10 Things Startups Need To Know About Tax Reform
For the first time in decades, clients across the country are saying “I can’t wait to meet with my tax attorney and CPA!” While this is admittedly a stretch, the Tax Cuts and Jobs Act (a.k.a., “tax reform”), signed into law on December 22, 2017, has created a renewed interest in tax law. Tax reform made dozens of changes to the Internal Revenue Code. What do entrepreneurs need to know about these changes? IrishAngels preferred partner Baker Tilly outlines the ten changes that are most relevant to startups.
(1) Patent sales are now taxable at ordinary income rates. Historically, patents and other self-created intellectual property were generally subject to reduced capital gain tax rates upon sale. Tax reform has now eliminated this favorable tax treatment for “a patent, invention, model or design (whether or not patented), or a secret formula or process.” Thus, gain on the sale of these properties will now be taxed at ordinary income rates.
Note that tax reform did not repeal the law that allows individual inventors to obtain favorable tax rates when transferring all substantial rights to a patent. This narrow rule still applies.
(2) Bonus depreciation is available for 100% of eligible assets. Prior to tax reform, companies could immediately deduct the so-called “bonus depreciation” on qualified assets in the year of purchase. Bonus depreciation was equal to 50% of the purchase price of these assets. Under tax reform, the eligible bonus depreciation percentage is increased to 100%.
These new depreciation provisions can produce present value tax savings for businesses with considerable capital expenditures. However, startup companies that are in a loss position should be mindful of the Net Operating Losses limitations described in (3) below before taking bonus depreciation.
(3) There are new ways to use Net Operating Losses. Under tax reform, post-2017 Net Operating Losses (“NOLs”) are subject to two significant restrictions.
First, NOLs can no longer be carried back to prior years, but they can be carried forward indefinitely. Prior to tax reform, NOLs could be carried back two years and carried forward for 20 years.
Second, NOL carryforwards generated after 2017 will only be allowed to offset 80% of taxable income in subsequent years. Prior to tax reform, an NOL carryforward could be used to offset 100% of subsequent year income. Taxpayers can no longer rely upon NOLs to wipe out all income taxes.
(4) State grant funds are now taxable. Tax reform also repealed the rule that exempted state grant funds from a corporation’s income if those funds met certain requirements. These grant funds are now taxable. Note, however, that the increased thresholds discussed in (2) above lighten the blow. That is, grants funds are now taxable, but capital assets purchased with those funds may be immediately expensed under the 100% bonus deprecation threshold.
(5) The C-Corp tax rate is reduced to 21%. Tax reform reduced the income tax rate for C-Corps from a top rate of 35% to 21%. In light of this rate reduction, pass-through entities might consider a C-Corp conversion if any of the following apply:
(a) The business does not expect to distribute earnings.
(b) The business is subject to income taxes in a high tax state (i.e., California, New York).
(c ) The business is not eligible for the new 20% pass-through deduction (see (8) below).
(d) The business has good reason to not distribute retained earnings.
(6) There is a 20% pass-through deduction: Prior to tax reform, pass-through income from partnerships and S-corporations was taxed at the highest ordinary income tax rates. Under tax reform, income from these pass-through entities is generally eligible for a 20% pass-through deduction at the partner/shareholder level, which lowers the effective tax rate on pass-through income.
Highly complex restrictions apply to the 20% pass-through deduction if a partner/shareholder has income in excess of $157K if single or $315K if married and filing jointly.
(7) Expansions were made to the cash method of accounting. Historically, there have been strict guidelines to report income using a cash method of accounting. More specifically, the $5MM average gross receipts test was the largest obstacle to use the cash method. Tax reform drastically increased the gross receipts threshold to $25MM, allowing more accounting method flexibility for startup companies.
(8) Changes were made to fringe benefits. Tax reform changed the tax treatment of various fringe benefits. For example, entertainment expenses (e.g., tickets to a sports event) are no longer deductible, the employee exclusion for bicycle commuting benefits has been repealed; and moving expenses are no longer deductible.
(9) Centralized Partnership Audit Rules: Prior to tax reform, Congress created a new way for the IRS to examine partnership tax returns. In short, the IRS can now assess income tax liabilities against partnership entities. Partnerships that meet certain criteria can elect out of the so-called Centralized Partnership Audit Rules. Partnerships should strongly consider amendments to operating agreements to account for these new rules.
(10) R&D Credit to offset employment taxes: Though not part of tax reform itself, this is highly relevant for startup companies in 2018. Many early-stage companies rely heavily on innovation and technology. These expensive outlays often enable the company to qualify for R&D tax credits. Unfortunately, most start-up companies are in a loss position and the R&D tax credit has historically been non-refundable and applicable only against income taxes.
However, as of 1/1/2016 the IRS enacted a new law allowing companies who generate R&D activities to use the credit to offset employment taxes. Thus, startup companies in a loss position can now use the R&D tax credit.
Tax reform is complex and presents an opportunity to save real dollars. If you have any questions about your company or if you would like to talk to a tax professional, please contact Baker Tilly.
IrishAngels thanks Colin Walsh (email@example.com) and Ben Scott (firstname.lastname@example.org) of Baker Tilly for sharing their expertise in this guest blog post.