Insights

The Tax Cuts and Jobs Act (the Act), which the President signed on December 22, 2017, contains numerous provisions that could affect contractors at the corporate and individual levels.

Corporate Changes:

The corporate tax rate changes, both at the C corp level and the pass-through level, are currently hot topics regarding tax reform.

• Corporate Tax Rates
  • For tax years beginning after December 31, 2017, the corporate tax rate is a flat 21% for C corps.
• Income from pass-through
  • A 20% deduction on qualified business income.

The 20% deduction is not allowed in computing Adjusted Gross Income (AGI), but, rather, is allowed as a deduction reducing taxable income. (Code Sec. 62 (a), as added by Act Sec. 11011(b))

Limitations:

For pass-through entities, other than sole proprietorships, the deduction cannot exceed the greater of:

• (1)  50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or
• (2)  The sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is defined in Code Sec. 199A (b) (6) as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.

These changes have caused many pass-through entities to consider changing to a C corporation for the 21% flat tax. There are several other items to consider to determine the best option.

Corporate Alternative Minimum Tax (AMT):

• For tax years beginning after Dec. 31, 2017, the corporate AMT has been repealed.  AMT credits offset regular tax liability for any tax year and is refundable for tax years beginning after 2017 and before tax year 2022.
• This change along with the change in small contractor exemption (see completed contract method below) should also be part of the consideration when thinking about changing to a C corp.

Increased Code 179 Expensing:

• Starting for tax years beginning after December 31, 2017, a taxpayer may be able to expense up to $1 million of qualified property purchased. This amount begins to phase out after $2.5 million of purchases.  The old law had a maximum expense of $500,000 and started to phase out at $2 million.
  • Qualifying property is tangible personal property purchased for use in the active conduct of a trade or business.

100% Cost Recovery of Qualifying Business Assets:

• A deduction of 100% for new or used qualifying property placed in service from September 27, 2017 to before January 1, 2023. This tax deduction should not be confused with the above mentioned 179 which is subject to different rules.
• In later years, the first-year bonus depreciation deduction phases down, as follows:
  • 80% for property placed in service after Dec. 31, 2022 and before Jan. 1, 2024.
  • 60% for property placed in service after Dec. 31, 2023 and before Jan. 1, 2025.
  • 40% for property placed in service after Dec. 31, 2024 and before Jan. 1, 2026.
  • 20% for property placed in service after Dec. 31, 2025 and before Jan. 1, 2027.

Domestic Production Activities Deduction Repealed:

• New law. For tax years beginning after Dec. 31, 2017, the DPAD is repealed. (Code Sec. 199, as amended by Act Sec. 13305

Methods Allowed to Recognize Income:

• Completed Contract Method.
  • Under the New law, starting after December 31, 2017, the small contractor exemption applies to contracts that are (1) estimated to be completed within two years of the start of construction and (2) is performed by a taxpayer that, for the tax year in which the contract is started, meets the $25 million gross receipts test.  The gross receipts test is satisfied if a taxpayers average annual gross receipts for the three taxable years preceding the contracting year do not exceed $25 million. The $25 million was changed from $10 million which was previously stated and never adjusted for inflation since 1986 when IRC 460 “Special Rules for Long Term Contracts” was issued.
    • This method generally gives the maximum tax deferral
    • The small contract exemption is used on a cut-off basis for contracts that qualify
• Cash Method
  • New law. For tax years beginning after Dec. 31, 2017, the cash method may be used by taxpayers (other than tax shelters) that satisfy a $25 million gross receipts test regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Under the gross receipts test, taxpayers with annual average gross receipts that do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years are allowed to use the cash method.

• Currently a deduction of 50% of expenses relating to entertainment are allowed.
• New law. For amounts incurred or paid after Dec. 31, 2017, deductions for entertainment expenses are disallowed, eliminating the subjective determination of whether such expenses are sufficiently business related. The current 50% limit on the deductibility of business meals is expanded to meals provided through an in-house cafeteria or otherwise on the premises of the employer; and deductions for employee transportation fringe benefits (e.g., parking and mass transit) are denied, but the exclusion from income for such benefits received by an employee is retained. In addition, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees (e.g., between the employee’s home and the workplace), except as provided for the safety of the employee.

• Unlike individuals, pass-through entities are able to deduct entity – level state and local taxes

• A corporation NOL deduction is limited to 80% of taxable income (determined before the use of any NOL deduction) for losses from tax years beginning after 2017. The NOL carryback provisions is repealed. NOL’s can be carried forward indefinitely.

Individual Changes:

• Seven tax brackets preserved with the highest tax bracket now 37%, dropping from 39.6%

• For tax years beginning after 12/31/2017 and before 1/1/2026 personal exemptions is effectively suspended by reducing the amount to zero.

• Under current law “kiddie tax” provisions, the net unearned income of a child was taxed at the parent’s rates if the parent’s tax rates was higher than the tax rates of the child. The remainder of a Childs’s taxable income (i.e., earned income, plus unearned income up to $2,100, less the child’s standard deduction) was taxed at the child’s rates. The kiddie tax applied to a child if: (1) the child had not reached the age of 19 by the close of the tax year, or the child was a full-time student under the age of 24, and either of the child’s parents was alive at such time; (2) the child’s unearned income exceeded $2,100; and (3) the child did not file a joint return.
• Under the new law for tax years beginning after 12/31/2017, the taxable income of a child attributable to earned income is taxed under the rates for single individuals, and taxable income of a child attributable to net unearned income is taxed according to the brackets applicable to trusts and estates. This rule applies to the child’s ordinary income and his or her income taxed at preferential rates.)

• Under the new law, the Act generally retains present-law maximum rates on net capital gains and qualified dividends.

• In computing AMT, only Alternative Minimum Taxable Income (AMTI) above the AMT exemption amount is taken into account. The AMT exemption amount is set by statute and adjusted annually for inflation, and the exemption amounts are phased out at higher income levels.
  • Under pre-Act law for 2018, the exemption amount for married filing joint was scheduled to be $86,200
  • That exemption amount was reduced by an amount equal to 25% of the amount by which the individuals AMTI exceeded $164,100 for married filing jointly.
  • For new law beginning after 12/31/2017 the exemption amounts for married filing joint is increased to $109,400.
  • The exemption amounts are reduced to an amount equal to 25% of the amount by which the AMTI of the taxpayers exceeds the phase-out of $1 million for joint filers.

• State and Local Taxes
  • Capped at $10,000. Combined amount for real estate taxes and income taxes.
• Mortgage Interest
  • Home equity for debt interest is repealed for the 2018 through 2025 tax years.
  • Interest deduction allowed for debt up to $750,000 for newly purchased homes.

• New law. For estates of decedents dying and gifts made after Dec. 31, 2017 and before January 1, 2026, the Act doubles the base estate and gift tax exemption amount from $5 million to $10 million.

• For any divorce or separation agreement executed after Dec. 31, 2018, or executed before that date but modified after it (if the modification expressly provides that the new amendments apply), alimony and separate maintenance payments are not deductible by the payer spouse and not included in the income of the payee spouse.

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