The Tax Cuts and Jobs Act (TCJA) of 2017 created a number of changes for individuals and businesses, prompting Forbes to refer to it as the “biggest tax bill in 31 years.”[1] As its namesake suggests, the primary focus of the Act is on cutting taxes, for both individuals and businesses alike. As with any tax act, there are a number of areas for devious planners to take advantage. Following is a list of strategies you can take to ensure your business benefits from the new business tax landscape.
Choose the Best Business Entity Type
Slashed from 35 percent to 21 percent, the change in corporate tax rate has been one of the most publicized aspects of the TCJA. As I have discussed in other blog posts, a corporation may elect to be taxed as either a C corporation or an S corporation. Because S corporations are pass-through entities, only C corporations receive the benefit of the 21 percent rate. While the improvements sustained by C corporations were more substantial, S corporations and other pass-through entities are not left completely out in the cold, receiving a deduction of up to 20 percent for their “qualified business income.”[1] Yet while the reduced corporate tax rate means the initial tax paid by C corporations may be significantly less than that paid by S corporations and other pass-through entities, the overall tax paid by pass-through entities will generally continue to be lower than C corps because of their lack of double-taxation.
The following are a few tips to mitigate your tax liability:
- C Corporation. If you choose to incorporate and do not elect otherwise, your business will be taxed as a C corporation and will be subject to double taxation. In so doing, you should be cognizant of two things. First, with C corporations (as opposed to pass-through entities), shareholders may avoid the second level of taxation so long as business profits are retained by the corporation and the shareholder does not sell their stock at a gain. Thus, the second level of tax may be deferred so long as the corporation refrains from distributing dividends to shareholders and the shareholders retain their stock. Second, the second level of tax may be avoided altogether where a shareholder dies while owning stock; this allows the heirs receiving the stock to receive a “stepped-up” basis, which basically means they don’t need to pay capital gains tax on the gain or loss realized.
- S Corporation (and Other Pass-Through Entities). If your business is taxed as a pass-through entity, you should strive to get the benefit of Internal Revenue Code Section 199A–the “qualified business income” deduction. Though not as drastic a cut as the aforementioned 21 percent C corporation tax rate, §199A deduction allows the owners of pass-through entities to deduct up to 20 percent of qualified business income generated by their business.
- Use Deductions. Finally, business owners should seek to deduct everything they can. This means deducting all ordinary and necessary business expenses. And, by the way, the IRS incentivizes debt financing (taking out loans) over equity financing (selling stock) because paying interest on your debt is a deductible business expense, whereas issuing dividends is not!
If You’re Going to Acquire Assets, Do So Now.
Generally, the cost of fixed assets purchased for use in a trade or business must be recovered over the asset’s useful life through the use of depreciation deductions. The amendment to I.R.C. §179 makes it a great time to acquire business assets by (1) expanding the definition of “qualified real property,” and (2) increasing the expensing limitation from $500,000 to $1,000,000. Accordingly, eligible taxpayers are now able to immediately deduct up to $1,000,000 of qualifying assets placed in service during the taxable year.
Reduce GILTI.
Applicable to large multinational companies and to U.S. shareholders of certain foreign corporations, GILTI –Global Intangible Low-Taxed Income – is an outbound provision that broadens the scope of foreign earnings subject to U.S. taxation by limiting the amount of foreign income a U.S. shareholder can defer from taxation. While the calculation is long and complex, just keep in mind that if a U.S. corporation owns a foreign subsidiary and shareholder’s “net CFC tested income” exceeds the their “net deemed tangible income return,” they will likely owe GILTI tax.
If you think you may be subject to GILTI, you should speak with an attorney. However, here are a few tips you can use to mitigate your liability for GILTI tax:
- Reduce Ownership Below 10 Percent. GILTI applies to shareholders owning 10 percent or more of a controlled foreign corporation (CFC). Drop your ownership interest below 10 percent, problem solved!
- Fail the CFC Test. A CFC is any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock or 50 percent of the total value of the stock is owned–either directly, indirectly, or constructively–by U.S. shareholders on any day during the foreign corporation’s tax year. Fail this test, problem solved!
- Make a Section 962 Election. Section 962 of the Internal Revenue Code allows a taxpayer to elect to be treated as a C corporation for tax purposes. In other words, you file a form with the IRS notifying them that you would like to be subject to double-taxation rather than the single-level of tax characteristic of pass-through entities. This allows the corporation to pay the new corporate income tax rate on the GILTI amount of the CFC, and the individual shareholder, while being taxed at individual rates on the distributions of the CFC, may defer the individual tax until the CFC makes a distribution.
Business Interest Expense Limit.
Traditionally, businesses have been able to deduct interest paid, thereby incentivizing businesses to finance activities with debt as opposed to equity. The Tax Cuts and Jobs Act changes the calculus, however. Beginning in 2018, all businesses (except those with average gross annual receipts of $25 million or less for the last three years) have limits on their ability to deduct business interest expense. Basically, the TCJA provides that businesses can deduct interest equal to up to 30 percent of their “adjustable taxable income.” Any interest exceeding this amount is nondeductible. Fortunately, disallowed interest may be carried forward indefinitely, meaning one year’s disallowed interest can be deducted in future years.
[1] I.R.C. §199A.
[1] Steven Floyd, Tax Planning, The Big Picture, And the New Tax Laws, Forbes, July 18, 2018, 09:15 a.m. https://www.forbes.com/sites/impactpartners/2018/07/18/tax-planning-the-big-picture-and-the-new-tax-laws/#96a815035f8c.
