Pulling back the curtain on tax reform
BDO’s Scott Ziemer calls portions of reform “a very positive benefit for profitable operators.”
Months after the Tax Cuts and Jobs Act passed in late 2017, business owners are still trying to unwind the positive—and negative—tax law changes that will impact their bottom lines for years to come.
Corporations landed a huge windfall in the new tax reform with a reduction in the tax rate that will drop from 35 percent to 21 percent effective this year. Rather than being taxed at the corporate rate, small businesses operating as “pass-through” entities, such as S-corps, LLCs, partnerships and sole proprietorships, generate income that flows through to their individual tax return. The new tax laws reduced the individual rate for those in the highest tax bracket from 39.6 percent to 37 percent.
That 2.6 percent reduction looks pretty paltry compared to the 14 percent drop that major corporations will see. Yet Congress didn’t want pass-through business entities to feel like they were getting left out of the savings. One of the biggest changes is a new Section 199A deduction that offers an additional 20 percent deduction on qualified business income for pass-through entities.
“For people in the franchise business, this is a very positive benefit for profitable operators,” says Scott Ziemer, tax office managing partner at BDO in Phoenix. Based on how the tax law was written, the 20 percent tax deduction on business income will be in place for 10 years. Over the next decade that could result in substantial savings for a profitable operator, he says.
A 20 percent tax cut certainly sounds enticing, but getting to that full deduction won’t be easy. “That 20 percent deduction is clearly going to be a benefit for many, but not for everybody,” says Matt Talcoff, a partner and tax industry leader for consumer products at RSM US. The first step is figuring out who is eligible to claim the deduction, as not every pass-through is eligible. Franchisees that are clearly eligible are restaurants and retailers that have many employees and fixed assets. Service businesses such as accountants, lawyers and those in the medical field are not eligible.
Even for those business entities that do qualify for the deduction, there is a limitation that comes into play for a married person filing jointly when taxable income gets above $315,000.
The new tax law creates a limit or cap on the deduction based on the business owner’s share of 50 percent of the W2 wages of a business, such as a restaurant. For example, if a restaurant owner generates $4 million in annual business income, the 20 percent deduction would calculate out at $800,000. However, if that same restaurant pays out $1 million in annual W2 wages, the max deduction the restaurant owner would be allowed under the limitation would be $500,000. So, in this scenario, that 20 percent deduction effectively drops to 12.5 percent.
Cashing in on bonus depreciation
Another big tax law change for franchisees relates to depreciation rules. Previously, bonus depreciation laws allowed operators to deduct 50 percent of the cost of items such as FF&E and leasehold improvements or renovations in the year that they occur. Under the old law, it had to be new property in order to qualify. Used appliances or equipment didn’t qualify. Now the 50 percent deduction goes up to a 100 percent for the year it was put into service, and it also includes used property.
Specific to leasehold improvements, the intent of legislators was to allow 100 percent of property improvements to be deductible. However, they inadvertently put the code section in the wrong place. As it stands, the law applies to new property that was acquired or put into service after September 27, 2017, and before January 1, 2018. The law needs to have a technical correction to make qualified improvement property eligible for the 100 percent bonus depreciation after December 31, 2017.
“Most people feel that that will happen, it’s just that we don’t have that technical correction in place,” says Marshall Varano, a tax partner with CohnReznick who leads the firm’s hospitality practice in San Diego.
Pass-through entities also need to look at those new depreciation rules holistically, adds Talcoff. “What we’re suggesting to our clients is that they look at their cap-ex spend over a number of years, do projects out five years and figure out what years might be the best years to put cap-ex deductions in versus other years,” he says.
Another important detail to note is that some states are not adopting the new federal tax law as it applies to leasehold improvements. Individual states may require the operator to have a separate schedule that slows down depreciation beyond the new one-year federal deduction, notes Talcoff. So, franchisees will have to look at state tax law to fully determine the tax implications related to property depreciation.
The Tax Cuts and Jobs Act was pushed through at the last minute. Given the rush to get it approved along with the large-scale changes, there are a lot of details that business owners and accountants are still trying to wrap their arms around. There are a number of inconsistences that have to be resolved, and the IRS is continuing to issue guidance that provides more clarity on how some of the new tax law will be interpreted.
Some of the other tax changes that are important to note for franchisees include new limits on business loss deductions and a change to employee meal deductions. The new tax law does put more limits—another cap—on the amount of business loss an operator can deduct in one year. For example, under the old rules if an individual had a $1 million loss in one year on a restaurant business and also had $1 million in income from other sources, such as wages or capital gains, then the net income was zero.
Under the new tax law, if business losses exceed $500,000, the individual cannot claim those in the current year. In this example, the owner would only be able to take half of the business loss of $500,000, which would drop their taxable income to $500,000. The individual can carry the remainder of that loss forward, but under the new tax law, an individual can only use 80 percent of net operating losses in a given year. So, the 100 percent of the loss that is carried into the future becomes $400,000 for the next tax year.
Another tax change impacts business-related meals. Previously, a business was able to deduct half the value of a business-related meal or entertainment, such as an employee who picked up the tab for a client lunch. Restaurants that provided meals to employees before, during or after a shift could deduct 100 percent of that value.
The new law eliminates business-related meal expense deductions and reduces the deduction for employer-provided meals to 50 percent.
Diving into tax law changes can get complicated very quickly. The best advice for franchisees is to educate themselves and work with their accountants to fully understand the changes. Pass-through entities need to develop a “roadmap” for navigating in the new landscape says Talcoff. “No one wants to pay more tax, but at least if it’s planned properly you can deal with the strategic decisions in a fashion that makes sense,” he says.
It also is important to be proactive and not wait until the last minute to figure out the impact. “A lot of these things may be beneficial, but there also are some negatives changes,” says Varano. “The negative changes may cause you to have more tax to pay, and you want to know that before you do your tax return.”
Businesses should run calculations for 2018 to fully understand how the new tax laws will impact them. No one wants to get a shock of a higher tax bill, and there are some changes that operators could make during the year to improve the outcome.