Are you ready for tax reform? Thanks to the recently passed Tax Cuts and Jobs Act (TCJA), the tax rate for incorporated shops will be reduced from 35 to 21 percent for the 2018 tax year and beyond. The news isn’t as good for pass-through businesses.
Pass-throughs – operating as partnerships, limited liability companies, S corporations and sole proprietorships – pass income to the owner or owners who pay tax at the individual rate. The TCJA created a 20 percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by pass-through entities.
All businesses under the income thresholds, regardless of whether they’re service professionals or not, can take advantage of the 20 percent deduction. For pass-through income above the ceiling, the new law also provides a 20 percent deduction, but only for “business profits,” limiting the owner’s effective marginal tax rate to no more than 29.6-percent.
The TCJA places limits on just who can qualify for the pass-through deduction to ensure that wage income does not receive the lower marginal tax rates for business income. Thus, that 20 percent deduction applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner, which has yet to be defined.
Unlike past years when a woodworking business was required to claim depreciation, spreading the recovery of its equipment costs over several years, many shops will be able to fully and immediately deduct expenditures for certain equipment retroactive to Sept. 27, 2017. The write-off falls to 60 percent in 2023 and 40 percent after 2025.
Section 179 remains an improved option. The immediate write-off, or expensing of capital asset expenditures is appealing because, unlike so-called bonus depreciation, the use of equipment doesn’t have to begin with the woodworking shop or business.
Section 179 allows up to $1 million (up from $500,000 in 2017) of expenditures for business equipment and property to be treated as an expense and immediately deducted. The ceiling after which the Section 179 expensing allowance must be reduced, dollar-for-dollar, has also been increased from $2 million to $2.5 million.
And now, improvements including roofs, heating, ventilation, air conditioning systems, fire prevention, alarms and security systems qualify under the new Section 179 rules, providing yet another opportunity for woodworking shops that actually need equipment.
Under the TCJA, the 10 percent credit for qualified rehabilitation expenditures for pre-1936 buildings has been repealed. The 20-percent credit for qualified rehabilition expenditures for certified historic structures can still be claimed, ratably, over a five-year period.
On a related note, the TCJA has also repealed the tax credit so many woodworking professionals claimed when retrofiting or fixing up their shops, showrooms and offices to be handicap friendly. The Disabled Access Credit that helped make the premises of so many woodworking businesses ADA compliant has also been repealed.
In the past, with a few exceptions, interest was usually tax deductible, protecting the ability of small businesses to write-off the interest on loans. In an attempt to level the playing field between businesses that capitalize through equity and those that borrow, the TCJA caps the interest deduction to 30 percent of the adjusted taxable income of a woodworking professional or business.
Every business is subject to the disallowance of a deduction for net interest expense in excess of 30 percent of the operation’s adjusted taxable income. A special rule applies to pass-through entities that requires the 30 percent determination to be made at the entity level rather than at the tax filer level. In other words, at the partnership level instead of the partner level.
Other exceptions exist for small businesses, generally those with gross receipts that have not exceeded a $25 million threshold for a three-year period, to protect their ability to write off the interest on loans that help them start or expand a business, hire workers and increase paychecks.
The tax law’s Section 1031 governing like-kind exchanges currently allow woodworking professionals to defer the tax bill on the built-in gains in property by exchanging it for similar property. Although more a strategy for deferring a tax bill when business assets are sold, traded in, swapped or otherwise disposed of, with multiple exchanges, gains can be deferred for decades and ultimately escape taxation entirely.
Under the TCJA, like-kind exchanges are limited to so-called real property (but not for real property held primarily for sale). This ensures real estate investors maintain the benefit of deferring capital gains realized on the sale of property.
Cash is king
Simplifying the rules governing the method of accounting that must be used for tax purposes is a welcome option. Thus, businesses with average annual gross income of less than $25 million may now use the simple cash-basis accounting method.
Accrual basis taxpayers include amounts in income when all of the events have occurred that fix the right to receive income can be determined with reasonable accuracy. Cash basis taxpayers generally include amounts in income when actually or constructively received.
Under the new law, the current $5 million threshold for corporations and those partnerships with a corporate partner has increased to $25 million and the requirement that such businesses satisfy the $25 million limits for all prior years has been repealed. Also, thanks to the new law, the average gross receipts test will be indexed to inflation.
With the cash method of accounting, a woodworking business may account for inventory as non-incidental materials and supplies. Or, as an alternative, a business with inventories using the cash method of accounting will be able to account for its inventories using the same method of accounting used for its financial statements or its books and records.
Losing with NOLs
One of the major benefits of Net Operating Losses (NOLs) was the fact that they could be carried back to more prosperous years to create a refund of taxes paid in those earlier years to create an immediate infusion of badly-needed cash. Today, the NOL deduction has been severely limited, reducing its effectiveness. The NOL write-off is now limited to only 80 percent of the woodworking operation’s taxable income and only in special cases will a NOL carryback be permitted. Fortunately, there is no limit on how far forward NOLs may be carried.
When it comes to the one tax deduction that many woodworking professionals most often overlooked or neglected, the Section 199, Domestic Production Activities Deduction (DPAD), won, hands-down. The DPAD allowed woodworking shops and businesses to claim a deduction equal to 9 percent (6 percent for some oil and gas activities) of their production activities income or their taxable income for the year, whichever was less. Of course, the deduction was limited to 50 percent of the W-2 wages paid during the year and Section 199 applied only to income derived from goods and property manufactured, produced, grown or extracted within the U.S., construction activities and some engineering or architectural services. Now, thanks to the TCJA, the DPAD has been repealed after the 2017 tax year.
Obviously, there are many more changes contained in the massive, Tax Cuts and Jobs Act. The newly passed law provides immediate relief from the so-called Death Tax by doubling the estate tax exemption. The higher thresholds would sunset in 2026.
The corporate Alternative Minimum Tax has been repealed; deductions for local lobbying expenses eliminated; S corporations attempting to convert to regular ‘C’ corporations will face new rules; and partnerships will no longer automatically terminate upon the death or exit of a partner.
According to our lawmakers, the TCJA modernizes our international tax systems making it easier and far less costly for U.S. businesses to bring home foreign earnings. The international provisions of the TCJA also prevent U.S. jobs, headquarters and research from moving overseas by eliminating incentives.
All in all, the TCJA appears to favor businesses over individuals with longer-lived tax savings. Unfortunately, with few exceptions, the potential savings won’t be seen until the tax bill for 2018 comes due.
This article originally appeared in the February 2018 issue.