U.S. business tax laws changed significantly in 2018 and bankers need to consider this for their U.S. based borrowers or Canadian borrowers with U.S. operations. How do these changes impact banking business clients and what do you need to know when reviewing tax filings for 2018 and on?
The Tax Cuts and Jobs Act was signed into law on December 22, 2017. This was the largest major tax reform in over 30 years and the impact to businesses was significant. In the next few months many bankers will be reviewing 2018 financial statements and/or tax returns as part of their analysis. In the discussion below, we will point out the most critical issues that affect banking business clients and prepare you for what to expect when reviewing 2018 financial statements and/or tax returns.
- Change in Tax accounting method to Cash Basis. Companies that satisfy a $25 million dollar gross receipts test can now file tax returns using cash basis. This method is now available to manufacturers and distributors who, prior to 2018, had to file tax returns on the accrual basis because they had inventory. This is a game changer. On cash basis a company does not pay tax on income until collected and does not deduct an expense until paid. How does this affect clients in 2018 and on?
- The client may report a tax loss or a significant decrease in taxable income in the year they elect to change to cash basis.
- The tax return will not tie out to the financial statements.
- The tax return will become less useful for financial analysis purposes requiring more reliance on internal reports or statements prepared by CPA firms.
- The year of conversion can create major tax savings. The difference between accounts receivable and accounts payable and accrued expenses is generally a deduction in the year of conversion.
- The change should provide additional working capital and cash flow relief to business owners. The deferral of tax liability can be for many years.
- Note that there are “Cash Basis” strategies such as drawing on the line of credit to pay accounts payable to minimize income taxed in the current year. I think you will see some clients draw on lines at the end of the year to manage tax liabilities. This will cause the balance sheet to report a higher than normal line balance at the end of each fiscal year. The line should go back to normal levels during the first quarter, but the client will likely draw on the line at the end of each tax year.
Reminder: Cash method is only available for taxpayers with average gross revenue under $25 million.
- Section 199A deduction (The 20% deduction). Owners of flow through entities like S corporations and LLCs will generally get a new 20% deduction on income from their businesses. You will not see this on the business tax return. Each owner’s K1 will contain supplemental information that will allow the owner to compute the 20% deduction on their personal tax return. This deduction is “below the line”, after adjusted gross income. It brings the top effective individual rate on business income to 29.6% (80% of 37%).
- The deduction is subject to limitations based on wages (W2s) and capital investment. I believe almost all businesses will qualify unless they are a “Specified Service” which includes CPAs, attorneys, doctors, consultants, etc.
- This will provide significant tax savings to businesses and we should expect shareholder tax distributions to decrease.
- The 20% deduction is available for owners of real estate as well. This will be missed by many professionals, but I expect that in most cases the income from owner occupied buildings will qualify for the 20% deduction.
- New C Corporation rate – Starting in 2018 C corporations pay a flat rate of 21%. While this is lower than the 29.6% top rate on flow through income it should be noted that C corporations still have a double taxation issue that in most cases will make the S corporation option preferable to being taxed as a C corporation. Most of our clients are flow through entities but businesses that are C corporations will see a large decrease in Federal tax. Prior to 2018 the C corporation rate was 35%.
- Interest Expense Limitations – It is important to note that beginning in 2018 the interest expense deduction is subject to a new 30% limitation for companies with annual average gross receipts over $25 million. This is a complex calculation but keep in mind that a client could have their interest expense deduction limited. Interest expense above the 30% limit is not lost as it can be carried forward and used in a future year.
- 100% Bonus Deprecation and Section 179 Expanded – 100% Bonus depreciation may allow for the seemingly unlimited, immediate tax deduction for tangible personal property. This rule can provide tax relief to those companies making an investment in equipment and other tangible property. Under the new law these provisions may allow for the immediate write off of certain qualified improvements to real estate. New roofs, HVAC, etc. may qualify for immediate expensing. In many cases improvements to the interior of a building will qualify for an immediate deduction. Section 179 and 100% bonus depreciation are similar. Section 179 does have spending and income limits whereas 100% bonus does not. The rules can be complicated but you should note that business owners will reap immediate tax benefits when they make investments in their businesses. The primary benefit is reduced tax liability and more cash available for expansion or debt service.
- Wayfair Supreme Court ruling – This is a sales tax collection issue, not an income tax issue. It is not just for “Online retailers”. This is an issue that affects any business that ships products out of state. The Wayfair Supreme court ruling eliminated the physical presence test for sales tax collection and replaced it with an economic presence test. The court ruled that sales of $100,000 or more to a state would create an economic presence. Most states have or will adopt the Wayfair ruling as the law.
- Most businesses are not prepared for this and many are not even aware of it. Now is the time to develop a plan on how to comply with this new ruling and manage potential liability.
- This guidance is intended to alert you to changes that may potentially impact your clients and help with your discussions with your client. Seek out expert advice for further details and/or understanding how these changes specifically impact your client. Due diligence of financial statements is essential.
- Ask your clients how the Wayfair Supreme Court ruling may affect their business.