The Tax Cuts & Jobs Act (TCJA, or “tax reform”) was the biggest overhaul of the Tax Code since 1986. Tax reform made major changes to the Tax Code and affected big corporations as well as small businesses. A couple of the changes that small business owners should keep in mind are the new qualified business income deduction, the changes to meals and entertainment expenses, updated net operating losses rules, and new limitations on deducting excess business losses.
QUALIFIED BUSINESS INCOME DEDUCTION
The new qualified business income deduction allows taxpayers to claim a deduction of up to 20% of their qualified business income (or QBI). In general, if your qualified business income is $10,000, you can take a deduction for up to $2,000. For “high-income taxpayers”, the deduction is limited based on the type of trade or business, taxable income, and other factors. Business owners can take this deduction even if they don’t itemize.
This deduction is not available for C corporations or LLCs that have elected to be taxed as C corporations. However, don’t worry. Tax reform did include a reduction in the maximum corporate tax rate from 35% to 21% for C corps.
MEALS & ENTERTAINMENT EXPENSE
Prior to 2018, you were generally able to deduct 50% of your meals and entertainment related expenses for your business. These expenses included taking clients to dinner to discuss business, meals that you or your employees purchase while traveling overnight for business (such as conferences, training, meetings, etc), as well as providing your clients with tickets to sporting events or hunting trips as an appreciation for your working relationship. You were even able to include the cost of inviting your client’s spouse and family – if there was a clear business purpose, of course. Bonus – you didn’t even have to be there to treat your client to a good time.
Tax reform eliminates the deduction for entertainment expenses and continues to allow the 50% deduction for meals. You or an employee must be present and the cost of the meal cannot be lavish or extravagant. Don’t worry, this doesn’t mean you can’t take clients and employees out to nice restaurants. The term “lavish or extravagant” is based on reasonableness as determined by the facts and circumstances.
There are some exceptions to the 50% limitation. When you purchase food for holiday parties or employee cookouts, snacks for the break room (mmmm, donuts in the break room), food to provide to the general public for advertising purposes (branded water bottles or cookies, anyone?), and other food for recreational or social employee activities, your expense is not limited to 50%. These expenses are 100% deductible. Keep in mind that, in order to be deductible, meals still have to be ordinary and necessary for your business. They also have to be either directly related to or associated with the conduct of business.
Here’s a tip: when you purchase food and entertainment together (think taking your client to Top Golf to discuss a deal) make sure the cost of the food and drink are stated separately on the bill or purchased separately altogether. Otherwise, the entire purchase will be considered entertainment and nondeductible.
NET OPERATING LOSSES
A net operating loss occurs when your business has more expenses than it does income. Under previous tax law, if you had a net operating loss (or NOL) you were required to “carry it back” two years. You could offset 100% of your prior income by the NOL assuming you had enough NOL to do so. For example, if you had an NOL in 2017 you would have been required to carry it back to 2015. If, after you offset any income you had in 2015, you had any additional NOL left over you would carry it to the next year – 2016. If you still had NOL left over after 2016, you would then be able to claim it on your 2018 return. You could claim any remaining NOL for up to 20 years. This enabled you to get an immediate tax refund for the prior years if you paid any tax in those years. If you had paid tax in 2015 and 2016, you could potentially get a refund of 100% of what you paid if you had enough NOL to offset all of your taxable income in those years.
Alternatively, you could elect to “forego” the carryback and choose instead to only carry your NOL forward up to 20 years. In this case, you would wait until you filed your 2018 tax return to claim the NOL. If your business generated an NOL in the first year, you just weren’t required to file tax returns in the prior years, or you expected your tax rates to increase in the future, foregoing the carryback and choosing to only carry your NOLs forward might have made the most sense for you.
With tax reform, you no longer have the option to carry your NOLs back to prior years, and your carryforward period is now indefinite. Additionally, your NOL can only offset 80% of your income. For example, if you had an NOL in 2018 you would automatically carry the loss forward to 2019 instead of carrying it back. If your 2019 taxable income was $100,000, you would only be able to use at most $80,000 of NOL to reduce your income to $20,000. If your NOL was greater than $80,000 it would be carried forward to 2020.
Net operating losses generated in 2017 or prior are subject to the old rules while NOLs generated in 2018 or later are subject to the new rules. States have different rules for the utilization of NOLs, and the statute of limitations before they expire is usually much shorter than Federal. It’s important that you (and/or your tax professional) keep track of your NOLs on a per-year basis so that you know which NOLs are expiring.
EXCESS BUSINESS LOSSES
Prior to tax reform, if your business generated a loss you could use that loss to offset your other nonbusiness income. If you had a 9-5 job and a side hustle, you could use the loss from the side hustle to reduce your W-2 income and pay less tax overall. Now with tax reform, your ability to deduct your business losses against your other income may be limited for the current year.
With the new excess business loss rule, if your noncorporate business losses exceed $250,000 (or $500,000 if married filing jointly), the excess is disallowed and treated as a net operating loss to be carried forward to the next year. For example, assume you’re a single taxpayer with $400,000 in wage income and $300,000 business loss. Under the old tax law, you would be able to net the two together and your total income would be $100,000. However, the new excess business loss rule says that you can only utilize $250,000 of your loss this year. Your total income would be $150,000 and the remaining $50,000 of loss would be carried forward to the next year as a net operating loss.
I know what you’re probably thinking. $250,000 in losses is a LOT and you can’t even imagine losing that much money in one year! For some industries, it would be almost impossible to lose $250,000 in one year but there are some industries and businesses that can get close to or exceed that without effort.
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