On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (H.R.1) into law. The law contains numerous changes that will affect essentially all individuals and businesses. Broadly speaking, it includes sweeping modifications to the Internal Revenue Code, reductions to both individual and corporate tax rates, and a number of changes to allowable credits and deductions.
While the law was greeted with both cheers and jeers, we reached out to Lisa LaSaracina, a partner in tax services at Fiondella, Milone & LaSaracina, for the skinny on how the new law’s provisions will impact young companies and their employees. Several of the key implications are detailed as follows.
Key Implications for Startups
Corporate tax rate: The act replaced the prior law’s graduated corporate tax rates, which taxed income over $10 million at 35 percent, with a flat rate of 21 percent. The new rate took effect January 1, 2018. This may not impact startups in their early stages, when they might be incurring losses.
Pass-through business tax rate: S corporation and partnership income is taxed at the shareholder or partner level and not at the business entity level. The most significant new provision for pass-through entities is the deduction for qualified business income, which reduces the effective tax rate for pass-through income. The deduction for each taxable year is equal to the sum of:
The lesser of (A) the taxpayer’s “combined qualified business income amount” or (B) 20 percent of the excess of the taxpayer’s taxable income over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
The lesser of (A) 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer or (B) the taxpayer’s taxable income (reduced by the net capital gain).
For each qualified trade or business, the deduction cannot exceed the greater of (A) 50 percent of the W-2 wages paid by the qualified business, or (B) 25 percent of wages paid plus 2.5 percent of the unadjusted basis immediately after acquisition of the “qualified property” of the business.
Net operating losses: The act limits the deduction for net operating losses (NOLs) to 80 percent of taxable income. Taxpayers are allowed to carry NOLs forward indefinitely. This is important in cash planning for growth companies as they become increasingly profitable and their losses may be limited. For example, suppose ABC Corp incurs an NOL of $5,000 in 2018 and $4,000 in 2019. In 2020, the ABC Corp has taxable income before NOLs of $3,000. Under the act, ABC Corp can use only $2,400 of its $9,000 NOL, resulting in taxable income of $600. Keep in mind, however, that NOLs incurred before 2018 are not subject to this limitation.
Limitation on losses for taxpayers other than C corporations: Effective for tax years beginning after December 31, 2017, the new law disallows an excess business loss for an individual taxpayer. However, an excess business loss is treated as part of the taxpayer’s net operating loss carryover to the following year. An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for all other taxpayers, indexed for inflation).
For example, suppose an investor (filing single) receives pass-through losses on a schedule K-1 as follows: ABC LLC $300,000 loss, XYZ LLC $400,000 loss and DEF LLC $250,000 in income, for an aggregate loss of $450,000. Under the act, $250,000 (the threshold amount) of the loss can offset other sources of income (assuming no other limitation applies), and $200,000 can be carried forward to the next tax year.
The limitation, which applies at the partner or S corporation shareholder level, expires after December 31, 2025.
Bonus depreciation: The act extended and modified bonus depreciation under Sec. 168(k), allowing businesses to immediately deduct 100 percent of the cost of eligible property in the year it is placed in service. Typically, fixed assets are capitalized and expensed over a number of years. Bonus depreciation allows for the acceleration of the depreciation deduction to the year the property is placed in service. The act also removed the original use requirement (i.e., it can be used property). For capital-intensive startups, this allows immediate expensing.
Cash method of accounting:The act expanded the number of taxpayers that are eligible to use the cash method of accounting by allowing taxpayers that have average annual gross receipts of $25 million or less in the three prior tax years to use the cash method. The $25 million gross-receipts threshold will be indexed for inflation after 2018. For startups with tight cash flow, this can be beneficial in managing cash flow since their tax liability will mirror their net cash. In other words, they will not pay taxes on sales that they have not collected or get deductions for items that have not yet been paid.
Key Implications for Startup Employees
Carried interests:The act provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held in connection with the performance of services by the taxpayer. It treats as short-term capital gain (taxed as ordinary income) 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.
Qualified equity grants:The act allows a qualified employee to elect to defer, for income tax purposes, income attributable to qualified stock transferred to the employee by the employer. An election to defer income inclusion for 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. The deferral is generally five years.
The Bottom Line
The preceding highlights are by no means an exhaustive review of every facet of the new tax law and its impact in every taxpayer situation. It is a summary of some of the law’s major provisions as they currently stand and their likely impact on startups and their employees. Furthermore, as a result of the accelerated timing of the bill’s approval, the rules are expected to see some subsequent technical corrections and/or modifications throughout the year.
About Fiondella, Milone & LaSaracina LLP
FML is a public accounting firm headquartered in Glastonbury. Their practice is dedicated to providing individualized audit, tax and business consulting services to a wide array of companies, including early-stage/high-growth and traditional middle market companies as well as those operating in publicly traded markets.