Interpreting the GOP Tax Reform Plan -- Part 1
Last week, the House Ways and Means Committee released their long-awaited tax reform bill. Note that this is only a bill and is just a starting point for discussing tax reform.
This bill will be changed several times until the House and Senate can agree on the portions of the bill, and then the president signs the bill into law. In Part 1 of my series, we are going to discuss business tax reform.
CORPORATE TAX CUTS
Subtitle A of the bill focuses on Corporate tax rates. The C-Corporation tax rate is reduced from a graduated rate to a flat 20 percent. For personal service corporations, the rate is a flat 25 percent, while for S-Corporations, the tax rate on the flow-through is 25 percent. Any additional amounts would be taxed as compensation at ordinary income tax rates.
Each owner or shareholder would separately determine their proportion of business income. Net income derived from a passive business activity would be treated entirely as business income and fully eligible for the 25 percent maximum rate. Owners or shareholders receiving net income derived from an active business activity (including any wages received) would determine their business income by referencing their “capital percentage” of the net income from such activities.
Under the provision, owners or shareholders generally may elect to apply a capital percentage of 30 percent to the net business income derived from active business activities to determine their business income eligible for the 25 percent rate. That determination would leave the remaining 70 percent subject to ordinary individual income tax rates.
Alternatively, owners or shareholders may elect to apply a formula based on the facts and circumstances of their business to determine a capital percentage of greater than 30 percent. That formula would measure the capital percentage based on a rate of return (the federal short-term rate plus 7 percent) multiplied by the capital investments of the business. Once made, the election of the alternative formula would be binding for a five-year period.
A special rule would apply to prevent the recharacterization of actual wages paid as business income. An owner’s or shareholder’s capital percentage would be limited if actual wages or income treated as received in exchange for services from the pass-through entity (e.g., a guaranteed payment) exceeds the taxpayer’s otherwise applicable capital percentage. The determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules within regulations governing the limitation on passive activity losses under Internal Revenue Code Section 469. Under these rules, the determination of whether a taxpayer is active generally is based on the number of hours the taxpayer spends each year participating in the activities of the business.
Income subject to preferential rates, such as net capital gains and qualified dividend income, would be excluded from any determination of a business owner’s capital percentage. Such income would not be recharacterized as business income for these purposes and would retain its character. Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible for recharacterization as business income. Interest income properly allocable to a trade or business would be eligible to be recharacterized as business income.
Under the provision, the default capital percentage for certain personal services businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would be zero percent. As a result, a taxpayer that actively participates in such a business generally would not be eligible for the 25 percent rate on business income with respect to such personal service business. However, the provision would allow the same election to owners of personal services businesses to use an alternative capital percentage based on the business’s capital investments. This election would be subject to certain limitations and its provision would also apply a maximum 25 percent rate on certain dividends from a real estate investment trust (REIT) and patronage dividends from cooperatives.
COST RECOVERY – INCREASED EXPENSING
Under this provision, a business would be allowed to immediately expense 100 percent of the cost of any equipment purchased. This would immediately increase the number of businesses that would be allowed to deduct these costs, because the requirement of the equipment use commencing with the taxpayer would be removed.
The small business expensing limitation under section 179 would be increased to $5 million and the phase-out amount would be increased to $20 million. The provision would modify the expensing limitation by indexing both the $5 million and $20 million limits for inflation. The provision also would modify the definition of property in section 179 to include qualified energy efficient heating and air-conditioning property permanently.
The provision to modify the definition of section 179 property to include qualified energy efficient heating and air-conditioning property would be effective for property acquired and placed in service after November 2, 2017. The provision to increase the dollar limitations would be effective for tax years beginning after 2017 through tax years beginning before 2023.
SMALL BUSINESS ACCOUNTING METHOD AND SIMPLIFICATION
Cash Method of Accounting
Under the provision, the $5 million threshold for corporations and partnerships with a corporate partner would be increased to $25 million, and the requirement that such businesses satisfy the requirement for all prior years would be repealed. The increased $25 million threshold would be extended to farm corporations and farm partnerships with a corporate partner, as well as family farm corporations. Also under the provision, the average gross receipts test would be indexed to inflation.
Accounting for Inventories
Under the provision, businesses with average gross receipts of $25 million or less would be permitted to use the cash method of accounting even if the business has inventories. Under the cash method of accounting, a business may account for inventory as non-incidental materials and supplies.
Also, under the provision, a business with inventories that qualifies for and uses the cash method of accounting would be able to account for its inventories using its method of accounting reflected on its financial statements or its books and records.
With capitalization and inclusion of certain expenses in inventory costs under the provision, businesses with average gross receipts of $25 million or less would be fully exempt from the Uniform Capitalization (UNICAP) rules. This exemption would apply to real and personal property acquired or manufactured by such businesses.
Accounting for Long-term Contracts
Under the provision, the $10 million average gross receipts exception to the percentage-of completion method would be increased to $25 million. Businesses that meet the increased average gross receipts test would be permitted to use the completed-contract method (or any other permissible exempt contract method).
This is Part 1 of my 5-part series on tax reform. Part 2 will address more business provisions, and Part 3 will feature individuals, Part 4 will be additional individual provisions, and Part 5 will be my summaries and opinion.
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...