By Derek Rawls, CPA, Gray, Gray & Gray, LLP
The Tax Cuts and Jobs Act was passed by Congress on December 20, 2017 and signed by the president on December 22, 2017. It represents the most comprehensive overhaul of the federal tax laws in nearly 40 years. While it is a sprawling and complex document that will likely take months to fully unravel, we do know that the tax law includes many provisions that are important to anyone running an energy business. Let’s look at them in this article.
NOTE: Unless otherwise indicated, these changes take effect for tax years beginning after December 31, 2017 with the individual changes expiring after 2025.
The corporate tax rate was reduced to a flat 21% rate and the corporate alternative minimum tax was repealed. Good news for C Corporations.
However, many companies in the retail energy segment are pass-through entities, including sole proprietorships, S Corporations, partnerships, and LLCs. The determination of the effective tax rate on business income received from pass-through entities becomes increasingly more complex. An individual can deduct 20% of “qualified business income,” subject to special definitions, thresholds, phaseouts, and limitations.
“Qualified business income” is defined as the net amount of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the United States. In addition, “qualified business income” does not include payments to the taxpayer for services rendered for the trade or business, including reasonable compensation paid to a shareholder; guaranteed payments paid to a partner; or any payment to a partner outside of his or her partner capacity. Investment income is also specifically excluded from this definition.
This 20% deduction is taken “below-the-line,” reducing taxable income, rather than being taken “above-the-line,” in determining adjusted gross income. This is important because most states use federal adjusted gross income as their starting point. Therefore, when filing state income tax returns in these states, individual taxpayers will not benefit from the 20% deduction at the state level. The deduction does not apply for purposes of determining self-employment tax. The deduction can be taken regardless of whether a taxpayer takes the standard deduction or itemizes deductions.
While many energy retail and distribution businesses are likely to be eligible for the 20% deduction, not all businesses have restrictions. Individuals with income from specified service businesses are only permitted the 20% deduction if their taxable income is below a threshold of $157,500 for unmarried individuals or $315,000 for married individuals filing joint returns. These specified services include health (i.e., medical services by physicians, nurses, and dentists), law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, trading, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. The deduction is completely phased-out for these specified services over the next $50,000 of taxable income for unmarried individuals or $100,000 of taxable income for married individuals.
For individuals with taxable income above a “cliff” level ($207,500 for unmarried individuals or $415,000 for married individuals filing joint returns) and that have “qualified business income” from non-specified services, the 20% deduction is limited to the greater of:
• 50% of the taxpayer’s allocable share of W-2 wages relating to the qualified trade or business; or
• The sum of 25% of the taxpayer’s allocable share of W-2 wages relating to the qualified trade or business plus 2.5% of the taxpayer’s allocable share of unadjusted cost basis of qualified property, immediately after acquisition.
State Tax Issues
While the 20% deduction could prove favorable, an individual’s deduction of state income taxes (including those related to income from a pass-through entity) could be limited. Deductions for state income taxes, sales taxes and property taxes, in any combination, are limited to $10,000 per year. This differs from a business organized as a C corporation that would be able to deduct all state income taxes.
Business losses are also limited at $500,000 for married individuals filing jointly or $250,000 for other individuals, with the excess adding to or creating a net operating loss carryover. Carrybacks are barred.
The number of individual brackets remains at seven, but the ranges have been modified and the rates are lowered with the highest marginal rate dropping from 39.6% to 37%. Preferential rates for qualified dividends and capital gains are unchanged and the 3.8% net investment income tax stays in effect.
While these developments raise new questions about the ideal entity choice, the best decision will be driven by each taxpayer’s unique facts and circumstances.
All businesses will see favorable expensing provisions for capital expenditures. The Internal Revenue Code (IRC) Section 179 limit is raised to $1 million and the phase-out is increased to $2.5 million. The definition of IRC Section 179 property is expanded to include the following improvements to nonresidential real property: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems. Any other building improvements to nonresidential real property that aren’t elevators or escalators, building enlargements or attributable to internal structural framework are now included as Section 179 property.
Bonus depreciation expensing is raised to 100% for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023, but is later phased out over four years, starting in 2023. Original use by taxpayer is no longer required, thus allowing bonus depreciation on the purchase of used property.
Taxpayers that have average annual gross receipts of $25 million or less in the three prior tax years are now permitted to use the cash method regardless of whether the purchase, production, or sale of merchandise is an income-producing factor.
The IRC Section 199 Domestic Production Activities Deduction is repealed, and numerous other business tax preferences have been eliminated.
Interest expense for businesses (other than farming and real estate rentals) with gross receipts over $25 million is limited to interest income, plus 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). This will tighten further in 2022, when the deductibility of interest will be capped at 30% of earnings before interest and taxes, but after depreciation and amortization expenses. These limits are imposed at the entity level for partnerships and S corporations, with disallowed interest expenses carried over.
Entertainment costs, including dues for clubs organized for business, pleasure, recreation or other social purposes, are now non-deductible. Employee meals on the business premises are still a tax-free fringe benefit, but are limited to a 50% deduction and become non-deductible after 2025.
Lobbying expenses related to local legislation are now non-deductible.
Like-kind exchanges are limited to real estate with no auto or truck trade-ins or other swaps after 2017.
Qualified transportation fringe benefits for employees, other than those necessary for ensuring the safety of the employee, are non-deductible.
R&D credits have been modified with capitalization and 5-year amortization on the horizon. For amounts paid or incurred in tax years beginning after Dec. 31, 2021, “specified R&E expenses” must be capitalized and amortized ratably over a five-year period (15 years if conducted outside of the U.S.). Accordingly, taxpayers currently deducting R&D costs in the year incurred will be required to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
For C corporations only NOL carryovers are allowed with no expiration period and an 80% income limitation.
The complexity and lack of clear guidance on certain issues makes it more important than ever for business owners to consult a qualified tax advisor to evaluate the impact of these changes.