Passive is determined under existing IRC Section 469 rules. It is based on “material participation” rules, which means to be considered passive the goal is to work under 500 hours per year (plus other tests) in that business.

Active means you materially participate (i.e. 500 or more hours) and do not meet the passive activity requirements.

I didn’t write that to bore you. I wrote that because it will be very important going forward.

Under the tax proposals, passive pass-through income will be taxed at a flat 25% rate. In an amendment to the proposal, a 9-percent tax rate will be available on the first $75,000 in net business taxable income of an active business owner earning less than $150,000 then phased out at $225,000. The Senate is proposing a 17.4% pass-through deduction for non-service businesses.

While the current system taxes all pass-through income at the individual marginal rates, the new system will include a split between individual tax rates and a flat 25% rate.

Passive business interests will be subject to the flat 25% tax rate.

Active business interests will be split between “labor” and “capital contributions.” Labor will be taxed at the individual tax rate. Capital contributions will be taxed at the flat 25% rate.

If you operate with an S Corporation, the theory might sound familiar. These rules resemble the requirement to pay a “reasonable salary.” That is a wage that represents labor you provide to the business. The difference is that the wage and the profit are both taxed at the same individual tax rates.

Active business interests will include a default provision that 30% of business income will be subject to the capital contribution tax rate (i.e. 25%). The remaining 70% will be taxed at the individual tax rate (i.e. your marginal tax rate(s)).

Here is an illustration to help visualize it:

If you are paying a Guaranteed Payment (Partnership) or a Reasonable Salary (S Corporation) then that income is automatically considered labor income.

Capital-intensive businesses (ex: manufacturing) will determine the capital percentage by multiplying their capital investments into the business at an assumed rate of return. The rate of return is suggested to be short-term rates plus 7%.

Any business can go in excess of the default 30% capital contribution. However, it will be based on facts and circumstances. Planning for that should start today.

Service Providers

If your key business activity is providing a service, the default rule is that 100% of your income is labor income. Not only is this designed as a “fairness” rule, it is an anti-abuse rule put in place to create a disincentive for highly compensated employees from being classified as independent contractors.

A Specified Service Activity is defined under IRC 1202(e)(3)(A) as:

“any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,”

A planning idea is for service-based business owners to demonstrate a greater than 0% capital percentage based on their actual capital contributions to the business.

The motto of “work ON your business, not IN your business” will be more applicable than ever.

Planning will surround how business owners can scale down their involvement to the point of not being an active participant. This is a total perspective shift because passive business rules were bad but now passive income rule is good.

If you operate an entity with a mix of business activities, here is the ultimate sign you need to split out those activities into separate entities.

The end of S Corporations?

Anybody who utilizes an S Corporation wants to pay the lowest salary possible to avoid self-employment taxes (i.e. Social Security and Medicare). Under the new law, there may be even more incentive to lower your salary for high earning S Corporations.

The lower the S Corporation salary, the more income that would be exposed to the 25% capital contributions rate versus the potentially higher individual tax rates.

Since fighting a lower reasonable salary could be a losing battle, there might be motivation to move to a partnership or LLC. Presumably, it will be easier to qualify for the full 30% capital contribution safe harbor since there are no salaries reducing the amount exposed.

Yet, self-employment taxes will still play an important part in that decision process.

Back to Schedule C?

Schedule C may end up being the default choice for many Solo S Corporation owners. In the past, the break-even between an S Corporation and a Schedule C could be determined by looking at the tax savings in self-employment tax versus the cost of compliance. That wasn’t the final point in the decision, but the primary driver.

I expect solo S Corporations to need to re-evaluate the necessity of filing a separate tax return. This will be driven by comparing the income tax rate difference and the self-employment tax savings. Something that will be a new layer of the decision process since income tax rates don’t matter in the current system.

Will C-Corporations be the entity of choice?

The current C-Corporation law has a four-tier rate schedule (15%, 25%, 34%, and 35%). The proposed C-Corporation law will utilize a flat 20% rate (Senate provision will delay until 2019). Unless you’re a personal service corporation, which is subject to a flat 25% tax rate.

C-Corporations have different rules in terms of getting money out of the entity and employee benefits. These rules may or may not be favorable for everybody, but the lower entity rate will be attractive.

There are certain taxpayers who may benefit from eliminating their C-Corporation. C-Corporations that pay a 15% tax rate, they could see a tax rate increase under the new system if their business income is $50,000 or less.

What should we do by 12/31/17?

Knowing how the rates are expected to stack up gives you good insight on whether or not you should accelerate deductions and defer income.

Now is the time to think about how your business operates and what you can change to take advantage of the more favorable rates on the horizon.

Transaction Decisions

Making purchases or sales are always an important part of the decision process. Some of these decisions will need to be re-evaluated under the new rules.

Immediate Expensing of Capital Assets

We’re all used to Section 179 or Bonus Depreciation. There have been years where we had 100% bonus depreciation, which is the immediate deduction of purchases that qualify as under 20-year life (primarily 5 and 7-year property).

The bill will provide 100% expensing for under 20-year life property acquired and placed in service after September 27, 2017, through January 1, 2023. I assume the sunset provision is listed for budget reconciliation purposes. The desire would be to keep this permanent.

Bonus depreciation is available to “new” assets, not “used” assets. What isn’t clear is if this new law will have the same goal.

If the capital asset can be 100% expensed whether it is new or used, then Cost Segregation studies could become an even more powerful strategy. In fact, it could end up being foolish for most not to utilize a cost segregation study.

Like-Kind Exchanges

Personal property such as business equipment will no longer be eligible for like-kind exchange treatment. Trucking companies or farmers who have large equipment would want to keep an eye out for this.

It is reasonable to consider a like-kind exchange before the end of 2017.

Fortunately, real estate like-kind exchanges would remain in play.

Other Miscellaneous Changes

If you own a business with more than $5 million in revenue or with foreign interests then there other changes that I will not address. If that’s you, then talk to your CPA and start the discussion.

Otherwise, here are a few additional changes and planning ideas.

Will Incentive Stock Options make a comeback?

If you read my individual tax reform guide, you will notice that people with incentive stock options have a year-end decision to ponder.

For business owners, it is possible that ISO’s could become a popular compensation choice. With the repeal of AMT, only capital gains would be paid upon the sale of ISOs.

Last call for business and energy credits

With the reduction in tax rates for businesses, a compromise is needed. This compromise includes the repeal of various tax credits:

  • The work opportunity tax credit (Sec. 51).
  • The credit for employer-provided child care (Sec. 45F).
  • The credit for rehabilitation of qualified buildings or certified historic structures (Sec. 47).
  • The Sec. 45D new markets tax credit. Credits allocated before 2018 could still be used for up to seven subsequent years.
  • The credit for providing access to disabled individuals (Sec. 44).
  • The credit for enhanced oil recovery (Sec. 43).
  • The credit for producing oil and gas from marginal wells (Sec. 45I)

I suspect this list will be added to and revised in the coming weeks after taking time to digest some of the new proposals. Stay tuned for updates and revisions.


Do you want to understand how to make your money work for you and keep more of what you have earned?

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.