Small Business Taxes & ManagementTM--Copyright 2017, A/N Group, Inc.
President Trump and the Congressional Republicans have released their framework for tax reform. While the release provides additional information on the direction that the Republicans intend to take, it gives only the roughest of indications of the final bill. Not only are there many holes to file, the holes left by the release can be critical to the ultimate effect of the bill on any particular taxpayer. Finally, more than a few legislators, lobbyists, groups, etc. will offer their views.
Individual Tax Changes
Tax Rates The seven tax brackets would be reduced to three (possibly four)--12%, 25% and 35%. Certainly a simplification for those few people who do their returns by hand, but of limited value to those who use tax software. While the top rate looks like it's cut, the fate of any taxpayer depends on both the bracket threshold and the rate. There is no mention of the rate breakpoint. If the 25% rate starts at $200,000 for a married couple--there will plenty of happy taxpayers. It it starts at $100,000, there won't be much benefit. And it's possible their will be a rate abouve the 35%. That's still open.
There is also no mention of preferential treatment for capital gains and qualified dividends. However, it's assumed that special treatment will be retained.
Increased Standard Deduction and Child Credits The standard deduction and personal exemption would be melded into one standard deduction-$12,000 for single individuals and $24,000 for a married couple. But that's only slightly above the $10,400 a single individual now enjoys for a standard deduction and personal exemption and $20,800 for a married couple with no children. When possible offsetting benefit eliminations are considered, the increased deduction could prove nonexistent. But that doesn't account for children. A married couple with two children would currently have a $12,900 standard deduction and $16,200 in exemptions (husband, wife, two children) and, no adjustments to income such as student loan interest, would escape all tax on the first $28,900 of income. Then the tax on the next $18,650 of income would be in the 10% bracket, or $1,865 in tax on $47,550 in income. Under the proposed plan the same taxpayer with taxable income of $47,550 would pay $2,826 before any child credits. (Currently there's a $1,000 credit per child. We've ignored any child credits.)
Of course, one example doesn't tell the whole story. A similar couple making more would fare better because they'd be taxed at 12% rather than 15% on part of the income. And child credits could easily change the result.
The proposed change would increase the child tax credit, but there's no mention of how much. It would have to be relatively significant in order to offset the loss of an exemption for each child. A $500 credit would also be available for caring for non-child dependents, such as parents.
Itemized Deductions This could be the big change for many taxpayers. Under the proposal, itemized deductions would generally be eliminated, with the exception of mortgage interest and charitable contributions. But if there's a choice between the standard deduction of $24,000 and deducting mortgage interest and charitable contributions, you'd have to have a mortgage of over $400,000 (at current interest rates) and/or substantial charitable contributions. Because of other deductions such as state and local taxes, taxpayers with less mortgage interest would still itemize. Individual taxpayers would fare better.
It's already been pointed out that taxpayers in states with high income and/or real estate taxes could be losers. But so would taxpayers with significant medical expenses and miscellaneous itemized deductions. More than likely some accommodation would have to be made for deductions such as gambling losses, attorney fees on settlements, and unreimbursed employee business expenses.
The issue of tax deductions for state and local taxes may have to be opened for discussion. There are enough Republican Congressmen from high tax states that may not agree to this provision.
That vacation home is likely to prove more costly to own. And, while home mortgage interest is expected to be deductible, the same may not be true for a vacation home (or boat or motor home that has living accommodations).
On the other hand, only about 20% of taxpayers itemize their deductions. Renters, and others without mortgage interest and real estate taxes generally wouldn't benefit from itemizing.
Work, Education, and Retirement The framework retains tax benefits that encourage work, higher education and retirement. The intention is to simplify these benefits (e.g., there are currently a number of benefits available for higher education). At present there is no indication of what form the benefits would take.
Individual Alternative Minimum Tax The proposal would eliminate the alternative minimum tax (AMT). Under the current law that would result in significant tax savings for taxpayers with incomes between $200,000 and $500,000. Even if kept, under the framework, it would generate substantially less revenue because of the elimination of most itemized deductions. There's no question that despite computer software, the AMT increases the complexity of preparing returns. This is one provisions that only a tax professional who bills by the hour can love.
Other Individual Provisions There's no question the Code is loaded with special deductions and credits. The adoption credit, energy credits, electric vehicle credit, child and dependent care expenses, retirement savings contribution, etc. Some of the credits are arcane. The framework would eliminate many of these credits.
Special Interests There are many special interest provisions in the Code. Some have been temporary, some permanent. Teachers can deduct $250 toward adjusted gross income (AGI); college graduates can deduct student loan interest; investors can deduct investment interest; employees can deduct job related moving expenses; many taxpayers can deduct contributions to an IRA; etc. These special benefits aren't of interest--until they affect you. A teacher who loses his or her $250 deduction could pay some $60 more in taxes. Not being able to deduct moving expenses could easily cost $1,500 in taxes (although unlikely to be a regular occurrence). There is no specific mention of which of these benefits will be retained or eliminated. But eliminating them would go a long way to simplifying the Code. Unfortunately, this is where the fights begin.
State Tax Effects State taxation rules vary widely. Some states follow the Federal law when computing income; some follow it with modifications; some just use a percentage of Federal income taxes; and some start essentially from scratch. For example, New York starts with Federal AGI and eliminates all social security income on the Federal return. It also allows taxpayers to exclude the first $20,000 of retirement income. The same itemized deductions allowed on your Federal return are generally allowed, but not the deduction for state and local income taxes. California and many other states use the same approach with different exclusions and deductions. Massachusetts works up its own definition of income and allows a limited range of deductions. But simplification of your taxes will still be distant target if the states don't follow the IRS.
Estate and Generation-Skipping Transfer Taxes The framework would eliminate these two taxes. Because of the high exemptions the estate tax only affects some 5,000 people a year now, and only about 80 small businesses and farms. While the amount of money generated is material, the loss of this revenue won't significantly impact the scoring of any bill.
Business Tax Changes
Corporate Tax Rate Cut The change everyone has heard about is the lowering of the top corporate rate to 20%. That's unlikely to help most small businesses because they don't do business as a C (regular) corporation but as an S corporation, LLC, sole proprietorship, etc. The lower tax rate is likely to help the stock market, as well as big corporations. In addition, the framework would eliminate the alternative minimum tax for corporations.
Pass-Through Entities Most small- to mid-sized businesses operate as S corporations, LLCs, partnerships, or sole proprietorships. The entity's income is not taxed but passed through to the shareholders, partners, etc. and taxed on the owner's individual tax return. The framework creates a top tax rate of 25% on the income from these entities. This should be a help for many smaller businesses allowing them to retain more profits for reinvestment after paying the owners.
The obvious question is why not switch to a C corporation for the lower 20% rate? Generally, that's unlikely to make sense because after being taxed at 20% the profits of a C corporation distributed to the shareholders as dividends will be taxed again. Disallowed deductions such as undocumented T & E would be considered deemed dividends and disallowed as a deduction, but taxable to the shareholders. There may be a second tax when the business is sold. Nonetheless, there could be some situations where a switch to a C corporation would be advantageous. This is not a step to be taken lightly. Get good advice.
Expensing of Business Assets The law now allows taxpayers to expense up to $500,000 of business asset purchases a year (Sec. 179). That includes furniture, machinery, computers, equipment, etc. and certain real property like qualified restaurant property, retail property, and leasehold improvements. If expensing isn't elected or available, 50% bonus depreciation allows a large first-year writeoff of new equipment. Under the proposal, all expenditures, except those for real property, could be expensed in the year of purchase. That's clearly big incentive to replace and upgrade equipment. It also simplifies recordkeeping, particularly for small businesses. This provision is intended to be effective for purchases made after September 27, 2017.
This provision isn't the answer for every business. Pass-through entities where the income is taxed at the individual shareholder's, partner's, etc. level may want to level out income to prevent taking deductions when in a low bracket only to pay taxes the following year in a high bracket. Presumably the law will contain a provision allowing to opt out of expensing for all purchases made in a year.
Interest Expense There have been rumors of limiting the deduction for interest expense in general. The framework does put a limit on net interest expense for C corporations and mentions that the treatment of interest expense for non-corporate taxpayers will be taken up in committee. This could be a real issue because many businesses carry substantial debt. Financial professionals now consider debt to be a cheaper form of financing than equity capital.
Other Business Deductions and Credits The proposal would make other changes to business taxes. The Section 199 deduction for domestic production activities would be eliminated. Other deductions and credits may be repealed or restricted. The framework specifically provides that the R&D credit would be retained. The proposal would make changes to the tax regime of specific industries to better reflect economic reality and reduce the possibility for tax avoidance.
Territorial Taxation The framework would change the law such that dividends repatriated from foreign operations where a U.S. company has a 10% or greater interest could be brought back to the U.S. without tax. The proposal would treat accumulated foreign earnings under prior law as repatriated. The proposal would create additional rules to prevent companies from shifting profits to tax havens.
Overall Observation Clearly, there's more missing than here in the framework. The final bill is sure to be several hundred pages; the framework is nine, with a generous amount of blank space. There's much to be resolved and many special interest groups to satisfy. Touch oil and gas and Congressmen from Texas, North Dakota, Oklahoma, etc. will light up like the night sky over a field of oil rig fires from methane burnoff. The states with high state and local taxes are already digging in their heels. Realtors are probably planning their own action. That's certainly not to say it won't be done, but it may take longer than indicated and may end up to be less comprehensive than the framers envisioned. The budgetary restraints may also limit the changes.
Overall Effect Despite the rhetoric surrounding the release, the savings for most middle income taxpayers will depend heavily on their situation and the starting and ending points of the tax brackets. Don't take advantage of any special credits or deductions? You'll probably come out ahead. But even so don't go picking colors for the new car. Married with no children, pay a modest amount of state income tax and $6,000 in real estate and other taxes, pay $12,000 in mortgage interest and have $1,500 in charitable contributions on a salary of $100,000 you'll probably pay the same tax either way. If your income is higher, you'll probably do better, until you get to the 25% bracket. Since there's no indication where that starts we'll stop any comparisons here.
For the middle class, the proposal is neither the "middle class miracle" espoused by President Trump, nor is it a "miracle if it helps the middle class" Senator Schumer claims.
The result is different for business owners that have total income closing in on $200,000 or more. The 25% cap on business income could allow many more businesses to retain income for expansion, working capital, etc. The savings on $100,000 of income between the 39.6% (current top rate) and 25% rates is $11,900. That's significant. The ability to quickly write off asset purchases could provide additional up-front cash flow.
Undisclosed and unknown takebacks could reduce the savings for business owners, but the pros should outweigh the cons for the majority of business owners.
Simplification Much like the 1986 changes, the proposal would further simplify taxes for those taxpayers who already have a simple return. More taxpayers would opt not to itemize. Higher income taxpayers and those with more complicated returns would also benefit from the elimination of the alternative minimum tax and some other provisions of the tax law. However business owners, taxpayers with rental properties, complex investments, etc. may not feel a big reduction in complexity. And the first year is likely to be confusing.
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 09/30/17