Tax Reform Spells Tax Relief for Colorado Businesses
The nuts and bolts of the Tax Cuts and Jobs Act
Congress has passed and the President has signed into law sweeping tax reform legislation known as the Tax Cuts and Jobs Act. TCJA took effect Monday, Jan. 1, and for businesses, this new law has far reaching implications.
TCJA affects businesses operating either as C corporations, sole proprietorships or pass-through business entities, e.g., S corporations, partnerships and LLCs taxed as partnerships. A C corporation’s income is subject to double taxation: first it is taxed at the corporate-level, then again at the shareholder-level when the corporation distributes dividends. By comparison, income of a pass-through entity is reported on the owners’ or shareholders’ individual income tax returns whether or not distributed, effectively subjecting this income to one level of tax at individual income tax rates.
Under pre-TCJA law, a C corporation’s taxable income was taxed at graduated rates of upwards to 35 percent. If a C corporation was a personal service corporation, its taxable income was taxed at a flat 35 percent rate. A personal service corporation is one where substantially all of the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. Starting this new year, the taxable income of all C corporations will now be taxed at a flat rate of 21 percent.
Further, prior law subjected C corporations to a 20 percent corporate alternative minimum tax to ensure that certain tax preference items were taxed. Under TCJA, this tax is repealed.
Compared to the changes affecting pass-through entities discussed below, these C corporation changes are intended to be permanent.
For the vast majority of Colorado businesses that conduct operations either as sole proprietorships or pass-through entities, for taxable years 2018 through 2025 TCJA lowers the top individual rate from 39.6 percent to 37 percent, for married individuals filing jointly having taxable income in excess of $600,000, and for other taxpayers with income in excess of $500,000. Moreover, for these same tax years, certain pass-through business owners, shareholders and sole proprietors are entitled to claim a new 20 percent deduction relating to their “qualified business income.”
For a non-corporate taxpayer whose taxable income does not exceed $315,000 (for joint filers) or $157,500 (for all others), the deduction is limited to 20 percent of qualified business income. For joint filers with taxable income between $315,000 and $415,000, and for other taxpayers with taxable income between $157,500 and $207,500, this aspect of the limitation is phased out and is gradually replaced with one based on a percentage of W-2 wages. For those with taxable income in excess of the $415,000 and $207,500 amounts, the sole measure of the deduction will be one based on a percentage of W-2 wages.
Not all sole proprietors and pass-through business owners and shareholders can benefit from this new deduction. For those who perform services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services, including investing and investment management, trading or dealing in securities, partnership interest or commodities, along with any trade or business where the principal asset is the reputation or skill of one or more of its employees, owners or shareholders, this deduction is available only if prescribed thresholds are not exceeded. For joint filers that threshold is $415,000; for all other filers it is $207,500. If one exceeds the threshold, no deduction is allowed. Specifically excluded from this rule, however, are architects and engineers.
Other deductions affecting business taxpayers of all types include the election to currently deduct (rather than capitalize and depreciate) the cost of acquiring up to $1,000,000 of depreciable tangible personal property (now including property used predominantly to furnish lodging or in connection with furnishing lodging); off-the-shelf computer software; certain leasehold/retail improvement and restaurant property; and nonresidential real property improvements consisting of roofs, heating, ventilation and air-conditioning property, fire protection and alarm systems, and security systems. This deduction, however, is reduced by the amount by which the cost of such property exceeds $2,500,000.
Additionally, taxpayers can claim a 100 percent first-year bonus depreciation deduction for qualifying property acquired and placed in service after September 27, 2017 and before 2023. For taxable years 2023, 2024, 2025 and 2026, the first-year bonus depreciation is 80 percent, 60 percent, 40 percent and 20 percent, respectively.
Under pre-TCJA law, interest paid or accrued by a business was generally deductible in the computation of taxable income subject to a number of limitations. Beginning 2018, the net interest expense of every business, regardless of its form, is limited to 30 percent of the business’s adjusted taxable income. Any disallowed interest expense is carried forward indefinitely.
Generally, the net interest expense disallowance is determined at the tax filer level. However, a special rule applies to pass-through entities requiring the determination to be made at the entity level rather than at the shareholder, partner or member level.
Importantly, TCJA contains a small business interest expense exception. The interest disallowance rule does not apply to businesses with average annual gross receipts for the three-year period ending with the prior taxable year that does not exceed $25,000,000 (the “$25 million gross receipts test”).
Building on the $25 million gross receipts test, TCJA expands the universe of taxpayers who may use the cash (versus accrual) method of accounting. Under TCJA, the cash method may be used by taxpayers that satisfy the $25 million gross receipts test, regardless of whether the purchase, production or sale of merchandise is an income-producing factor or not. Included in this expanded universe are any farming C corporations or farming partnerships/LLCs with a C corporation partner/member.
Enthusiasm for these and other business deductions is tempered by a new loss limitation rule applicable to non-corporate taxpayers. This new rule is applied on top of the “passive activity loss” rules introduced in 1986.
For taxable years 2018 through 2025, “excess business losses” of a taxpayer other than a corporation are disallowed for the taxable year in which they were incurred. The disallowed losses are treated as part of a taxpayer’s net operating loss and carried forward to subsequent years. An excess business loss is a taxpayer’s aggregate trade or business deductions, less the sum of aggregate trade or business gross income or gain plus $500,000 for joint filers or $250,000 for all others. In the case of a pass-through entity, this loss limitation applies at the shareholder or owner level rather than the entity level. This rule seems to have the effect of accelerating income into the first eight years of the tax bill.
TCJA introduces significant changes to the tax laws. Described above is only a sampling of those changes. Taxpayers of all types are strongly urged to contact their tax advisors for a more in depth explanation of this sweeping tax reform legislation.