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Tax Cuts & Jobs Act- How It Is Going to Affect Small Business

April 19, 2019
Taxes

After strings of debates and online discussions about the goodness and badness of the TCJA Act, the president finally signed it and it is now a part of the law. On the surface it seems that a lot is changing, and of course, in some areas there will be huge changes. However, many of the changes that seem “unprecedented” to the people are not considerable modifications. Let us first get to an overview of TCJA and then go into the details to know what its effects will be on business entities and individuals.

The Tax Cuts and Jobs Act– An Overview

TCJA will affect almost all the different forms of taxes that you know of—taxes that individuals pay on their yearly incomes to taxes that corporations have to be pay based on their structure type. The highlights of TCJA include the 21% flat tax rate for C-Corporations. The other highlight is the increased deductions for individuals. The third change that has received a lot of attention from the public is the new deduction of 20% (the pass through deduction) that individuals will be able to claim as QBI (qualified business income). The Tax Cuts and Jobs Act is a territorial taxation system whose aim is to bring home the money stored in foreign countries by large companies.

TCJA for Individuals

Before the enactment of TCJA, there were seven income tax brackets for individuals,and they will stay the same way. However, the tax percentage will see a small cut. For example, the tax percentage for the second taxable income bracket was 15% in 2017, but will be reduced to 12% from 2018. The only income tax bracket that will not experience any change is the first, which the IRS will still tax as 10%. Standard deductions have bumped up considerably for single and joint filers. The new standard deductions for single filers will amount to $12,000 from only $6,350 previously.

Standard deductions have almost doubled for joint filers as they are now at $24,000 increasing from $12,700 previously. The bad news has come for individuals who have big families. Previously, families with lots of children had lots of exemptions. For each person they claimed they could get an exemption of $4,150,but this exemption is completely gone now. One might think that the increased standard deductions will cancel that out—and they of course will in many cases—but for larger families, they might end up paying more tax.

There has been some controversy around the increase in standard deductions. National Association of Realtors has vehemently spoken against this bump because they think it will drive the taxpayers away from mortgage interest deduction. Another bad news is for individuals who were happy to claim their itemized deductions because now they will not be able to claim most of them. However, there will be no changes for homes where someone is serving in the military. There is one area where taxpayers will face a dilemma, the local and state deductions where they will have to make a choice between claiming either sales/income taxes or property taxes.

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TCJA for Corporations

With tax cuts and jobs act, corporations will see a huge decrease in their taxes,coming down to just 21% from 35% maximum. The biggest attraction for business owners is the pass-through deduction. The 20% pass-through deduction is nothing but good news for business owners. However, here is a list of corporations or business types that qualify for this type of deduction:

·        S Corporations

·        Limited Liability Companies (LLC)

·        Partnerships

·        Sole Proprietorship

One thing to keep in mind is that this deduction will remain in effect only until 2025. Most importantly, it is only the small business owners that will benefit from the new deduction. You should spend some time researching your options to know if you qualify for it. Private equity funds, hedge funds and real estate companies also qualify as businesses that can qualify for the pass-through deduction. As for individuals providing services, there exists a phase-out that starts at$315,000 for those filing jointly and $157,500 for the single filers.

Interest expense deduction is still there for the corporations but it is now come down to only 30% of the earnings of the corporation. The federal government will calculate this deduction as EBITDA based deduction in the first four years whereas after the first four years, the government will use income prior to taxes and interest as their base for deductions.

It is imperative at this point to know that the 20% pass-through deduction will not be the same for all the qualifying businesses i.e. there are dependencies.The two factors that will affect this deduction will be the income generated by the owner of the business and the business nature. The deduction might seem very straightforward on the surface but the dependencies do make it a little difficult to understand. It is interesting that your pass through deduction can also get affected by how your employees are paid.

If you own a personal service firm, and you are either a single that generates over $207,500 or a couple that makes over $415,000 as income, the deduction does not apply to you i.e. you will not get it. While the deduction could phaseout, there is a 2-part test that business owners must pass to be eligible for this deduction. They will have to make a comparison of their pass-through income with one of the two options given below.

1.      25% of the wages that the business is paying to its employees PLUS 2.5% of the fixed assets of the business.

2.      50% of the wages that the business is paying to its employees.

The deduction that the business qualifies for must not be more than the greater of one of the options given above.

However,you can get half the benefit of the new deduction if your income falls anywhere between the two incomes limits stated above. The good thing is that you will qualify for this type of deduction regardless of the type of business you own or run. However, the deduction that you can qualify for if you own a personal service firm will phase out.  

It is easy to understand this type of deduction for those whose taxable incomes are below the $157,500 (for single filers) and $315, 000 (for joint filers) marks.So, let’s say you are a single filer and your business qualifies for pass-through deduction based on the fact that you are making less than$157,500.

In this scenario, you will have to look at the net income your business is generating. For this net income, you can claim the 20% as pass-through deduction but you must also know that the deduction can be either 20% of the taxable income or 20% of the net income—whichever is lower. On the other hand,let’s say you have a pass-through business that you own solely.

This business makes taxable income of more than $415,000. Looking at that income figure, you should know that you don’t qualify for that 20% pass-through deduction. However, you can only qualify if you pass the 2-part test stated above.

Is C-Corporation a Better Structure than S-Corporation Now?

Most of the people who saw the 21% tax rate for C-corporations that it was time for them to change their business structures. If things were as simple as they appear on the surface, of course, C-corporation would have been the better choice. However, for anyone trying to decide between a C and S corporation, the decision will still be difficult to make. The biggest issue with C structure is that it still has to face double taxation. At the same time, the 20%pass-through deductions is quite an attraction for pass-through business owners.

Despite the fact that C-corporation owners will be able to get their local and state taxes deducted, the double taxation makes C structure less desirable. As an owner of C-corporation, you will have to reinvest the profits of your business back into the business. If you do not do so and distribute the profits among owners, double taxation will act as a double-edged sword for you. Moreover, you are at a disadvantage if your C-corporation ends up with accumulated cash. You will then have to face either personal holding company tax or accumulated earning tax, which are more like tax penalties.

Furthermore,selling a C-corporation also proves to be disadvantageous i.e. it will face double taxation yet again.

1.      The liquidation of the corporation will result in taxation when the owners decide to get sale proceeds in exchange of their shares.

2.      The assets being sold are taxed too.

Overall,C-corporations have a tax-laden structure and now with the flow through deduction, it just makes more sense to be an S-corporation if you are a small business owner.

Conclusion

Yes,some changes have definitely been made in how individuals and corporations are taxed after the enactment of TCJA. However, these changes seem more noticeable on paper but will not result in a sudden conversion of all S-Corporations into C-Corporations. Business owners will still have to work with their accountants and lawyers before they make their business structure selections. Just as before,the S-corporation is the clear leader over sole proprietorships and C-corporations. If you are not yet an S-corp, make sure you consult with an experienced accountant as the benefits do require some compliance to be handled correctly.  

Christopher Ragain, CPA

Christopher Ragain, CPA is the founder of Halon Tax and one of the industries top authorities on micro-business taxation and tax planning.

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