By Mark E. Lumsden, CPA
Now that the Tax Cuts and Jobs Act has been signed into law, you’ve probably heard about many of the larger provisions on the news or internet. Of course, being that there are literally hundreds of changes to the tax code as part of the law, which is the largest reform of the tax code in over three decades, news outlets typically highlight the areas that affect the most viewers and readers. There are many very big changes to how businesses and their owners are taxed – some good, some bad – that haven’t been discussed much. So in this article, we are highlighting six of these changes – three good, and three bad.
1. THE GOOD – Simplification of Accounting Methods for Small Businesses
The Act provides relief from many requirements for how income is calculated and reported for certain small businesses. These methods of accounting are often burdensome and require complicated calculations that merely affect the timing of when income is recognized. The relief applies to businesses whose average annual gross receipts over the prior three years don’t exceed $25 million (adjusted for inflation after 2018), and includes:
- An exemption from the complicated “uniform capitalization” (or “UNICAP”) rules for businesses carrying inventory. UNICAP requires these businesses to allocate a portion of their overhead costs to inventory, which delays their deductibility. Previously, retailers with average gross receipts of $10 million or less were exempt from the rules, but there was no exemption for manufacturers, requiring even the smallest manufacturing startups to be subject to these complicated calculations.
- An exemption from being required to use the percentage-of-completion method (“PCM”) for long-term construction contracts. Construction companies were previously required to use PCM on most of their contracts if their annual gross receipts exceeded $10 million. PCM requires revenue to be recognized over the life of a contract, requiring taxpayers to calculate the percentage complete on a job-by-job basis. Contractors who are exempt from this requirement may choose from several other methods, including the completed contract method, which allows profit to be deferred until a contract is complete, or the accrual method.
- The ability to use the cash method of accounting. This method generally allows taxpayers to defer revenue until they are paid, rather than as the work is performed or goods are delivered.
Businesses that fall beneath this $25 million revenue threshold should assess whether their current methods of accounting are the most tax efficient, and consider applying for changes where it makes sense.
2. THE BAD - Limitations on loss deductions.
The new rules make two major changes to the deductibility of business losses. First, in the case of net operating loss (“NOL”) carryovers, any losses incurred in years beginning after December 31, 2017 can only be used against 80% of a future year’s income. For example, if a taxpayer reported a $100,000 NOL in Year 1 and $100,000 of profit in Year 2, the taxpayer would only be able to offset $80,000 of Year 2’s income, thereby leaving $20,000 of taxable income (and several thousand dollars of tax due), and a $20,000 loss that will carry over to Year 3. In addition, the previous rule that allowed NOLs to be carried back two years, thereby allowing taxpayers to claim refunds on taxes paid in earlier years, has been repealed.
The second modification to deductibility of losses is a new concept of “excess business losses.” Taxpayers other than C corporations (namely, individuals, trusts, and estates) that have aggregate business losses of $250,000 or more ($500,000 in the case of joint filers) may not deduct these excess amounts, and instead will carry them forward as an NOL, further subject to the limitations discussed in the paragraph above. Therefore, taxpayers that have significant income from sources other than pass-thru activities, and have historically deducted pass-thru losses against that income, could face a large increase to their tax liabilities.
These new rules may require updates to tax planning strategies. Partnerships and S Corporations showing losses may elect for certain deductions to be spread out over time, rather than deducting them as incurred, increasing their losses and risk being subject to the above limitations. Examples of these new strategies could be a less aggressive approach to depreciation, such as electing out of bonus depreciation, or electing to amortize research and development costs over time rather than deducting as incurred.
3. THE GOOD – The repeal of the corporate AMT and increase to the AMT exemption for individuals.
One of the biggest promises as the tax reform bills began to take shape was that the alternative minimum tax (“AMT”), which limits the tax benefits of certain types of deductions and deferrals of income, would be repealed. Congress was unable to fully deliver on their promise, but they still made significant changes that will limit the effect of the AMT.
The corporate AMT was fully repealed for tax years beginning after December 31, 2017, which is great news for mid-sized and larger businesses taxed as C corporations. Any C corps that have AMT credits carrying forward into 2018 will be able to claim these credits as a refundable credit between 2018 and 2021.
The individual AMT was left intact, but with changes to the income exemption and the phase-out thresholds. Beginning in the 2018 tax year, the exemption amounts for all taxpayers were raised by about 30% over the previous amounts. But more important was that the income threshold before these exemptions begin phasing out was raised from 2017 levels of $160,900 and $120,700 for joint and single filers, respectively, to $1 million and $500,000, respectively. Many individuals previously fell victim to the AMT simply because of this exemption phase-out, and with these new thresholds, the number of AMT taxpayers will significantly decrease.
4. THE BAD - Changes to deductibility of meals and entertainment expenses.
Businesses that incur large expenditures related to entertaining clients and prospects may be caught off guard by these new rules. Effective for tax years beginning after December 31, 2017, entertainment costs are completely nondeductible, as opposed to being 50% deductible under the old rules. Meals will continue to be 50% deductible, but the 50% limit has been expanded to include meals provided to employees on or near the company’s business premises, which previously may have qualified as being fully deductible. Companies that regularly provide office lunches (or even have a cafeteria within their office location) may soon have to plan for an increase to their taxable income as a result of losing these deductions.
5. THE GOOD – Opportunity for employees to defer income from new “Qualified Equity Grants” of nonpublic traded employers
The taxation of some forms of stock compensation leaves employees, particularly of startups, in a bit of a tax paradox. For example, recipients of restricted stock are generally required to report income based on the value of the shares as they vest. For successful companies whose valuations significantly increase over the typical four-year vesting period, this could result in significant amounts of taxable income – but with no cash to pay the tax. The employee can elect to recognize all of the income at the time the shares were granted, thereby preventing additional taxes due as the company continues to appreciate, but this still requires income to be reported immediately and forces the employee to take the risk of reporting the income only to possibly end up with worthless shares (or that they leave the company before their shares vest).
There are similar rules for stock options. For nonqualified options, the employee is required to report the appreciation in price at the time they exercise their options (but haven’t necessarily sold them, which creates a tax liability with no cash to pay it), and Incentive Stock Options (“ISOs”) allow the employee to defer any income reporting until the shares are ultimately sold – for regular tax purposes—but still have to be reported as income at the time of exercise for AMT purposes.
The new rules provide an opportunity to elect to defer this income for qualified recipients of qualified stock of qualified companies. There were a lot of qualifiers in that last sentence, which may limit how many people actually get to take advantage of this new rule, but it can really help those who do. In order to qualify, the company must be privately held and have a written plan to offer stock, restricted stock, or options to at least 80% of its employees. The employee qualifies if they don’t own 1% or more of the company, aren’t the CEO or CFO, and aren’t one of the top four highest compensated officers of the company. The deferral is made through an election and allows the employee to defer the income from these grants until the earlier of five years, the date that the company becomes publicly traded or that the stock becomes transferrable (including to the employer), the date the employee is no longer a qualified employee, or the date that the employee revokes the election. This deferral is for income tax purposes only, and payroll taxes may still be due as the shares vest or options are exercised.
This opportunity may incentivize companies to offer equity compensation to more employees, and the opportunity to defer the income may provide a mechanism to attract more and better talent.
6. THE BAD - Repeal of capital gain treatment for self-created patents and other intellectual property
In a change that could affect exit planning strategies, sales of self-created patents, inventions, models or designs, or secret formulas or processes will be considered ordinary income for dispositions occurring after December 31, 2017. Previously, self-created IP was generally considered a capital asset, and therefore sales thereof would qualify for the lower capital gains rates. As a result of this change, business sellers may be less welcoming to transactions treated as asset sales, since the portion of gain allocated to IP will be taxed at higher rates. Sellers may instead insist on a stock sale structure, or a higher sales price to compensate for the increased tax burden.
The sweeping change in tax laws will affect most people and I recommend that you discuss your individual situation with a qualified CPA with extensive knowledge of the new tax laws. Mark Lumsden is a tax partner at Anton Collins Mitchell LLP (ACM) and can be reached at firstname.lastname@example.org or 303.440.0399.