Small Business Taxes & ManagementTM--Copyright 2017, A/N Group, Inc.
While it's far too early to seriously discuss any tax planning related to tax reform, there are some points that should be made. Clearly, you should avoid any risky actions. Any significant changes in the tax law probably won't come until later in the year, if at all in 2017. Congress has a number of issues to deal with and there are differing opinions on the final form. While a reduction in tax rates is a certainty in any package, how that will be paid for looms large. Lower rates should generate economic growth, but economic projections and history suggest the increased revenues from that growth would only partially offset rate cuts. A cutback in deductions (often called expenditures) is likely, but which ones to cut will be sure to generate a fight among numerous competing groups. You don't have to be a tax expert to get an idea of the special benefits available to various groups. Income averaging was eliminated from the tax law over 25 years ago--but not for farmers and fisherman. Use a small plane in your business? It can be depreciated over 5 years despite the fact that most 40-year old small planes are still in regular use. Own timberland? Selling the timber can result in capital gain rather than ordinary income.
We're not passing judgment. Farmers' incomes can be highly variable and income averaging can lessen the inequity in the system. The rapid depreciation available for a small plane? It encourages investment that can increase productivity for a small or mid-sized business.
In the discussion below we explore possible changes in the law and a few points to keep in mind. Be sure to talk to your tax adviser before acting.
Timing. It's July and even if the Republicans release a bill in the House today, it has to go to the Senate. Tax reform could suffer much the same fate as health care. More than likely, under the best scenario, a comprehensive tax bill is unlikely to emerge until later this year. That probably means major changes won't take effect until next year. And cutbacks in some deductions that affect many taxpayers might be phased in over several years. The latter is what happened in the '86 reform act.
Could certain changes be made retroactive to the beginning of the year? Yes, it's been done, but it's usually done by addressing individual changes.
Rate cuts. This is likely to be where the biggest benefits lie. And rate cuts are a sure thing under any new legislation. A dollar of income before taxes may result in $75 in your pocket (under a new law) versus only $60 (or less) under current law. But there's a flip side. A dollar of deduction would be worth less. Under current law, if you're in the 39.6 percent bracket a dollar of deduction costs you only about 60 cents out of pocket; the government is paying for the other 40 cents through a tax saving. If tax rates are 25 percent a dollar of deduction will mean you're out of pocket 75 cents. The point is important because it can affect your tax planning with respect to issues below.
Brackets. Any new law would reduce the number of tax brackets. There are currently seven. But the implications here are far less than what most people believe. Would a reduction in the number of brackets simplify things? Probably not. First, consider that in 1970 there were 24 brackets (plus a tax surcharge which had to be calculated). The highest tax rate for that year was 70 percent and applied to income over $200,000 for a married couple filing jointly; the 50 percent rate started at $44,000. By 1983 the number of brackets had dropped to 14, with the top rate set at 50 percent for incomes over $109,400.
The number of brackets has now become inconsequential from a computation standpoint. The vast majority of tax returns today are prepared by computer. Tax planning? Doing so without a computer, except for a ballpark estimate, is foolhardy. Conversely, there could be negative implications with fewer brackets. The big question is where the breakpoints will occur and that hasn't been revealed.
Interest deductions. There is serious talk about eliminating the deduction for interest. Whether or not it will come to pass is up in the air. This is an area that could have a major impact on many business, particularly small to mid-sized operations that rely heavily on debt. Interest deductions for current debt could be grandfathered (i.e., remain deductible) or the deduction could be phased out. It's certainly an issue that should be kept in mind when doing any business or tax planning.
Investment expenditures. Under any new law depreciation could be largely a concept of the past. You could be able to immediately deduct expenditures for equipment, machinery, office furniture, etc. Some businesses are considering holding back on investments to take advantage of this potential benefit.
Whether or not delaying a project or purchase makes sense depends on a number of factors. First, many small businesses can take advantage of the Section 179 expense deduction--writing off up to $500,000 in machinery, equipment in the year it's placed in service. If you can't take advantage of this benefit (there are some restrictions), bonus depreciation allows you to deduct half of the cost of the equipment in the first year plus the first years' depreciation on the remainder. On a $100,000 machine that would be $57,145 in the first year for 7-year property.
Second, reducing your income beyond a certain point can actually backfire because those deductions won't be available later. And writing off the cost of a $70,000 truck one year only to sell it a year or two later and generate $50,000 of income from the sale can result in wild swings in income.
Finally, the real issue here is business considerations. If the investment makes business sense today, you should commit. Waiting for a faster writeoff and missing the market for a new product or losing out on cost savings may not be a smart move. Talk to your accountant or tax advisor.
S Corp, C Corp. One of the big advantages of doing business as a S corporation, LLC, etc. is the avoidance of double taxation when earnings are taken out of the business. That could shift under any new tax law. The amount of the shift will depend on the tax rates for a regular corporation and those for an individual. (There can be some other factors to consider, such as the self-employment tax for small businesses.)
In theory, if tax rates for a C (regular) corporation fall, a corporation that retains its income to be reinvested in the business may do better from a tax standpoint as a C corporation rather than as an S corporation (or other pass through entity) because of the higher tax rates on individuals. Currently, distributions (dividends) from a C corporation are usually taxed twice; once at the corporate level and again when received by the shareholder. S corporations avoid the double tax. The analysis here can become complicated. Many small businesses routinely distribute the bulk of their income to owners. Another issue is excessive compensation. The IRS can challenge amounts paid as salary to employee/shareholders that exceed a "reasonable amount". This can be an argument you don't want to get into. Finally, expenditures made by a C corporation and disallowed as personal expenses of the shareholders by the IRS are disguised dividends. That can be a real problem for small businesses as the line can often be fuzzy or crossed inadvertently.
While you can change entities, it's not to be taken lightly. Getting good advice before making a final decision can be more important now than ever.
State taxes. States are far slower and less likely to change their rules. Many do follow Federal law, but with modifications. There's a good chance you'll be doing one thing for Federal purposes and another for state. This isn't as much a tax planning issue as it is an added complication.
Best advice? Watch the tax news and don't commit until the law is clearer. Jumping the gun will be a big mistake. And, as always, business and investment considerations should come first; then a tax analysis.
Copyright 2017 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/07/17