The 2017 tax changes aimed to incentivize American business growth. The C corporation tax rate, which at one point was 35%, dropped to 21%. Section 199A of the act gave many pass-through businesses (sole proprietorships, partnerships, and S corporations) a 20% qualified business income deduction.
While Congress has a history of extending expiring tax provisions from previous legislation for a year or two, the fate of certain aspects of the 2017 tax law remains uncertain. To be prepared for potential tax changes, business owners should understand the consequences of these provisions sunsetting.
Here’s what you need to know and consider right now.
The Tax Cuts and Jobs Act allowed full expensing of most assets. However, starting in 2023, the 100% bonus depreciation deduction rate for qualified assets dropped to 80%, and it is scheduled to decrease by 20% annually until it is fully phased out. The net effect is a creeping increase in taxable income that is easy to overlook.
New in 2022, businesses are required to capitalize their research and development expenses. The provision is broad and applies to more than laboratory research and development. Most manufacturers have eligible R&D expenses that are subject to capitalization, though they may not realize it. If you are developing new product offerings or investing in something to be more efficient, you may have to capitalize on some of those costs and amortize them over five years.
The 2017 act included an interest cap of 30% of adjusted taxable income which set limits on how much interest expense businesses could deduct. In the past, adjusted taxable income was defined essentially as EBITDA, but in 2022 the definition narrowed to just EBIT—taxable income plus interest. Unfortunately, this roughly coincided with rising interest rates, so as businesses began paying more interest, they were also able to deduct less.
The sunsetting of the 199A deduction will be especially significant for many private businesses. It may even cause some to rethink their current tax classification or tax structure.
199A provides a 20% deduction for many pass-through businesses. At a top tax rate of 37%, taking the 20% deduction effectively moves the tax rate down to 29.6% for that business. However, with the sunsetting of 199A, the top tax rate will jump to 39.6%. So pass-through businesses that previously benefited from IRC 199A will see a 10% tax increase. If you make $1 million, your taxes will go up $100,000. Those changes can be significant, particularly when compared to a C corporation.
Here’s an example:
| Post-Sunset | Pre-Sunset | ||
| Entity Structure | C Corp | Pass Through | Pass Through |
| Pretax Net Income | $1,000,000 | $1,000,000 | $1,000,000 |
| Tax Rate | 21% | 39.60% | 29.60% |
| Entity Income Tax Liability | $210,000 | $396,000 | $296,000 |
| $790,000 | $604,000 | $704,000 | |
| Dividend Tax Rate | 23.80% | n/a | n/a |
| Dividend Taxes Paid | $188,020 | n/a | n/a |
| Net Income After Tax | $601,980 | $604,000 | $704,000 |
What will your business have to forego if your taxes increase by $100,000? Maybe you won’t be able to buy that new piece of equipment or invest in technology or people as planned. Are there things you can do now to prepare for that and ameliorate the effects?
Given the upcoming sunsetting of 199A, it is well worth revisiting this discussion with your tax advisor. Historically, it was almost always better to be a pass-through business because of double taxation. The whole premise of pass-through taxation was that you would earn your money, you would pay your tax, and the rest you could take without owing additional tax. You would pay it once and be done.
C corporations have traditionally paid a lower tax rate, however, when earnings were distributed at a later date, as dividends or a stock sale, for instance, those earnings were once again taxable—albeit at a lower rate.
When analyzing the conversion to a C corporation, other factors should also be taken into account:
What do you expect your business to look like over the next 5–10 years? The answers can significantly impact what type of tax structure would be most efficient for you and your business. If you expect to make major investments, expand abroad, significantly increase distributions, etc. your ideal tax structure will be impacted. Working with your tax team to model the possibilities can help you understand, at least at a high level, what’s likely to happen under various tax scenarios.
Every private business transitions at some point, no matter the situation. So it’s important to anticipate that eventual transition as part of your overall wealth management strategy. You do not want to make a structural change for short-term gain unless it also supports long-term goals.
It is also important to keep in mind that the estate tax exemption doubled several years ago and it is scheduled to be cut in half. This can be a big deal if your goal is to pass the business down to the next generation. It is important to consider that now prior to the schedule sunset.
While taking action might not be necessary immediately, the 18-month window before the sunset provision is a prime opportunity to consult a financial advisor. Understanding the potential tax changes can inform your current financial decisions and help you prepare for the future impact.
Brian Sweeney, CPA: August 23, 2024
This blog was originally written in 2021. It has been updated with new references and resources.
John Kammerer, CPA: August 15, 2024
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Editor's note: This piece was originally published in 2021 and has been updated to include additional resources.
John Kammerer, CPA