Tuesday, May 7, 2019

Small Business Tax Season Aftermath and Recap

The Tax Plan Benefits for Various Small Business Structures

Lower taxes are designed to energize the markets, help empower businesses to invest in their employees, and foster economic growth. Tax reform brought new deductions, new tax credits, and tools for small business owners to reduce their tax burden. How did the first year pan-out?  Take a look at our analysis and survey results.

Decreased Corporate Tax Rate for C-Corps

Perhaps the most widely debated change provided by the Trump tax plan were cuts to the corporate tax rate. Under the Tax Cuts and Jobs Act, C-corps are now taxed at a flat rate of 21%—a cut from the previous range of 15%-35%. American Startup customers report a rise in the number of C-corporation formations occurred during the last quarter of 2018 and the first quarter, 2019 (up about 28% from previous Q4 and Q1 numbers) indicating that the lower tax rate may have caused increased C-corp formation activity.

You may well ask, how does a reduced corporate tax rate impact small businesses, especially if this tax break applies to C-corps?

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While this became a point of contention for the new tax plan, most small businesses weren't previously structured as C-corps specifically because of the higher tax rate. The majority of U.S. small business are pass-through entities, such as S-corporations and Limited Liability Companies. Up until now, relatively few small businesses enjoyed the reduced C-corp tax rate and at the time of this writing, the reduction of a 2018 tax mostly impacted midsize to large corporations. American Startup's analysts see this as a trend that will continue, but expects to see the number of small business startups elect C-Corporation status for additional reasons as we'll discuss below.

Pass-Through Deduction

The main difference that distinguishes a pass-through entity from a C-corp is how taxation is handled. So, rather than paying income taxes as a totally separate entity, the pass-through entity passes the profits or losses through to the owner. The business owner then reports the profit or loss as personal income and it is taxed at that individual's tax rate.

An additional benefit under the Trump tax plan is that small businesses filing as pass-through entities were able to take a 20% business income deduction on their 2018 returns. To qualify for the 20% deduction, business owners must have had a taxable income of below $157,500 if single or $315,000 if married and filing jointly. So, if your business is structured as a S-corporation, a limited liability company, or a general partnership you may qualify. The deduction doesn’t lower an individual's adjusted gross income, and there is no requirement to itemize in order to take advantage of it.

Unfortunately, licensed professionals and financial consultants do not qualify for the 20% deduction.
If the pass-through business generates revenue through the professional services of an individual—doctors, lawyers, accountants, and consultants, for example, the deduction is not allowed.

Acceptable Write-Offs for Big Expenses

A new provision of Trump’s tax plan lets businesses write-off a larger portion of large equipment purchases up front as bonus depreciation, instead of depreciating them over a number of years. To illustrate, when a business buys a new piece of equipment, the company typically can write it off a little at a time each tax season. This new deduction lets the company write-off the entire cost of that equipment purchase for the year it was purchased.

Repealed Corporate Alternative Minimum Tax

Essentially, the AMT is a separate way of calculating your tax liability. The repeal of the AMT, while contested in the House and Senate versions of the bill, was met with excitement by the business community. Keeping it in place would get rid of a lot of the benefits of lower tax rates for businesses, because it guarantees that businesses pay a certain rate regardless of the deductions they take.

Updates to Accounting Methods

The new tax plan also allowed more companies to take advantage of the cash method of accounting, rather than the accrual method. Using the cash method, revenue is recorded as soon as the cash is received from customers, and expenses are recorded as soon as they’re paid to suppliers and employees. That’s different from the accrual method, in which revenue is recorded when it’s earned and expenses are only recorded when consumed.

The time difference is the important part. Under the accrual method, business owners could get stuck waiting until they sell inventory to deduct the cost of it, rather than being able to deduct it when they make the purchase. The takeaway is that more small businesses were able to deduct inventory when they paid for it, rather than needing to wait until that inventory was sold. 

Family Leave Credit

This new credit for wages paid for family or medical leave. The intention of this tax credit was to encourage employers to pay when their employees need leave—a fringe benefit that can be tough on small businesses. Depending on the amount of wages paid out, the tax credit can range from 12.5% to 25%. This part of the Trump tax policy isn’t permanent, though. Since it only lasts through 2019, we're not sure how many companies have used or plan to use this credit.

Some Negative Impacts to Small Businesses

American Startup VIP Managers report that a few leading CPA partners and wealth managers remarked that the new tax changes removed a few important benefits that small business owners may no longer claim. Here they are in no particular order:

Business Interest Deduction

The business interest deduction was an important part of the prior tax code that helped out business owners who took out small business loans to cover relevant operating costs. The interest on those business loans would be deductible as an ordinary business expense.  While the business interest deduction wasn’t fully repealed in the Trump tax plan, it was significantly decreased. Companies may only deduct an interest expense of up to 30% of their business’s EBITDA (earnings before interest, taxes, depreciation, and amortization).

While this mostly impacts companies with a taxable profit, like C-corps, small businesses that have a lot of debt on their books should be especially conscious of this change. But it’s not all bad news: If your small business has an annual average gross receipts of $25 million or less for the past three years, your business is exempt from this rule.

Section 199 Manufacturing Deduction

Trump’s new tax plan eliminated a deduction commonly claimed by manufacturing businesses, called the Section 199 deduction which allowed business owners to take a 9% deduction on income from qualified production activities.  For example, if a company assembled, a gift basket onsite, even if the basket comprised fully pre-manufactured goods, the gift basket company could claim the Section 199 deduction.  Manufacturing firms can no longer claim this benefit because it was repealed in this tax bill.

Deduction for Entertainment Expenses

Any business owner in client service is familiar with the dynamic of wining and dining a client. Sports games, dinners, drinks—all of that entertainment is fun, but pricey. At the same time, it can often be the best way to attract new business, so the trade-off is often worth it. Especially if you could write it off come tax season.

Prior to the Tax Cuts and Job Act, business owners could deduct up to 50% of expenses they’d paid for business-related entertainment. No more: The new tax plan does away with deductions for entertainment expenses entirely. Unfortunately, that means a lot of business owners are going to have to start paying taxes on things like box seats and dinners out with clients. Or drop them from their business plans entirely.
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Deduction for Providing Employee Meals

Another employee perk, popular at tech startups for attracting top talent, is company-paid employee meals. Previously, if you fed your staff on business premises, that food that was 100% deductible under the former tax law. It is now only 50% deductible. By 2025, it won’t be deductible at all. We have yet to hear how companies will adjust their meal programs - so far, there are not a lot of open discussions.

Deduction for Transportation Expenses

This one is pretty straightforward—and one that will cause a lot of pain for employers and employees alike. Under tax reform, business owners can no longer deduct the cost of providing employee parking, public transportation passes, and bike commute reimbursements. This one is going to hurt a lot of businesses in expensive metropolitan areas where parking is very expensive and normally paid by the company on behalf of the employees.

Things to Consider When Starting a Business

1. Invest in your mastermind team of professionals.
The most important assets a company has are it's key employees and management team - both inside the organization and outside through consultants, accountants, and lawyers. Hire the best and brightest, and expect to pay them well.

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2. Tax rules change. Stay up to date.
Speak with a CPA-accountant for the most accurate advice and especially the kind that pertains to your specific industry, and you personally. American Startup works with the very best business managers in the entertainment, fashion, and celebrity goods industries. If you need a referral, just visit our website at https://american-startup.com and request a referral.

3. Your company can change its tax status.
In some cases, it may be worth considering a change in tax classification for your company. Is your business set up the most advantageous way? Since this will impact the way you file your taxes and the eligible credits/deductions, this should be top-of-mind. Lower taxes are designed to boost the economy, help empower businesses to invest in their employees and growth. Talk to your mastermind team and take advantage of all of the small business tax information resources available to help you succeed.

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