3 limits to deductions: A major downside of the Tax Cuts and Jobs Act for small businesses
The Tax Cuts and Jobs Act — like any piece of federal legislation — is a tough nut to crack. This year, CPAs are doing double duty, helping clients file 2017 taxes, while also getting up to snuff on the recently passed tax law, so they can guide their clients’ future tax decisions.
Given the scope of the law, people are clamoring to know: What’s good, what’s bad, and what’s different about this new tax law? Is it good for small businesses? In an effort to answer these questions, we’ve teamed up with three Maryland CPAs: Dan Thrailkill, director at Ellin & Tucker; Jim Wilhelm, director at SC&H Group; and Beverly Bareham, president of Bareham CPA.
This is blog two of our three-part series. It explores some of the negative components of the Tax Cuts and Jobs Act. To read up on some of the more positive parts, be sure to check out part one: 4 Ways the Tax Cuts and Jobs Act Benefits Small Businesses.
Understanding the complexity of the Tax Cuts and Jobs Act
“With any kind of tax bill like this, you’re going to have a give and take on both sides,” says Dan Thrailkill. For instance, you may have lower tax rates, but you may have more dollars that are taxed. “It’s a wait-and-see,” he says.
Bareham agrees. “I have clients who are married and itemizing deductions,” she says. “Because the standard deduction is going up to $24,000 and the itemized deductions will be limited, they’re more likely to take the standard deduction next year.”
But while the increased standard deduction might be better for some taxpayers, it’s not the best deal for everyone.
“For example, some married taxpayers had $30,000 of itemized deductions last year, plus some personal exemptions,” says Bareham. (It’s important to note that next year, personal exemptions go away.)
“If the taxpayers’ $30,000 of itemized deductions was all charity, they would still itemize,” Bareham continues. “But if $20,000 of the itemized deductions were state taxes, they will lose $10,000 of itemized deductions, since this deduction has been capped at $10,000. Now, their itemized deductions are reduced to $20,000, compared to the $24,000 standard deduction. Thus these taxpayers’ best option is to take the $24,000 standard deduction. And remember, they no longer have the personal exemptions.”
It’s possible, thanks to the lower tax rates, such taxpayers may still come out ahead tax-wise. But those lower tax rates are offset by an increased amount of taxable income for some people.
For that reason, it’s important you speak with your CPA about your business’s specific situation before making any big decisions. Here are a few specific items you may want to ask your tax professional about.
1. Deductions lose power in high-tax states
One of the most notable changes to deductions under the new tax law applies to taxpayers in high-tax states.
Consider this: In years past, taxpayers would pay state and city taxes on their income. Then, your CPA would look at what you paid the previous year in state and local taxes and deduct that amount from your current year’s taxable income before helping you file your federal taxes on the remainder.
Now, the same rules apply, but there’s a $10,000 cap on the amount you’ll be able to deduct on your federal taxes, in reference to state and city taxes. Remember, small business owners pay taxes on their businesses’ profits, as those profits are considered their personal income.
For people living in high-tax states, this limitation could be big. “Residents in high-tax states will have lower federal rates, which may not offset the lost deductions they now face,” says Wilhelm. “As you have your 2017 return prepared, ask your CPA their thoughts about impacts in 2018, [and] develop a game plan for after April 17.”
2. Loss of the 199 production deduction
Next is the repeal of Section 199, which was a deduction originally intended for factories, but ended up applying to a variety of businesses — from dentists to trades workers.
“Certainly, the manufacturing and production deduction was a generous tax benefit. It applied to many industries,” says Bareham. Now, that deduction is gone, somewhat replaced by the 20 percent pass-through deduction. “That’s going to have a broader impact,” says Bareham, “because it’s going to apply to many pass-through businesses, not just manufacturing businesses.”
That said, the manufacturing deduction didn’t just apply to pass-throughs — it also applied to C corporations. “Again, some businesses are going to benefit, and some businesses are not,” says Bareham. “If you’re a C corporation that was in manufacturing, you just lost a tax deduction. If you’re a pass-through business that wasn’t in manufacturing, you just gained a deduction, potentially. I have a pass-through manufacturer who just lost the manufacturing deduction but gained the pass-through deduction, so they’re kind of on par with where they were previously.”
3. Entertainment deductions take a hit
Another negative has to do with deductions for certain fringe benefits. “We’re seeing certain benefits that were previously tax-free to the employee and deductible by the business that now may [still] be tax-free to the employee but not deductible to the business,” says Dan Thrailkill.
One example of this is event tickets, such as for a sporting event. “Those items were typically part of meals and entertainment, subject to the 50 percent deduction,” says Thrailkill.
While this limit may not be a huge deal to small businesses, where the purchase of game-day tickets might be a less frequent affair, for larger companies who’ve previously depended on such tickets as part of their businesses development, it could mean changes to company culture or tradition.
Final thoughts on the Tax Cuts and Jobs Act from our Maryland CPAs
The new law is a mix of positives and negatives for small businesses, and in the end, there’s really only one blanket statement that can be made about it: Business owners must sit down with their CPAs to fully understand how the law will affect them. With that in mind, here are a few parting words from our experts:
From Jim Wilhelm:
“Most of the changes are good, with the positive likely outweighing the negative by a solid margin. Some of the good news is what wasn’t in there — changes to self-employment taxes that the House considered, as one example.
“For right now, those same folks will need to be tracking certain expenses that are no longer deductible. Set up your general ledger now to capture it, not 10 months from now. They also might hear from employees who want the business to take on some of their business-related expenses since they can no longer deduct them on their personal returns.”
From Dan Thrailkill:
“I think what people aren’t paying attention to are some of the nuances that affect the employer/employee relationships and who’s allowed to deduct, or not deduct, certain items.
“Those [employee/employer deductions] shouldn’t be addressed with a wait-and-see approach. You have to be proactive to see where the benefits are and how to plan for the remainder of the year. There are certain issues that are going to impact the majority of clients that need to be addressed sooner rather than later. Reach out to your CPA about those issues, and set up a time to speak with them about tracking certain costs a little closer.”
From Beverly Bareham:
“The reality is, with this tax law, there are winners and losers. And it’s not, generally speaking, one group versus another. There are very similarly situated taxpayers with slight differences, where some are going to benefit and some are going to pay more. It is not something you can take a broad brush and say ‘Everyone is going to pay less’ or ‘This group is going to pay more.’
“There are a lot of details in this new tax law. The IRS is going to issue regulations, which will provide even more details. We are also expecting technical corrections to be made. And when there are changes such as these, they try to think through what all the impacts are going to be, but there are always unintended consequences.
“It is a great year for taxpayers to speak with their CPAs and see how the new tax law impacts their specific circumstance and plan accordingly!“
So that’s it. Is the Tax Cuts and Jobs Act good for small businesses? You’ll have to decide for yourself. Hopefully, after reading parts one and two of this blog, you have a better understanding of the law’s impact and repercussions.
Wondering how the Tax Cuts and Jobs Act will affect you as a sole proprietor or freelancer? Be sure to check out part three of this three-part blog series for our final installment: Mixed News for Independent Contractors.