Changes to interest expense and qualified expense deductions could mean surprises for some owners.
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With the 2019 year-end tax-planning season ramping up, many companies are still grappling with areas of complexity and confusion introduced by the landmark U.S. Tax Cuts and Jobs Act of 2017 (TCJA). The good news is that some of the fog surrounding key parts of the TCJA have been lifted as a result of new rules issued in the past year and as the IRS drips out additional guidance. The bad news is that in two important areas, the rules have been clarified in a way that is likely to lead to a bigger-than-expected tax bill for a lot of businesses.
Meanwhile, there are many areas where accounting departments are struggling against the clock to interpret the meaning and implications as best they can. One cornerstone of the TCJA that has become significantly clearer is the limit on interest-expense deductions that companies can take. Meant as a way to offset the steep reduction in the corporate tax rate, the law stipulates that companies can only deduct interest expenses up to 30 percent of their tax-basis earnings before interest, depreciation and amortization.
Here are four realities — some more heartening than others — of the coming tax season to keep in mind.
1. Interest-expense change could hurt.
Until the IRS released proposed rules surrounding the deduction limit last year, it had been unclear what exactly would count as interest expenses. The IRS adopted a much broader definition of interest expenses than companies are used to, including things like debt-issuance costs and interest-rate swaps or derivatives that businesses may have used to hedge against debt.
As a result, many items that would previously have qualified for a full deduction will now be classed as interest expenses and subject to the 30 percent limit. This will be particularly painful for businesses in capital-intensive industries such as manufacturing, where debt is often a critical component of day-to-day operating expenses. We are still waiting for final rules, which are expected by the end of the year, but taxpayers may have to initiate planning techniques long before knowing what those final rules will say.
2. Qualified business income is a tricky area.
The other key part of tax reform that now has more clarity is the 20 percent deduction on “qualified business income” earned from pass-through entities. Certain businesses are excluded from this tax break, but until recently companies had been left hanging on exactly how those “bad businesses,” which include consulting, law, accounting and financial services, would be defined.
The IRS cleared up the uncertainty in January with final rules that give a strict interpretation of which businesses are eligible for the deduction. Specifically, it is now clear that even an otherwise “good” company that has as little as 5 percent of its gross receipts from a “bad” business will be entirely disqualified from claiming the break. This development heightens the risks that companies face by taking positions on the deduction that could be perceived as in a gray area. They are already facing fine margins on this because the law reduces the leeway on misstating tax liability to 5 percent from 10 percent for those claiming the deduction when determining whether a taxpayer can be subjected to penalties.
3. Uncertainty remains.
Unfortunately, many other aspects of the new tax law remain shrouded in uncertainty. Much of the legislation was simply written badly and needs to be fixed by Congress. A prime example of the problems this is causing is the qualified improvement property depreciation, which companies can claim for any interior improvements to their real estate.
The new law was meant to increase the QIP deduction limit to 100 percent from 50 percent, but because the law was not written properly, businesses currently can’t apply the deduction at all. Eventually, the rule will be fixed and likely apply retroactively to 2018, but companies are in the dark as to when that will happen.
As if federal taxes had not become complicated enough, state filing requirements are also giving accounting departments a major headache. Each of the 50 states, plus Washington, D.C., are interpreting the federal tax changes in their own way, leading to a particularly complex challenge for companies that have to file in multiple states.
4. Options exist to reduce taxes.
So how should businesses respond to this rapidly shifting and still partly unclear new tax landscape? Based on the recent rules and guidance, there may be some tweaks that companies can make to improve their 2019 tax situations. As far as the interest expense limit is concerned, businesses could consider steps to manage their taxable income in a way that maximizes the deduction, alter transactions to shift a deduction from a category that is now defined as interest expense to something else, or they could consider changing their overall capital structure.
There are arguments that companies could try to make to avoid losing the pass-through deduction due to a “bad business” classification, or they could try to alter their gross-receipts mix to ensure that the “bad business” gross receipts are below the threshold.
With the 2018 tax year already over, companies will be better off focusing on changes they can make to improve their situation in 2019 and beyond. And many such changes are better done sooner in the year rather than later. The longer you spend in your old capital or entity structure, for example, the more problems you’ll continue to have in the new tax environment.