2018 Tax Reform Explained
By: Hugh Pendleton, President
The US tax code is 2,600 pages long. To put that in perspective, Frodo and Sam traveled to Mount Doom and back in 1,008 pages. Harry Potter defeated Voldemort in 4,224 pages. And what does the tax code do in 2,600 pages? Breaks our minds and drags down our hearts. (And I wish I was kidding.)
If I were to explain why it’s so long, it would take way too many pages, so let’s skip that. Instead, let’s focus on the changes made by the 2018 tax bill.
If it actually made our tax code simpler, you wouldn’t need me, but as you can see, the information is still pretty dense. That’s why you’re here. Layman’s terms and a quick overview coming right up.
I'm only going to cover business tax changes, not individuals. BUT, if I get enough requests for an additional blog, you may see a 2018 personal tax explainer pop up next week.
What’s changed for businesses
If you’re a corporation, your tax rate is now a flat 21%. Before, it ranged from 15-35% depending on your total taxable annual revenue. What does that mean for you?
If you pay taxes on $50,000 or less per year, your taxes will increase by 6%. If you pay taxes on $50,001 or more, your taxes will decrease by 6-14%. Please note there is a difference between total revenue and total taxable revenue. Depending on the number of deductible expenses you have for things like supplies, business travel, and office space, you could have total revenue of $100,000, but only pay taxes on $75,000.
Let’s use our friends Barbie and Ken to explain in more detail.
Barbie runs her fashion empire out of her Dream House and makes $10,000,000 per year. She uses her pink convertible for business travel and often hosts industry pool parties in her killer backyard. She’s able to deduct her house and 100% of her business expenses, excluding the events, leaving her with $5,000,000 in profit (aka taxable income). Mostly good for Barbie, but she’s sad she can no longer deduct business entertainment (those parties are great PR generators, but they're costly).
Barbie’s lover and budding fashion rival Ken has just started a clothing line and makes $100,000 per year. He also runs his business via a home office in his two-bedroom condo and has some start-up related expenses and deductions that bring his total taxable income to $45,000.
So, Barbie with her large fashion empire gets a tax break, while Ken with his designer startup gets a tax increase. Additionally, deductions for business entertainment are no longer deductible, but travel meals are. So Barbie’s lunches with Ken are no longer deductible. However, Barbie can still deduct her meals while at Fashion Week in Milan (50%).
If you’re not sure how much you’re deducting vs. earning, ask your accountant how much taxable revenue you have to find out your 2018 tax rate.
Next, the 179 deduction limit has been increased to $1,000,000. This deduction allows you to write off your fixed assets purchases (cars, equipment, etc.) immediately rather than depreciating them over a few years. You can claim this deduction no matter your business type. This deduction is also limited to taxable income and any excess can be carried over.
Let’s say Ken decides to buy new manufacturing equipment for $200,000. He can now deduct the entire $200,000 up front, rather than claiming the deduction as a percentage of the annual depreciation over the lifetime of the equipment. Unfortunately, he only has $45,000 in income, so the balance of $155,000 gets carried over to next year. Barbie could have used it all.
Using this deduction almost always makes sense if you have sufficient income to utilize it. In Ken’s case, next year, he’ll have a $155,000 carry-over deduction to the extent that he has income. If next year’s income were $125,000, he would use $125,000 of the $155,000, leaving $30,000 to carry over to the following year. It’s better if you can use the entire deduction up front, but Ken’s method is still better than depreciating the asset.
The Corporate Alternative Minimum Tax has also been repealed. It's an additional tax you have to pay if the IRS determines that you’ve deducted too much and haven’t paid enough tax. But no more! Now when Barbie travels around the world launching her new swimsuit line, she doesn’t have to worry about her deductions causing an increase in her overall taxes at the end of the year. Go ahead, Barbie, have another Martini on Barbie Fashion, Inc.
If, unlike Barbie, you are an S Corp, LLC, Partnership, or Sole Proprietor, what happens? Don’t you pay taxes for your business as an individual? Yes, and the flat corporate tax doesn’t apply to you since you pay your taxes differently.
If you file your taxes under any of these entities, you are now limited to a maximum 20% deduction of your net income. This deduction also can’t exceed either 50% of payroll or 25% of payroll plus 2.5% of fixed asset additions. Payroll paid to principals (i.e., owners) doesn’t count, and if you’re involved in professional services like medicine, legal, accounting, engineering, etc., you get no deduction at all. So this new structure is excellent for big businesses but hurts smaller businesses.
Please note: If your income is under the threshold amounts, you may take the 20% deduction irrespective of wages paid. The threshold amounts are $157,500 single and $315,000 married.
Let’s say Barbie and Ken both decide to reclassify their businesses from C Corps to S Corps. Their tax breakdowns would look a little something like this.
Barbie has $10,000,000 in sales and $5,000,000 in expenses of which $2,000,000 are payroll. She has no significant fixed asset purchases. Her deduction would be 20% of income ($5,000,000 X 20%), $1,000,000 OR 50% of Payroll ($2,000,000 X 50%) $1,000,000. In Barbie's case, the 20% income deduction is the same as her maximum payroll deduction so she would pay tax on $4,000,000.
If the payroll deduction exceeds 20% of your income, you're still capped at 20%. If the 20% income deduction is more than 50% of your payroll, you're capped at 50% of your total payroll. So, if Barbie made $6,000,000 next year but still only had $2,000,000 in payroll, she could only deduct $1,000,000, not $1,200,000 ($6,000,000 x 20%).
Since poor Ken is under the threshold amount, he would get the 20% deduction. If he had been over the threshold amount, he would have been subject to the payroll limitation. And you wondered why Barbie has the mansion, the convertible, and all the rest. Maybe she’ll buy Ken dinner (but won’t be allowed to deduct it).
Congress also added the Family Leave Tax Credit. If you are (or plan to) provide paid family leave, you can now claim a tax credit, provided you meet all criteria. This credit offsets between 12.5% and 25% of the payroll cost for providing family leave. This benefit mostly helps businesses who already offer paid family leave, even though the intention is to encourage more companies to provide paid leave. If you're considering this, please contact a qualified payroll provider to see how these provisions apply to you and to help maximize your credit.
And the final change: no more lawsuit deductions if it involves sexual abuse or assault and includes a non-disclosure agreement. So businesses can no longer hide behind an NDA and deduct their costs. You may have been hoping for one more example from Barbie and Ken, but on a more serious note, this is a huge step forward in increasing penalties for businesses who fail to protect their employees from abuse and assault. They can no longer use civil penalties as another tax break. Hopefully, this will encourage business owners to not only stand up and protect individuals who experience this but take steps to make sure it doesn’t happen in the first place.
What hasn’t changed
Pretty much everything else. You still have to keep receipts, file on time, etc. No simplification, no new forms, and the usual April 15 deadline.
What you should do next
Seriously re-examine your legal and tax form of business. Depending on your income and expenses, a C Corp which is now subject to a flat 21% tax may be a lot more attractive. Or if you have been a small corporation paying 15% in taxes, it may make sense to become an S Corp to avoid a tax increase.
While this new bill doesn’t affect your 2017 tax return, you should start talking to your tax advisor now. If you don’t, by the time the end of 2018 rolls around, you could end up paying higher taxes, and nobody wants that.
If you don't have a tax advisor, we'd be happy to help. With 35 years of CPA experience under my belt, I've collectively saved clients several million dollars. Get in touch and let us help you too.