Tax Reform & Business Owners: A Year Later
The Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017. This long-awaited tax reform was the most sweeping tax legislation our nation has seen since the Tax Reform Act of 1986 was signed into law by President Reagan. TCJA made reductions to income tax rates for individuals as well as significantly reduced income tax rates for businesses. Unfortunately, in providing new opportunities for tax reductions, the legislation also created many additional questions and some confusion as business owners began sifting through the new law. Tom Lalley, CFA, CFP®, and Bill Bruns, Principals of John D. Dovich & Associates, LLC, recently met with Thomas J. Munninghoff, CPA, JD, Mark L. Connaughton, CPA, and Jonathan J. Hickman, CPA, from Munninghoff, Lange & Co. to discuss what the new tax law has meant for business owners in the past year.
John D. Dovich & Associates: A year later, what has been the primary effect of the TCJA on your clients that are business owners?
Munninghoff, Lange & Co.: The TCJA provided business owners a lot of new areas of discussion and forced them to review their business structure. We have been consistently asked by clients about what specifically in the TCJA applies to their situation and whether the TCJA changes are as beneficial as they were portrayed. In many cases, the changes are positive if a business is a C corporation, now paying a flat 21% tax, if its income is generally greater than $90,000. Businesses with income less than $90,000 will actually pay more tax under the new law because the 15% bracket has been eliminated. Another positive change occurs if the business structured as a pass-through entity that is not classified as a Specified Service Trade or Business (“SSTB”) because it can qualify for the full Qualified Business Income Deduction (“QBI”). However, for many of our successful, high earning clients, whose business is classified as an SSTB, the new tax law is discriminatory – those owners do not get the benefit of the 20% deduction when their taxable gross income is in excess of either $212,500 (single) or $415,000 (joint filers) with a phase-out corridor leading up to those amounts. We had to have that difficult discussion about the denial of the deduction with some of our clients who own a SSTB which will not see a net tax reduction because of the TCJA.
JDA: Relative to that topic, are you seeing any guidance from the IRS to tighten down the definition on who qualifies and doesn’t on the Qualified Business Income deduction (QBI)?
MLCO: Within the original regulations, there were vague categories of SSTBs. Last summer new language came out to give some clarification. In healthcare, individuals such as physicians, physical therapists, dentists, nurses, pharmacists, even veterinarians, do qualify as SSTBs. In addition, any and all “healthcare professionals who provide medical services to patients” qualify as SSTBs. The IRS also clarified the financial services industry definitions language by adding all return preparers, auditors and “similar professionals who work with clients” are considered SSTBs. You can go down the list of professions and see how the IRS tightened up the definitions for professional services because there was so much vagueness in the TCJA legislation.
JDA: With the lowering of the corporate tax rates, have you seen many conversions of S corporations to C corporations?
MLCO: I know there’s been many discussions on this topic, but I’m not aware of any of our clients converting from S corps to C corps. Some clients were analyzed and we discussed the possibility, but they did not make the change. For a growing business with working capital reinvestments, a C corp remains a good vehicle, but if distributions are desired, we’re still advising clients they need to strongly consider LLCs as a business model because of the flexibility. The tax act greatly benefited C corps and leveled the playing field, but not to the point where LLCs and S corps will go away. Clients need to keep in mind that C corps still contain double taxation with a 21% corporate tax rate plus up to 23.8% dividend tax when funds are withdrawn.
After the 1986 tax act, S corps were the way to go and everyone seemed to be making that election. With the TCJA we’re not so sure change is needed – it has become more complex in how our businesses operate and considerations such as W-2 wages test for the Section 199A 20% deduction must be taken into consideration. If you are the owner of an LLC, profit distributions do not count as wages for purposes of the QBI deduction calculation which can be problematic. To help with this, we advise our clients to own the LLC in an S corp and have the S corp pay W-2 wages to the individual owner, which will meet the 50% QBI wages test. This way you receive the advantage and flexibility of the LLC and possibly qualify for the QBI deduction.
JDA: What about corrections to the original TCJA?
MLCO: There are still some corrections that are needed. For example, under prior law, 20-year lease hold improvements were eligible for 50% bonus depreciation. However, under the TCJA, as written, the 20-year property was excluded from the 100% bonus depreciation expensing. To make a change in eligibility retroactive back to 2018 in 2019, the correction will have to be re-introduced as a technical corrections bill. Senator Brady introduced such a bill in December but it did not pass the Senate vote after passing the House vote. Congress and the TCJA drafters should have gotten their act together and made these corrections before the new Congress was sworn in, but they didn’t. Everything happened very quickly during the drafting of the TCJA, yet the corrections have moved quite slowly.
JDA: What planning techniques are you suggesting for specified service businesses to keep the owners within the income limits for at least a partial deduction QBI?
MLCO: Within the new regulations of the TCJA, there is an opportunity for SSTB owners wanting to take advantage of the 20% QBI deduction to consider implementing a defined benefit or other qualified retirement plan to reduce income under the income thresholds. These owners should consider the various cost and employee coverage considerations with such plans and clients should be ready to commit to at least a three to four-year funding strategy for their plan. It boils down to cash flow – creating a retirement vehicle that will help you both defer income and reduce your taxable income to potentially qualify for the QBI will create a cash commitment many businesses cannot handle. It can be a complicated decision – the plan requires all eligible employees to be included as well because under federal law, employers cannot use a defined benefit plan only to benefit the owners. Revisiting the structure of retirement plans has been a hot topic of interest for clients, and it will continue to be moving forward as SSTB owners wrestle with the income limitations of the TCJA.
JDA: We’ve heard a lot in the news about depreciation and expensing playing a big part in the TCJA bill. What are your thoughts on this impact?
MLCO: The TCJA created tremendous depreciation planning opportunities by increasing the section 179 expensing as well as 100% bonus depreciation. Now with the QBI 20% deduction at play, a business owner may be faced with the decision to not be as aggressive with depreciation as maybe they would have been in the past. A prudent decision may be to slow depreciation down to take advantage of the QBI for many years instead of using accelerated depreciation to take income to zero and bypass the QBI deduction. It is a good idea for business owners faced with this scenario to consult a CPA familiar with the depreciation rules and planning techniques.
JDA: Do you still see guidance needed in the area of meals and entertaining with your business clients?
MLCO: The TCJA changed the tax treatment of entertainment expenses – the cost for athletic events, theatre tickets, golf greens fees and other pure entertainment expenses are no longer deductible. However, if you are out with a client at an entertainment event and the conversation turns to a specific business discussion, and you pay for food and drinks for your clients and you have obtained a separate receipt for the purchase, then you can deduct 50% of that meal. Hosting parties for employees, such as a holiday party or a picnic, however, is 100% deductible. If a company offers soft drinks and coffee to the public and keeps these refreshments in the lobby where they are readily accessible to anyone, it will get a full deduction. But, after 2025, providing soft drinks and coffee to your employees is not deductible. These different treatments of seemingly the same thing show how the tax code is not inherently intuitive to understand.
JDA: Even though the 2017 Tax Cut & Jobs Act is now entering its second year, there are still many questions being created and other questions that still need answers for business owners. Our advice is that all business owners seek professional tax advice to help them navigate these early days of the revised tax code along with coordinating their financial planning strategies with a trusted financial advisor.
John D. Dovich & Associates, LLC, is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202. You can reach them at 513.579.9400 or visit their website at www.jdovich.com
Munninghoff, Lange & Co. is located at 231 Scott Street, Covington, KY 41011. You can reach them at 859.655.2300 or visit their website at www.ml-co.com
Disclosure: All opinions and views mentioned in this report constitute our judgements as of the date of writing and are subject to change at any time. This material is not intended as, and should not be used, to provide investment advice and is not an offer to sell a security or a recommendation to buy a security. John D. Dovich & Associates, LLC is a Federally Registered Investment Adviser. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information within this material is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Please remember that past performance may not be indicative of future results.