Year one under the new tax law known as the Tax Cuts and Jobs Act (TCJA) brings significant changes for 2018 individual and business tax filings. Businesses are still processing the effects of the TCJA in 2019, particularly its potential ramifications on long-term planning. Below are four particularly important TCJA provisions for 2019.
Pass-Through Entity Deductions
The tax deduction for pass-through entities provides a business owner up to a 20 percent deduction against qualified business income (QBI) received from a qualified business. The deduction requires an evaluation of the nature of business activities and the sources of income from the business. Specified service trades or businesses, such as consulting, financial services, and athletics are generally excluded. QBI must be generated domestically, and excludes partner or shareholder compensation and investment income. The deduction is subject to several limitations, one of which is the lesser of 50 percent of W-2 wages (including bonuses, elective deferrals and deferred compensation) or 25 percent of W-2 wages plus 2.5 percent of qualified property.
The IRS published proposed regulations to clarify many ambiguities inherent in the provisions, but questions remain. One involves how the deduction applies to partner compensation that is received for non-partner capacity work. Another involves whether ineligible businesses can still take advantage of the deduction by implementing other strategies, such as funding retirement plans. Businesses will need to work with their tax advisors to ensure their pass-through entity deductions are calculated appropriately.
Limitation on Business Interest
The TCJA modified Section 163(j) of the Internal Revenue Code by capping the amount of business interest a taxpayer can deduct. The new limitation is equal to the sum of business interest income plus 30 percent of adjusted taxable income (essentially tax-basis EBITDA before 2023, or tax-basis EBIT thereafter). Businesses carry forward unused business interest indefinitely.
Certain types of businesses, including auto dealers, have exclusions from the limitation. Real estate, construction, and other real property businesses can elect out of the limitation, but they must depreciate their real property using slower ADS rules, which also disqualifies them for the TCJA’s enhanced bonus depreciation provisions. Fortunately, any business with average gross receipts for the prior three tax years under $25 million is exempt from the limitation.
The IRS published proposed regulations that partly address how consolidated groups should apply the limitation, and further define the types of income and expense treated as interest and therefore subject to the limitation calculation. Businesses will continue to work through the nuances of the limitation in 2019.
Accounting Method Changes
The TCJA created an “Earlier Of” test for tax purposes that radically changes the timing of revenue recognition for income tax. After 2017, taxpayers will recognize revenue at the earlier of the time when they would be required to recognize revenue under the historical “all events” test, or the time when the revenue is recognized in an applicable financial statement. This is important in 2019 because private companies must adopt new revenue recognition rules for financial reporting that generally result in faster revenue recognition. The TCJA’s Earlier Of test will likely require an acceleration of revenue recognition for income tax purposes at that time. As private companies adopt the new revenue recognition standards for financial reporting, they may also consider changing their tax method of accounting to conform with most of the new principles. Regardless of this consideration, all businesses must change their tax method of accounting to adopt the Earlier Of test.
Separately, the TCJA permits businesses with average gross receipts under $25 million to use the cash method of accounting, regardless of whether the business has inventory. Such businesses are also no longer required to use uniform capitalization rules.
The TCJA significantly lowered the corporate tax rate, and in some instances, the 21 percent rate may entice companies to restructure from “pass-through” treatment. Large pass-throughs that are ineligible for the pass-through deduction may be particularly interested. If your company wants to evaluate its entity structure, it should work with a tax advisor. Tax rates should not be the sole determinant in your decision. Other considerations include effective tax rates, exit timelines, prospects for law changes, and stock compensation arrangements.
Watch Out for More Guidance
Additional guidance from the IRS is expected as the year progresses. The rushed TCJA legislation left a lot of questions for the business and tax community, and time will tell the full impact that it will have.
Kenneth Tindall is a Senior Manager in the Los Angeles office of CBIZ and MHM. He specializes in tax and business consulting services to companies in the manufacturing, real estate, entertainment and professional services industries.
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