What the New Tax Reform Means for You and Your Firm
The interview below appeared in the January 29, 2018 issue of Crain’s New York.
With the Republican tax plan now signed into law by President Donald J. Trump, many New Yorkers are rushing to their accountants’ offices to make sense of how it will affect their personal tax situation and, if they run a business, their company’s finances as well.
The tax law—the first major reform of the U.S. tax code since 1986—is ushering in some important changes, which will be applied in 2018. When it comes to personal taxes, the exemption for individuals will rise from $6,350 to $12,000 and for couples from $12,700 to $24,000. Fewer people will be affected by the dreaded alternative minimum tax (AMT), with the exemption increasing to $70,300 for individual filers and to $109,400 for married couples.
At the same time, however, the $4,050 personal exemption is being eliminated. The reform is also bringing a $10,000 cap on the state and local tax deduction—a blow to those in high-tax states such as New York. Plus, new home buyers will only be allowed to deduct interest on the first $750,000 of their mortgage debt, also a potential challenge to New Yorkers, given high local housing prices.
On the business front, there will be a permanent corporate tax rate reduction from 35% to 21%, elimination of the corporate AMT, and new ceilings on net operating losses and net interest expenses.
Joe Bublé: The reduced rate for C corporations was enacted to encourage corporations to keep more of their operations in the U.S. In addition to the unfavorable new interest expense and net operating loss limitation rules, there are a number of favorable accounting method changes that will help small businesses.
The new law also repeals the exceptions to the limitations on excess employee compensation for covered employees of public companies. Under the previous law, exceptions applied to commissions and performance-based remuneration, including stock options. The compensation limitation remains at $1 million per year, but the new law repealed these exceptions.
The new law also reduces the corporate dividend received deduction. The 80% dividend received deduction under the previous law is reduced to 65% and the 70% deduction is reduced to 50%.
Joe Bublé: Under ASC 740, the effects of a change in tax law must be recognized in the period in which the law is enacted, in this case, December 22, 2017. Fiscal year-end companies must recognize the effect by the change in the interim period of the enactment. These changes will result in the revaluation of a company’s deferred tax assets and liabilities. The impact of the tax law change needs to be reflected directly in income tax expense or benefit from continuing operations, including items of deferred tax that were originally accounted for in other comprehensive income. Even though enactment of most provisions is not until 2018, the filing of 2017 financial statements requires the disclosure of this subsequent event and the impact on tax accounts.
Joe Bublé: One of the main issues to consider is the effective federal tax rate under various alternatives. A business owner with flow-through income from a business will pay federal taxes on the flow-through income of about 30%, assuming the business qualifies for the 20% deduction and is not otherwise limited. If the business does not qualify for the 20% deduction, the top tax rate is 37%. If the business elects to be taxed as a C Corporation, the federal tax rate will only be 21% at the entity level.
However, if the business typically distributes all after-tax earnings to the shareholders, the effective tax rate spikes to about 40% for C Corporation shareholders and will stay around 30% or 37%, respectively, for the flow-through business owner. Additionally, if the entity sells its business, the C Corporation structure may be tax-inefficient for an asset sale. In addition, the impact of self-employment taxes where applicable, net investment income tax and state and local taxes should also be analyzed.
Joe Bublé: Real estate entities can make an irrevocable election to avoid the interest limitation but have to extend depreciable lives in exchange.
For pass-through entities, the interest limitation is calculated at the entity level. Any disallowed interest is passed through to the owner to be used in future years.
Joe Bublé: The new law disqualifies certain taxpayers from using the Section 199A deduction by referencing a subsection under Section 1202 and then modifying that subsection. The Section 1202 subsection that is referred to excludes businesses that provide the following types of specified services: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation/skill of one or more its employees/owners.
The new law then modifies that definition by excluding architects and engineers (so these businesses qualify for the deduction) and adds businesses that perform services consisting of investing and investment management, trading or dealing in securities, partnership interest and commodities.
Joe Bublé: Everyone is talking about the corporate tax rates of 15.5% and 8% for deferred earnings invested in cash and illiquid assets, respectively. However, the rates applicable to individual shareholders could be significantly higher. These rates are derived via a deduction mechanism tied to the maximum corporate tax rate of 35%. The same deduction mechanism then needs to be done for individuals, substituting the 35% rate with the maximum individual rate of 39.6%. The computation then yields tax rates of approximately 17.5% and 9.05%, respectively, for individual shareholders and individual partners/members of partnership/LLC shareholders. Under the right circumstances, it may be beneficial for an individual shareholder to make an election to be taxed as a C corporation. The only U.S. shareholder for which the repatriation tax is not mandatory is an S corporation, but it becomes mandatory upon a triggering event.
In addition, the Net Investment Income tax of 3.8% applies to actual distributions, which cannot be deferred over eight years as the repatriation tax can.