Government Affairs Update: Tax Cuts and Jobs Act Reform of the Federal Tax Code

This morning, the US House of Representatives accepted the conference report on the Tax Cut and Jobs Act to reform the federal tax code. The conference report is the agreement worked out to reconcile differences between tax reform bills passed by the House and Senate. The US Senate accepted the report late Tuesday evening. The President is expected to sign the bill in to law. Provisions in the bill will take effect for the 2018 tax year.

We’ve been fighting for tax reform for years. NAED has three priorities in tax reform:

1. Lower rates on all businesses – I’d call this a “qualified” win. While it lowers rates for businesses, it falls short of true rate parity between C and S Corporations. The bill “sunsets” lower rates for pass-throughs at the end of 2025, setting up an annual battle to maintain the positive changes S corporations got in this bill. C corporations make out far better, with a permanently and significantly rate reduced of 21%.
2. Protect LIFO – the bill doesn’t touch LIFO. I’d call that an unambiguous “win.”
3. Repeal the death tax – this is another “qualified win.” The exemption to the death tax is doubled. However, as with the discounted S corp rates, the higher exemption sunsets at the end of 2025.

There is much to like in this bill. Along with the lower rates we will also benefit from higher Section 179 expensing levels, bonus depreciation and interest deductibility. As we soak in the details, it is difficult to ignore that this may have been a missed opportunity to fundamentally reimagine how we fund the federal government. On balance, however, the vast majority of our members will benefit from this legislation. The economy will benefit from repatriation of foreign earnings and incentives to investment.

Business Tax Rates:

• NAED member businesses classified as C corporations will have their tax rate reduced from 35% to 21%. Corporate AMT is repealed.
• Pass-through companies (sole proprietorships, partnerships, S corporations, and limited liability companies) will receive a deduction of 20% from their qualified business income.
• Pass-through income will still be taxed on the personal income rates, the Senate chose to keep seven brackets:

• For S corporations and partnerships, the 20% deduction is limited to 50% of W-2 wages paid to all employees or the sum of 25% of W-2 wages plus 2.5% of the purchase price of all qualified property (all capital investment that has not been depreciated excluding land).
• The pass-through rates and deductions sunset Dec. 31, 2025, however we expect them to be extended similar to the Bush tax cuts in 2010.

• Pass-through example:
  • A business doing $20 million in sales, paying $500,000 in wages and salaries. The net profit for the business after deducting net interest expense, insurance, advertising, vehicle, and full expensing on purchases is $1 million, and the business owner was paid $100,000 in reasonable compensation for a total taxable income of $1.1 million.
    • Business income taxes: $1,000,000 – $200,000 in pass-through business deduction = $800,000 = $235,379 (See last line of above chart for tax calculation)
    • Personal income taxes (assuming joint filing and standard deduction): $100,000 - $24,000 standard deduction = $76,000 taxable personal income x 37% = $28,120
    • Total taxes paid: $235,379 + $28,120 = $263,499
    • Effective tax rate: $263,499/$1.1 million = 24%

Death Tax:

• The unified exclusion for estate, gift, and generation skipping taxes is immediately doubled to $11.2 million per individual and $22.4 million per couple. The increase in the exemption sunsets Dec. 31, 2025.
  • Full step-up in basis is retained.
  • Example:
    • A business valued at $30 million would see their estate tax bill reduced by $2.24 million compared to current law.
      • Current law: $30 million - $5.6 million exemption = $24.4 million x 40% = $9.76 million estate tax due = 33% effective tax rate
      • New law: $30 million - $11.2 million exemption = $18.8 million x 40% = $7.52 million estate tax due = 25% effective tax rate
      • New law with full portability: $30 million - $22.4 million = $7.6 million x 40% = $3.04 million = 10.1% effective tax rate

LIFO:

• The Tax Cut and Jobs Act does not change LIFO accounting rules.

Interest deductibility:

• Pass-through firms with gross receipts of less than $25 million (averaged over three years) can deduct interest in full. Corporations and large pass-through firms are limited to an interest deduction equal 30% of EBITDA until January 1, 2022, before switching to EBIT, with an indefinite carry forward.

Section 179 small business expensing:

• The small business expensing limitation under section 179 would be increased to $1 million (from $500,000) and the phase-out amount would be increased to $2.5 million. The provision would modify the expensing limitation by indexing both the $1 million and $2.5 million limits for inflation after 2018.
  • Property qualifying for section 179 is expanded to include: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

Expensing:

• The legislation increases Bonus Depreciation to 100% for five years. Any property with a depreciation schedule of less than 20 years qualifies for Bonus Depreciation. After five years Bonus Depreciation is stepped down 20% per year before reaching zero in 2027.

Section 1031 exchanges:

• Section 1031 exchanges for the purpose of deferral of capital gains will be limited to real property. With the allowance of full expensing on most personal property there is no longer a need to provide preferential treatment to personal property under Section 1031.

Meals:

• Deductions for 50% of the cost of meals, including those consumed while on business travel are still allowed.

Transition from S corporation to C corporation:

• The tax bill makes it easier for companies choosing to convert to a C corporation in the first two years of the tax bill by allowing distributions from the accumulated adjustments account to be charged to the accumulated profits and earnings accounts.