A taxing transformation: Sponsored roundtable
With the swipe of a pen at the end of 2017, President Donald Trump wrapped up one process and helped launch another.
His signature turned the Tax Cuts and Jobs Act into law on Dec. 22, ending a feverish round of legislative horse-trading as lawmakers shuffled provisions in and out of the bill. The end result is a permanent cut in the corporate tax rate and a grab bag of measures, many temporary, affecting everyone else.
Now, the race is on to understand those measures and how they apply to business owners and individual taxpayers alike. What they learn will affect all kinds of decisions between now and the end of the year and beyond, from buying machinery to ushering in the next generation of business owners.
The Central Penn Business Journal recently convened a panel of experts in taxation, accounting and finance to help make sense of it all. The conversation was moderated by CPBJ editor Joel Berg. The version below has been edited for length and clarity.
CPBJ: What just happened?
Salvatore Bauccio: The Tax Cuts and Jobs Act passed into law on Dec. 22. It will not impact, for the most part, the tax return you’re filing in the next two or three months. It went into effect Jan. 1 with the 2018 tax year.
Vance Antonacci: The main thing for most individuals and business owners is what they do now to plan throughout the year so that when they file that tax return in 2019, they get the best results. The challenge is there’s a lot of unknowns. The legislation, like most tax legislation, has some opaqueness.
Katie Clarke: The goal was to make the U.S. competitive, to simplify the tax code, to spur business, to hopefully enhance the U.S. economy. While simplification probably hasn’t happened, the corporate tax cut is pretty significant.
Donna Mullin: It isn’t simplification from a business owner’s perspective because a lot of the small-business provisions are a little bit difficult, and a lot of details will have to be added after the fact. But for individuals we’re going to see that only one in 20 people who used to itemize will be itemizing next year. That will make their lives simpler. I think that individuals will probably realize that they are generally getting at least some kind of a tax benefit out of this law when the dust settles.
CPBJ: When was the last time that we’ve seen a change this big?
Antonacci: Probably 1986 when the Tax Reform Act was passed. That was a more comprehensive overhaul of the tax laws. In 2001 with (then-President George W.) Bush, there was also tax reform, but it was like this one, with a 10-year cliffhanger.
Bauccio: That’s an important distinction to make. The 1986 Tax Reform Act was approved by more than 60 percent of the U.S. Senate, so it was permanent. The 2001 tax bill, much like the 2017 tax act, has an 8-to-10-year expiration. So this is not a permanent tax reform.
CPBJ: What are some other differences between now and 1986?
Bauccio: The purpose of this tax act was to make America more competitive on the global stage. That was not the intent of the 1986 tax reform. Another key objective of this was to lower the tax rate from 35 percent to 21 percent for corporations and to spur multinational companies to bring cash back into the U.S. and reinvest in America.
CPBJ: What do you see as the impact on the economy from the 2017 tax act?
Clarke: There’s going to be more money in the pockets of individuals everywhere. To corporations that are taking this tax break, it’s significant. It’s also a tax cut to pass-through entities. The economy has a lot of positives working for it to begin with. This is really just putting a little more fuel in the fire.
Bauccio: The Tax Foundation anticipates that 40 percent of every dollar in tax savings by companies will be spent. And one company’s capital expenditures are another company’s top-line revenue. So I think we are going to have a big year in 2018 and 2019 for even our closely held companies in Central Pennsylvania as we start to see some of these tax savings invested and reinvested in the economy.
Antonacci: If you look at local businesses, the S corporations, the pass-through entities, I think most people that I deal with are not going to pocket the savings from the tax cut. It’s a tight labor market, so they’ll have to pay people more. They’re going to buy more equipment. They’re going to try to buy new business. They’re going to expand their product lines. You’re not going to see that in a stock market ticker symbol, but you’re going to feel it eventually locally.
Mullin: A lot of people’s willingness to spend money is emotional. And it’s a pro-business environment.
CPBJ: What do business owners really need to think about as they make decisions between now and the end of 2018?
Bauccio: First, whether you’re a pass-through or a C corporation, you have an opportunity for a significant tax reduction in 2018. If you’re a C corp, it’s automatic. Your tax rate goes from 35 percent to 21 percent. If you are a pass-through entity, which most of our local companies are — they’re S corporations or LLCs — you are potentially eligible to deduct 20 percent of your income if you are a non-service business.
CPBJ: How are non-service businesses defined?
Mullin: The law has defined service businesses, so non-service businesses are the rest. For service businesses, they’ve come up with a list of professions and types of businesses, like law and accounting. But it’s not that the deduction isn’t available for service businesses at a certain level. Service businesses where an individual is married, filing jointly and has taxable income from all sources of $315,000 or less, not gross, still benefit from the 20 percent deduction.
The law starts to phase out the deduction for individuals who are married, filing jointly with taxable income between $315,000 and $415,000. And then the deduction simply drops off the cliff after $415,000. Nonetheless, a vast number of people are going to benefit from this reduction in rates for even the service-provider sector.
And I think it is a misnomer to be calling it a pass-through deduction. It applies more broadly. For example, it will apply to people with proprietorships. It will apply potentially to rental properties held directly by individuals, not just partnerships.
Bauccio: Whether you’re a sole proprietor, an LLC or an S corporation, step one is determining whether you’re eligible or can become eligible for the 20 percent deduction.
CPBJ: What if you are on the border of losing the deduction?
Mullin: People are strategizing now to try to stay below the threshold for total taxable income, perhaps make additional contributions to their retirement plans or take other actions to reduce their business income to keep it at that $315,000 cap for those married and filing jointly. For individual filers, the cap is $157,500 and it phases out by $207,500.
Clarke: The irony is that this law was driven as a corporate tax cut. But to level the playing field, they brought in this pass-through deduction. And that’s the part that’s made everything so complicated. On the corporate side, it’s very simple.
CPBJ: What other calculations do you see businesses making?
Mullin: For non-service businesses, once you get over that $315,000 cap where you potentially can lose the 20 percent deduction, there’s a formula that allows you to take the full deduction. The formula is based on tests related to how much you pay in wages or what you hold in assets.
Bauccio: There’s also a new limitation on the interest expense deduction for companies, which could have a significant impact on the decision on whether to borrow and how much to borrow going forward. [Under the new law, companies can deduct interest only up to 30 percent of their earnings before interest, taxes, depreciation and amortization, or EBITDA. Up until now, the deduction had generally been unlimited.]
Antonacci: Or to issue equity instead. Most small businesses say, look, I can go to my bank and borrow money. But now the calculus might be: Well, I can only deduct so much interest, so maybe I’ll go find an equity partner instead.
Bauccio: You always have the option of raising debt or equity. But now the calculus has changed.
Mullin: The limitation on the interest expense deduction, though, only applies to entities with average receipts over the last three years of $25 million or more. So that will take a lot of small businesses out of that. And there also is an exclusion for real estate entities if they accept a longer depreciation period for their property. Since real estate entities tend to be highly leveraged, that’s going to be something they’ll be looking at.
Clarke: All of the businesses, all of our clients are modeling, a term you’ll hear a lot. Right now it is important that they begin to understand how they’re paying taxes, what their business structure is and what the effect is going to be of the new tax law. As we see the regulations finalized, they can then begin to take action.
CPBJ: Where do you see businesses business owners tripping up? It all does sound pretty complicated.
Antonacci: I think it’s just that. You don’t know what you don’t know. And you don’t want to take a step that’s hard to unwind, to restructure your business, for example. I generally just tell clients to keep doing what you’re doing to make money. We have a whole year here to try and figure things out.
What frustrates business owners is uncertainty, and there’s a lot of uncertainty. As favorable as this law is, the uncertainty is a negative.
CPBJ: What are some of the things that need to be fleshed out over the next six or seven months?
Clarke: One of the biggest things is understanding the service category. The definition of service includes any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. Further clarification and guidance will be very important.
Bauccio: It will be interesting to see how the $10,000 limitation on state and local tax deductions impacts state governments across the country. Cities like New York City are fearing the impact on their local economy. The average taxpayer in Manhattan has a $60,000 state and local income tax bill. In 2017, they could deduct the entire $60,000. In 2018 their deduction is limited to $10,000.
Clarke: We’re very fortunate to be in a relatively low-tax state. So it’s not as alarming generally to us. But it is still a big issue.
Antonacci: Where you might see it a little bit is Maryland. Maryland has a pretty high income tax rate and property tax rate. If you were thinking about moving to York and commuting to Baltimore, now you might be more inclined to do it.
Mullin: There’s a lot of worry in the charitable field about individuals losing their itemized deductions and saying “I’m not going to get a tax benefit now when I give to my church or my United Way” or whomever. But I personally don’t see people who are charitable cutting because they don’t get a tax deduction.
Antonacci: In Central Pennsylvania there are a lot of very generous people, from my experience. And people give significant six-figure sums every year to charity, never driven by tax planning but just because they’re generous. But they’re now going to have an additional benefit. Under the prior law, deductions for charitable contributions were limited to 50 percent of adjusted gross income. Now the limit is 60 percent. This helps charitable taxpayers because they can deduct more in the year of a charitable gift.
Mullin: I see the potential for people to bunch their charitable giving into one year, not doing it the next, in order to get a deduction, and itemize in one year, and then back off and do it in a more cyclical manner.
CPBJ: What do individuals need to know about the new law?
Clarke: This is money in their pockets almost across the board.
Bauccio: The top thing for high-net-worth individuals is the doubling of the estate-tax exemption from $5.6 million to $11.2 million for the next eight years.
Antonacci: If you’re still subject to the estate tax or close to it, you should try to think about taking advantage of planning now. If you’re a business owner, it’s a good time to think about shifting some equity to your children, for example, because it’s easier to gift it now if you’re inclined to do that.
Other people are not going to have any exposure to the estate tax. But they may have an older estate plan that accounts for the old estate tax. It’s a good time to dust off your plan and see if any changes should be made.
Mullin: And for those below the $11.2 million threshold, there’s a lot of tax-planning opportunities. For example, if you have assets that have appreciated in value, it may make sense to include them in the estate. Your heirs will acquire the assets at the value they held at death, not the value at which they were originally purchased, eliminating the capital gains tax if they decide to sell the assets.
CPBJ: Are there situations where you go through the modeling and some people might not come out ahead?
Clarke: The mortgage deduction was decreased from $1 million dollars to $750,000, although existing debt is grandfathered. And the deduction for home equity loans is generally being removed, but with some exceptions. If the home equity line of credit is used to make substantial improvements to the current home, and the combined total of the first mortgage and the HELOC stays below $750,000, the deduction should still apply. But it eliminates the ability for individuals to tap into their home equity for other uses and still get a deduction. From a financial planning perspective, it just brings another level of consideration to the table. With interest rates having been at all-time lows and home equity debt a deductible expense, utilizing HELOCs for non-home-related expenses has been quite common and often the best financial decision. With this tax-law change, coupled with rising interest rates, we are likely to see that change.
CPBJ: Are there businesses who were expecting to do better who might not in the end?
Bauccio: If you had to find a loser in the tax bill, it would be service providers that do not get that 20 percent deduction. But we’re already hearing from service providers that own ancillary businesses that would otherwise qualify for the deduction. They are considering bifurcating those two lines of business into two separate entities so at least one line of business gets the deduction. A service provider that owns real estate, for example, could spin off the real estate into a separate LLC and then charge the service company rent.
Mullin: Some people might not realize quite the tax decrease that others do. But overall everyone is going to realize a tax decrease,
CPBJ: What kind of questions do you hear most from clients?
Mullin: People are asking about restructuring. Should I do it now? They’re all anxious to have the right structure to take advantage of the tax benefits in the law.
Clarke: We’re not getting a lot of questions at this point because everybody knows it’s so early. And the experts are still getting their heads around the law as it is.
Mullin: There’s just so many little things that are unclear under the law. When you try to model this with a particular business, we bump into the question of how it’s going to work in this particular situation, and we have a lot of unanswered questions.
CPBJ: Are there questions business owners should be asking, given that it is early and that there are still a lot of grey areas?
Bauccio: Every one of these tax provisions is designed to incentivize or disincentivize a particular behavior. So business owners need to know which behaviors are being incentivized and disincentivized, so that when they do their long term planning, they can decide which actions to accelerate and which to decelerate.
CPBJ: What behaviors are being incentivized under this law?
Antonacci: Capital expenditures with the increased depreciation opportunities would be a large one.
Mullin: I see an opportunity for businesses to pass to the next generation a little more rapidly with the increase in the estate tax exemption. We have a lot of owners who are deep into succession planning, trying to figure out how to keep these small businesses running into the next generation. I think there’s some very positive impacts in the tax law to make that a possibility.
Clarke: Small-business owners that all along were planning to pass the business within their family might decide to do it now while they have the full $11.2 million lifetime exclusion as opposed to taking the risk that the ability to pass might be less at some point.
Bauccio: Great point, Katie. A top takeaway for individual business owners is they really have an eight-year window to complete their succession plans if they want to take advantage of some of the increased gifting and estate tax exemptions. There’s an eight year window because in 2026 this goes away absent another intervention by Congress. What we don’t want to do is tell our clients this is guaranteed in place for eight years. This was passed with a simple majority. So it’s not permanent law. A simple majority could undo it.
CPBJ: What are some of the behaviors that are being disincentivized?
Mullin: Most of the questions we have been getting from people with regards to positioning on their itemized deductions have dealt with the interest expense and second homes. Are they going to be willing to buy the beach house and leverage it quite as much when they’re going to run into the overall limitation on mortgages being $750,000 going forward? There may be some impacts there. But if the economy booms, people are going to buy anyway.
Antonacci: There’s a small disincentive to live in a higher taxed jurisdiction. So if you can live in Princeton, N.J., or across the river in Pennsylvania, maybe you want to choose Pennsylvania, or Miami instead of Manhattan. It’s a very small segment of the economy.
Bauccio: What everyone has to do now is take stock of their goals for the next five to 10 years. And then meet with their advisers and determine: Is there now a path forward or a strategy that I can adopt to achieve my goals more effectively or more quickly given the new tax law?