After Congress passed the new tax law in December, many people spent the next few weeks trying to figure out if they’d owe more or less to Uncle Sam under the new rules. But it seemed clear that business owners were likely to see a shrinking tax bill. “This tax act probably benefited businesses the most,” says Phillip Roemaat, an advanced planning attorney for Northwestern Mutual. “It’s favorable for them on many levels.”
Still, there are a lot of tax law changes for businesses to wade through, and some still require clarification from the IRS. Here are the four biggest things that business owners should know about the new law that could affect their 2018 returns.
THE NEW CORPORATE TAX RATE IS LOWER — AND PERMANENT
The new corporate tax rate is 21 percent. And this change will live on past 2025, which is when most of the other tax-law changes are set to expire. The new rate is also a flat tax, meaning it’s the same for all C corporations — that’s different from the previous corporate tax rates, which were 15, 25, 34 and 35 percent.
In theory, this means that corporations that used to qualify for the 15 percent corporate tax rate could end up paying more in taxes, but not many businesses fell into that category, Roemaat says. “That 15 percent rate is on net income of between $0 and $50,000, but most corporations don’t have income that low.”
THE CORPORATE AMT IS GONE FOR GOOD
Similar to the individual alternative minimum tax, corporate AMT was an additional way to calculate taxes to help ensure corporations paid a minimum amount of tax. Eliminating the corporate AMT also means getting rid of some of the tax liabilities for corporations that used to factor into the AMT calculation. For example, the cash value in permanent corporate-owned life insurance policies and any death benefits paid out were taken into account when calculating the AMT. These are typically not taxed under the regular corporate tax system.
SOME PASS-THROUGH BUSINESSES GET A BIG DEDUCTION
Pass-through businesses are entities like S corporations, partnerships and sole proprietorships whose profits pass through to the business owners, who then pay ordinary income tax on their personal returns. If you’re a pass-through business owner, the good news is you may be able to deduct up to 20 percent of your qualified business income (the net income that comes directly from your business). The bad news? You can only take it if you meet certain qualifications. Here are the two biggest factors that impact whether or not you can.
Your Income. How much you make helps determine whether or not you can take a full or partial deduction. Business owners who are married, file jointly and have taxable income of less than $315,000, “are likely to qualify for the 20 percent deduction, and they don’t have to jump through a lot of hoops,” Roemaat says. Single filers who make less than $157,500 may also qualify for the full deduction.
But if you have taxable income between $315,000 and $415,000 (for married filing jointly) or between $157,500 and $207,500 (for single filers), then you’ll likely get some portion of the 20% pass-through deduction. Once you reach $415,000 or $207,500, however, whether or not you can continue to take any deduction depends on whether you’re considered a service or non-service business.
The Type of Business You Own. If you own a service business, you’ll phase completely out of the pass-through deduction once you surpass the upper income limit. “If you’re an accountant, actuary, attorney, doctor, etc., and you make over $415,000, you’re not getting a pass-through deduction,” Roemaat says. There are specific professions that are defined as service businesses, but the catchall definition is when a business’ principal asset is the reputation or skill of one more of its owners or employees. (The exceptions are architecture and engineering firms, who are exempted from this definition.)
But if you own a non-service business, the answer is a little more complicated. Once you reach the upper income limit, you can still take a deduction, but it will be the lesser of two calculations:
- 20 percent of your qualified business income, or
- The greater of: 1) 50 percent of your W-2 wages or 2) 25 percent of your W-2 wages plus 2.5 percent of your qualified property cost (i.e., the cost of certain real estate or equipment you own).
Confused yet? There’s more: What qualifies as a service or non-service business isn’t etched in stone. For example, what if you run a software business that also sells some hardware? In this case, you could be considered both a service and non-service business. “A lot of us in the tax world are waiting for some guidance from the IRS between now and the end of the year on what this all means,” Roemaat says. In other words, keep in mind that determining what you owe in taxes as a pass-through business owner is going to get a lot more complicated. In some cases, it may even be worth changing the type of business entity you have. So it’s important to consult with your tax advisers before making any moves.
SOME BUSINESS DEDUCTIONS ARE GONE OR HARDER TO TAKE
Starting in 2018, some key deductions that businesses have relied on are either going away or getting stricter requirements.
Entertainment Expenses. Those courtside tickets for clients on the company dime used to be 50 percent deductible, but no more — entertaining clients is no longer considered a deductible expense. (Good news: Office holiday parties are still 100 percent deductible.)
Business Interest. Previously, any interest a business paid on business loans was generally deductible. Now, a business can only write off interest expenses that are equal to 30 percent of its adjusted taxable income. The rules around this can be complicated, though, and there are exceptions. A big one is for small businesses with average annual gross receipts of $25 million or less for the three-tax-year period ending with the prior tax year.
The main takeaway? “If you finance your business through debt, that may not be as attractive anymore, because you may not get that tax deduction going forward, or it may be limited,” Roemaat says. “Work with your tax adviser to make sure your debt-to-equity structure makes sense.”
Net Operating Loss (NOL) Deduction. In the past, if a business recorded a loss, it had the option to use those losses to either reduce any taxes paid in the past two tax years, or to reduce any future taxable income for the next 20 years. Under the new tax law, that NOL can only be carried forward, and is limited to 80 percent in any given year.
Roemaat gives this example: Let’s say your business records a NOL of $100,000 in 2017. But in 2018, you end up making $100,000. You can use your NOL to reduce your taxable income for 2018, but only 80 percent of it, or $80,000. That means in 2018, your taxable income would be reduced to $20,000. Whatever you didn’t use of your NOL can be carried over to future years, so your business could apply that remaining $20,000 NOL to its 2019 tax return.
The big picture? A lot of these changes stand to benefit business owners, but you may have to make some adjustments to your business strategy to take full advantage of them. Make sure you consult with your tax and financial advisers to figure out how your particular business may be affected.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.