By Mark E. Battersby / Published February 2018
Are you ready for tax “reform”? Thanks to the just-passed Tax Cuts and Jobs Act (TCJA), the tax rate for incorporated pressure washing businesses will be reduced from its current 35 percent to 21 percent for the 2018 tax year and thereafter. And, although the tax cuts for individuals are temporary, expiring in 2026, the business tax cuts are permanent.
Unfortunately, while regular ‘C’ corporations will be taxed at a flat 21 percent tax rate, the majority of small businesses doing business as pass-through businesses will face new personal tax rates higher than the corporate tax rate.
Pass-through businesses—such as partnerships, limited liability companies (LLCs), S corporations, and sole proprietorships—pass their income to their owners, who pay taxes at the individual rate. Owners who report business income on their personal tax returns will be able to deduct 20 percent of that income.
The TCJA does, however, place limits on who can qualify for this rate with strong safeguards so that so-called “wage income” does not receive the lower marginal tax rates for business income. All businesses under the income thresholds, regardless of whether they’re service professionals or not, can take advantage of the 20 percent deduction.
Under the new rules, owners can apply a 20 percent deduction to their business income, subject to limits that begin at $315,000 for married couples (or half that for single taxpayers). However, that 20 percent deduction applies only to business income that has been reduced by the amount of “reasonable compensation” paid to the owner. “Reasonable” compensation has not been defined as yet.
Lawmakers long ago created a unique 20 percent tax rate as part of a parallel tax system that limited tax benefits to prevent large-scale tax avoidance. Under this system, incorporated businesses were required to calculate both their ordinary tax and the AMT tax, paying whichever was higher. Fortunately, the Corporate Alternative Minimum Tax has been eliminated, lowering taxes and eliminating the confusion and uncertainty that surrounded it in the past.
Unlike in past years, pressure cleaning contractors and other businesses were required to claim depreciation, spreading the recovery of their equipment costs over several years. Now, many businesses will be able to fully and immediately deduct the cost of certain equipment. What’s more, this provision has been made retroactive to September 27, 2017.
Of course, the faster write-off of equipment costs is only temporary. It is at the 100 percent level for expenditures between September 27, 2017 and January 1, 2023. After December 31, 2023, and before January 1, 2025, the amount deductible drops to 60 percent with a further decrease to 40 percent after 2025 and to 20 percent after 2026. On January 1, 2027, the equipment cost write-off disappears.
Despite the narrowing of differences between bonus depreciation and the tax law’s Section 179, first-year expensing, with both offering 100 percent write-offs for both new and used property, Section 179 remains an improved option. The immediate write-off, or “expensing,” of capital assets is appealing because, unlike so-called “bonus” depreciation, the use of equipment doesn’t have to begin with the pressure cleaning business.
Section 179 allows up to $1 million (up from $500,000 in 2017) of expenditures for business equipment and property to be treated as an expense and immediately deducted. The ceiling after which the Section 179 expensing allowance must be reduced dollar-for-dollar has also been increased from $2 million to $2.5 million.
And now, improvements including roofs, heating, ventilation, air conditioning systems, fire prevention, and alarms and security systems qualify under the new Section 179 rules, providing another opportunity for pressure washing businesses that actually need equipment.
In the past, our tax laws have protected the ability of small businesses to write off the interest on loans. In an attempt to “level the playing field” between businesses that capitalize through equity and those that borrow, the TCJA caps the interest deduction to 30 percent of the adjusted taxable income of a pressure cleaning business. Exceptions exist for small businesses to protect their ability to write off the interest on loans that help them start or expand a business, hire workers, and increase paychecks.
The simplification of the method of accounting the pressure cleaning operation is required to use is a nice option to have. Businesses with average annual gross income of less than $25 million may now use the simple cash-basis accounting method.
The current $5 million threshold for corporations and those partnerships with a corporate partner has been increased to $25 million, and the requirement that such businesses satisfy the $25 million requirement for all prior years has been repealed. Also under the provision, the average gross receipts test would be indexed to inflation.
With the cash method of accounting, a pressure cleaning business may account for inventory as non-incidental materials and supplies. Or, as an alternative, a business with inventories using the cash method of accounting could be able to account for its inventories using the method of accounting reflected on its financial statements or its books and records.
And, when it comes to those long-term contracts used by some contractors, the $10-million gross receipts exception to the percentage-of-completion method has been increased to the same $25 million level that allows small pressure washing operations to use the cash basis method of accounting. Businesses that meet the increased average gross receipts test are now permitted to use the completed-contract method (or any other permissible exempt contract accounting method).
The tax law’s Section 1031 governing trade-ins, swaps, and like-kind exchanges currently allows pressure washing businesses to defer the tax bill on the built-in gains in property by exchanging it for similar property. Although more a strategy for deferring a tax bill when business assets are lost, sold, abandoned, or otherwise disposed of, with multiple exchanges gains can be deferred for decades and ultimately escape taxation entirely.
Under the TCJA, like-kind exchanges will be limited to so-called “real” property (but not for real property held primarily for sale). The provision redefines like-kind exchanges and includes language that limits Section 1031 exchanges specifically to exchanges of like-kind “real” property. This ensures real estate investors maintain the benefit of deferring capital gains realized on the sale of property and eliminates a business’s intangible assets.
One of the main benefits of net operating losses (NOLs) was the fact that they could be carried back to earlier, more prosperous years, creating a refund of taxes paid in those earlier years and providing an immediate infusion of badly-needed cash. Today, the NOL deduction has been severely limited. The write-off is now limited to 80-percent of taxable income and only in special cases will a NOL carryback be permitted. There is no limit on how far forward NOLs may be carried.
The 2010 Affordable Care Act—popularly known as Obamacare—required everyone, including small business owners and the self-employed, to buy health insurance or pay a federal penalty. Any individual who failed to buy health insurance
was required to pay penalties of $695 (higher for families) or 2.5 percent of their household income, whichever was higher. Fortunately, the new law repeals the penalties.
The federal estate tax is a tax on the transfer of property after someone’s death. That property must exceed a certain value amount for the tax to be applicable. Only the wealthiest 0.2 percent of estates owed any estate tax at last count, according to IRS data and the Center on Budget and Policy Priorities.
The tax law applies a 40 percent levy on estates worth more than $5.49 million for individuals and $10.98 million for couples. The newly passed law provides immediate relief from this so-called “death tax” by doubling the amount that is exempted and can be ignored, so the estate tax will now apply to fewer estates. The higher thresholds would sunset in 2024.
In a related area, the credit for estate, gift, and generation-skipping transfer taxes has also been increased, in this case to $10,000,000 for decedents dying and gifts made after December 31, 2017.
Obviously, there are many more changes within the massive Tax Cuts and Jobs Act. No longer will expenditures for the local lobbying of officials and government offices, though so often necessary, be permitted. S corporations attempting to convert to regular ‘C’ corporations will face new rules; Section 199, the deduction for so-called “domestic production activities,” has been repealed; and partnerships will no longer automatically terminate upon the death or exit of a partner.
All in all, however the Tax Cuts and Jobs Act appears to favor businesses over individuals with longer-lived tax savings. Unfortunately, with few exceptions, the potential savings won’t be seen by pressure washing operations and businesses until the tax bill for 2018 comes due. Naturally, planning and developing strategies to reap the potential savings offered by the Tax Cuts and Jobs Act should begin immediately.