On November 2, the House released its much-anticipated tax bill (H.R. 1 ) called the Tax Cuts and Jobs Act. The measure has many moving parts and it’s too early to describe what a final bill will contain. But it’s a good idea to know what the proposal has in store for small business owners.
Tax on C corporations
If your business is set up as a regular C corporation, the rate would be a flat 20%. If the C corporation is a personal service corporation (defined on page 7 of the instructions to Form 1120), the rate would be 25%.
Tax on pass-through entities
For owners of sole proprietorships, partnerships, limited liability companies, and S corporations, the tax rate is more complex. Those who are mere investors, the rate would be 25% on business income.
But those who work in their businesses, there would be a 70%/30% split. The 70% portion (viewed as compensation for services) would be taxed at the owner’s normal tax rates, which could be up to 39.6%. The 30% portion (viewed as the investment portion) would be taxed at a flat 25% rate. The determination of “working in the business” would be made under the existing rules for passive activities, so that a material participation test would come into play. However, instead of a 70%/30% split may be altered:
- Owners in capital-intensive businesses (e.g., manufacturing) would be able to use a facts-and-circumstances test to reach a more favorable allocation.
- Those working in specified service activities (e.g., those in the fields of accounting, law, medicine, etc.), the 30% becomes 0%; all earnings are taxed at the owner’s personal tax rate. But investors in these businesses would use the 25% rate.
UPDATE: The Ways and Means Committee made a last minute change for small business owners who are active in their companies: A 9% rate (instead of a 12% rate) would apply for the first $75,000 in net business taxable income of an owner earning less than $150,000. This would be tax on the 75% portion described above. The $75,000 limit would be for joint filers; it would be $37,500 for singles, and $56,250 for heads of households. This would be phased in over 5 years.
The outline released by the Ways and Means Committee does not address how this allocation would impact FICA and self-employment tax. It appears (but I can’t be sure) that S corporation owners would have their 70% ordinary income share subject to FICA regardless of what salary they actually receive. But we’ll have to watch this matter.
UPDATE: The Ways and Means Committee made another change: preserving current-law rules for payroll taxes on pass-through entities.
Write-offs for property investments
Buying equipment would probably be fully deductible. This is because:
- Bonus depreciation would be 100% (instead of the current 50% limit)
- First-year expensing (Section 179 deduction) would be $5 million (instead of the $510,000 for 2017)
The proposal would allow the higher limits to apply for part of 2017.
Estate taxes
Small business owners’ family would be less at risk of losing the business to pay the federal estate tax (due 9 months after death). The bill would increase the exemption amount to $10 million (it is otherwise scheduled to be $5.6 million in 2018). This means that only estates over $10 million, after the marital, charitable, and other deductions, would pay the tax. The estate tax would end entirely after 2023. The stepped-up basis for inherited property would be retained.
End to certain credits
The measure would repeal these credits used by small businesses:
- Work opportunity credit
- Disabled access credit
- Credit for plug-in electric vehicles
End to certain deductions
Net operating losses (NOLs) currently are 100% deductible. They can be carried back two years (longer in some situations) and forward for up to 20 years. The measure would limit the NOL to 90% and eliminate the carryback (except for a one-year carryback resulting from federally-declared disasters). The carryforward would be increased by an interest factor.
The domestic production activities deduction would be repealed.
But small businesses would retain the full interest deduction for their debt. Businesses with more than $25 million in average gross receipts would have their interest deduction limited to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), but there’s be a 5-year carryforward.
Bottom line
Who knows if we’ll get a tax law, what it will finally look like, and when provisions will take effect. Except where I noted, the changes wouldn’t impact your 2017 return but could affect your year-end tax planning (e.g., to take advantage of expiring rules). I’ll be monitoring things for you. Any changes effective for 2017 will appear in the Supplement to J.K. Lasser’s Small Business Taxes 2018.
