On November 2, the U.S. House of Representatives released the draft Tax Cuts and Jobs Act (H.R. 1) (Act) which includes many provisions that could have a significant impact on taxpayers in the professional services space. The majority of these provisions will be effective for the 2018 tax year and future tax years.
Specifically, the Act reduces the corporate tax rate from a series of graduated rates based on income to a flat rate of 20 %. However, this rate does not apply to Personal Service Corporation (PSC’s) most of which are professional services trades and businesses. Pass-through businesses will be afforded a tax rate relative to pass-through income of 25 % for 30 % of the pass-through income with the remaining 70 % of pass-through income being taxed at the individual’s effective tax rate for all other ordinary income. Again, this reduced tax rate for pass-through entities would not apply to personal services businesses (i.e. businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts).
Under the existing law, entertainment deductions are deductible in most cases up to 50% of the expense amount. According to the Act, the 50% limitation under the existing law would continue to apply only to expenses for food or beverages and to qualifying business meals under the Act, not entertainment expenses. In addition, there would be no deduction allowed for transportation fringe benefits, except to the extent that the employee has included the cost of these benefits in income as taxable compensation.
One other provision in the Act involves employees receiving nonqualified deferred compensation. Any employees who have nonqualified deferred compensation benefits that have not been paid to the employee, but have no substantial risk of forfeiture will be taxed on these benefits as soon as the benefits have no substantial risk of forfeiture. This provision would be effective for amounts attributable to services performed after 2017. The current rules would continue to apply to existing non-qualified deferred compensation arrangements until the last tax year beginning before 2026. These plans would then become subject to this new provision if tax had not been paid prior to that date.
Finally, one additional proposed provision that will impact nearly all businesses is the disallowance of a deduction for net interest expense in excess of 30 % of the business’s adjusted taxable income. It is important to note that the net interest expense disallowance would be determined at the tax filer level. In the case of pass-through entities it would be determined at the partnership or corporation level in the case of S Corporations. Adjusted taxable income for this purpose is a business’s taxable income computed by adding back depreciation, depletion and amortization, interest expense, interest income, net operating losses essentially an adjusted EBITDA amount. Any interest expense amounts disallowed under this provision would be carried forward to the succeeding five taxable years. Any amount of the 30 % of adjusted taxable income threshold that is not used at the business level can be passed through to the underlying partners and shareholders.
As you can see from the selected proposed provisions outlined above this tax reform will be anything but tax simplification. Please stay tuned because this draft bill will be ever-evolving. The day after the draft Act was released, there were amendments proposed to revise specific provisions.
Please return to the Our Thoughts On…Tax Reform blog for updates as they become available.