On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. The TCJA presents a number of changes to previous tax law – some that affect businesses. Here are three things you need to know about the new act and how it affects business profits:
Taxation for Pass-Through Entities
A pass-through entity are entities such as S-Corporations or Partnerships (such as multi-member LLC’s). The TCJA allows a 20% deduction of the earnings of such entities. The remainder of the earnings is paid on the members’ personal income tax rate, and would be available to both taxpayers who itemize and who do not itemize. This deduction is allowed only for purposes of a taxpayer’s Federal income tax. The deduction would not apply to reduce self-employment tax and will have no effect on the calculation of a taxpayer’s adjusted gross income. Therefore, if a taxpayer’s income tax is already is at 0 prior to the small business deduction and is subject to self-employment tax, the deduction cannot be used to offset or reduce the self-employment tax on the taxpayer’s personal income tax return.
Businesses may claim this 20% deduction up to a specified limit: 50% of the W-2 wages or partnership guaranteed payments that the business pays out. Such wage limitation phases in beginning at $315,000 of income for couples. This limitation is fully phased out at $415,000. However, if the business owner’s income is either $250,000 if single or $500,000 if married, filing jointly, then the wage limitation does not apply.
Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States, meaning any trade or business other than a specified service trade or business and other than the trade or business of being an employee. Included as specified service trades (and thus not treated as qualified trade or business) are: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Specified service trades or businesses will have a disallowance of the deduction, phased in at the threshold taxable income amount of either $250,000 if single or $500,000 if married, filing jointly.
Technical Termination of a Partnership
Prior to the TCJA, a technical termination of a partnership occurred when there was a sale or exchange of 50% or more of the total interest in a partnership’s capital and profits within a 12-month period causes the tax year of the partnership to close. Although a technical termination of a partnership caused the partnership’s tax year to close on the date of the sale or exchange, the partnership continued as a legal entity with the same employer identification number.
With the passing of the TCJA, however, the Technical Termination Rule has been repealed. As of January 1, 2018, a partnership is treated as continuing even if more than 50% of its total capital and profits interests are sold or exchanged. Additionally, under the TCJA new elections are not required or permitted.
Cash Method of Accounting
Prior to the TCJA, corporations and partnerships with a corporate partner who wished to use the cash method of accounting were capped at $5 million. The act has increased such threshold to $35 million. This increased threshold has also been extended to: farm corporations, farm partnerships that have a corporate partner, and family farm corporations. However, the cap for farm businesses is $25 million. Additionally, the prior requirement that such businesses satisfy this threshold amount for all years has been repealed with the passing of the TCJA. The provision also indexed the average gross receipt test for inflation.
As you can see, the TCJA brought about significant changes that affect the way small businesses file their tax returns for tax years beginning in 2018. If you are unsure if you are affected, or don’t know the extent of the effect on your business, give us a call or send us an email. We would be glad to answer any questions you may have.