What the New Tax Bill Means for Startups, Entrepreneurs and Investors
Below is a brief summary of the Conference Committee tax bill that was released late last week. It is expected that this bill will be approved by the House and Senate and signed by the president before Christmas. The summary isn’t comprehensive – it touches on the topics likely of interest to startups and with respect to personal tax filings of investors and entrepreneurs.
- INDIVIDUAL RATES. The top individual federal income tax rate is reduced from 39.6% to 37%, effective in 2018. The top rate kicks in at $600,000 of income on joint returns, $500,000 on single returns. If you include the 3.8% “Obamacare” tax, this brings the top federal tax rate down from 43.4% to 40.8%. While not a huge reduction, top bracket taxpayers may want to consider deferring income from 2017 to 2018 and/or accelerating expenses from 2018 to 2017.
- CORPORATE RATES. The top corporate tax rate is reduced from 35% to 21%, effective in 2018. C corporations have more of an incentive to defer income and/or accelerate expenses from 2018 to 2017, although accrual method corporations will be limited in their ability to do this.
- EXPENSING OF ASSET PURCHASES. Businesses can take 100% bonus depreciation for personal property placed in service after September 27, 2017, and used property now qualifies for this bonus. Placing business assets in service by the end of 2017 is one way to accelerate expenses.
- PASSTHROUGH RATES. Individuals allocated business income from passthrough entities (e.g., partnerships, LLCs taxed as partnerships and S corporations) or sole proprietorships can deduct 20% of such income (thus reducing the top effective rate on this income from 37% to 29.6%). However, the income subject to this 20% deduction is limited to the greater of:
- 50 percent of wage expense (i.e., payroll) of the business, and
- 25% of wage expense of the business (i.e., payroll) plus 2.5% of the cost of depreciable assets of the business.
(So much for simplicity!) These limits probably prevent most businesses from taking advantage of the full exclusion. For many of our cash-flow clients, planning to utilize this deduction will likely focus on optimizing wage expenses. For example, it may be helpful for income tax purposes to convert independent contractors to employees, to have different entities pay wages, or to defer wages paid from 2017 to 2018 (although this runs contrary to the general advice to accelerate deductions from 2018 to 2017 above). Personal service businesses, such as attorneys, accountants, doctors and dentists, cannot utilize this deduction unless taxable income is below certain thresholds (e.g., $315,000 on joint tax returns). However, engineers and architects may use this deduction.
- BUSINESS LOSS LIMITS. A new loss limitation rule for individuals applies starting in 2018. Under current law, passive losses can only be deducted against passive income. This rule survives, but a new rule limits the deduction of total business losses (regardless of whether active or passive) to $500,000 per year for joint returns, with unused amounts carrying forward as a net operating loss. This means that active business owners may not be able to deduct more than $500,000 of business losses against other income such as interest, dividends and capital gains.
- AMT. The corporate AMT is repealed, but the individual AMT survives with higher exclusion amounts (e.g., $109,400 for joint tax returns).
- NET OPERATING LOSSES. Net operating loss carrybacks are no longer allowed, carryforwards are indefinite in length, and net operating losses can only offset 80% of current-year income starting in 2018. This change will affect companies with large net operating losses, including their ability to use those losses to offset gain on a sale of assets.
- ESTATE AND GIFT TAXES. The estate tax is preserved, but the lifetime exclusion for estate and gift taxes is increased to $10 million per person (up to $20 million per couple), indexed for inflation occurring after 2011 (which brings the current exclusion to nearly $11 million per person). The step-up in basis at death is preserved. The estate tax rate remains at 40%.
- INTEREST DEDUCTIONS. For businesses with more than $25 million in gross receipts, interest deductions are limited to 30% of income before interest, depreciation and amortization. Real estate businesses may elect to avoid this rule if they use the alternative depreciation system that depreciates non-residential property over 40 years and residential property over 30 years. This may affect highly-leveraged clients (e.g., PE-sponsored entities).
- CARRIED INTERESTS (I.E., “PROFITS INTERESTS”). The bill would provide for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. It would treat as short-term capital gain taxed at ordinary income rates the amount of a taxpayer’s net long-term capital gain with respect to an applicable partnership interest if the partnership interest has been held for less than three years.
- SECTION 162(m). Current law defines a covered employee for purposes of Section 162(m) as the chief executive officer and the four most highly compensated officers (other than the CEO). The bill would revise the definition of a covered employee to include both the principal executive officer and the principal financial officer and would reduce the number of other officers included to the three most highly compensated officers for the tax year. The bill includes a transition rule so that the proposed changes would not apply to any remuneration under a written binding contract that was in effect on Nov. 2, 2017, and that was not later modified in any material respect.
- LIKE-KIND EXCHANGES. Like-kind exchanges after 2017 are limited to real property.
- STATE TAX DEDUCTION. Starting in 2018, individuals are limited to a total $10,000 deduction for state income, property and sales taxes. A last-minute amendment eliminates a great planning opportunity – 2018 state income taxes paid in 2017 will not be deductible in 2017. However, it may still make sense to prepay any unpaid 2017 state income tax, as well as the second installment of property taxes, before the end of 2017.
- CHARITABLE CONTRIBUTIONS. The limit on deductible cash charitable contributions increases from 50% to 60% of adjusted gross income in 2018.
- HOME MORTGAGE INTEREST. Home mortgage interest deductions are limited to interest on $750,000 of acquisition debt (including debt on second homes) starting in 2018. But debt incurred before December 15, 2017 is grandfathered and is subject to the $1 million limit. The deduction for interest on up to $100,000 of non-acquisition debt is eliminated.
- MEDICAL EXPENSES. Deductions for medical expenses are preserved for expenditures in excess of 7.5% of adjusted gross income.
- PRINCIPAL RESIDENCE GAIN. The rules for excluding gain on the sale of a principal residence did not change.
- MISCELLANEOUS ITEMIZED DEDUCTIONS. Miscellaneous itemized deductions are not allowed starting in 2018. To the extent you receive benefit for such expenses (e.g., investment management fees), it may be advisable to pay them before the end of 2017.
- QUALIFIED EQUITY GRANTS. The bill allows a qualified employee to elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to qualified stock transferred to the employee by the employer. An election to defer income inclusion with respect to qualified stock must be made no later than 30 days after the first time the employee’s right to the stock is substantially vested or is transferable, whichever occurs earlier. This provision will allow qualified employees to defer tax on options and RSUs and provide for considerable additional flexibility.