Financial experts say NH’s small businesses stand to gain from the federal Tax Cuts and Job Act that became effective Jan. 1 but that comes with complications. Larger companies, particularly those that are C corps, will benefit even more as they can take advantage of the drop in the corporate tax rate from 35 to 21 percent.
Small businesses represent 99 percent of the 130,000-plus firms in the state, according to the U.S. Small Business Administration Office of Advocacy, and most are “pass–through” companies that will be able to take a 20 percent deduction on qualified business income (gross income minus business expenses)—an entirely new tax cut. That’s on top of the reduction in the top individual tax rate from 39.6 to 37 percent for joint filers.
Pass-through companies—which include sole proprietorships, partnerships and S corporations—are so called because their profits “pass through” to the business owners, who pay taxes on them on their individual tax returns. Most are small companies, though S corporations can include large firms.
“The good news for New Hampshire businesses is, many of them are smaller, and smaller taxpayers will qualify for the pass-through deduction,” says Alison Perrella, co-managing partner at the Bedford-based Howe Riley & Howe accounting firm and former board president of the NH Society of Certified Public Accountants. “It makes it easier to qualify when you’re on the smaller side.”
But, notes Steven Burke, director of the tax, trustees and estates and corporate departments of the McLane Middleton law firm in Manchester, “there are limitations on how much a business owner can take. The entity itself will need to calculate and keep track of that information that it did not have to do before.”
Limitations and Complications
The deduction phases out starting at $315,000 of taxable income for joint filers and $157,500 for single taxpayers.
If the taxable income is higher than that, additional limitations must be considered to determine whether the 20 percent deduction applies, says Perrella. “The definition of qualified business income is complex, and there are many rules and questions relative to its calculation,” she adds.
At taxable income levels above the phase-out, service trades and businesses do not qualify for the deduction, nor does “any business where the skill or expertise of the employer is the principle asset of the business,” says Frank Saglio, a tax manager at Howe Riley & Howe. What constitutes those types of businesses has yet to be defined, though the IRS is expected to come out with regulations shortly.
And that’s just one complication. As a result of the new law, “Many of the longtime business deductions for entertainment have been eliminated, and meals [deductions] have been reduced and will eventually be eliminated,” says Burke. “It may seem like not a big deal, but it may force some businesses to look at their marketing and business development budgets.”
The new law also doubles the standard deduction, making it likely that fewer business owners will itemize on their returns, and that could have a negative impact on things like charitable donations, Burke adds.
It also caps the deduction for mortgage interest at $750,000 of home loan value, compared to the current $1 million, leading some to fear reduced incentive to buy and build homes and a negative impact on the housing industry. But financial experts say that will have less impact in NH than in states with higher-priced homes.
“At the end of the day, higher income people are going to own a home and spend what they want to spend regardless of policy,” says Steve Wamhoff, director of tax policy at the Institute on Taxation and Economic Policy in Washington D.C. “Lower income people might be more affected. I find it unlikely that it would have a huge impact.”
Further, the new tax code caps deductions for state and local taxes at $10,000—a factor for those who do business in more than one state and a consideration for whether to remain a pass-through entity, according to Perrella.
For major corporations including C corps, which are taxed separately from their owners, the benefits are more straightforward. They will enjoy a permanent corporate income tax rate drop from 35 to 21 percent, as well as a lower rate on some foreign earnings.
Manufacturers stand to benefit from a provision that allows them to immediately write off the value of investments in equipment and new plants for five years. In addition, the corporate alternative minimum tax, established so profitable corporations pay at least some tax, has been eliminated.
Financial experts say the change in the foreign tax structure—exempting corporations from paying taxes on most future foreign profits and dropping the tax on corporate income brought back to the United States to between 8 and 15.5 percent instead of the current 35 percent—is a major boon for NH companies with foreign subsidiaries.
“It makes us much more competitive,” says Hollis McGuire, Nashua regional director for the NH Small Business Development Center. “It levels the playing field.” The worldwide average top corporate income tax rate is 22.5 percent, according to the Tax Foundation. Canada’s is 15 percent and Ireland’s is 12.5 percent.
To C Corp or Not to C Corp?
All the changes have left many business owners wondering whether they should consider restructuring to take best advantage of the new law, says Burke. “One of the things we’ve received many questions about is whether to convert from a pass-through to a C corp or vice versa,” he says. “In almost every case, it still makes sense to be a pass-through.”
Saglio notes that in the case of the 20 percent deduction for pass-through companies, the qualified income does not include the owner’s compensation, which might lead some business owners to consider revisiting how that compensation is structured “to see if you can justify a lower salary and take more money as a distribution.”
But both he and Perrella urge caution. “I’m trying to tell clients to reserve judgments and don’t jump into making structural changes,” Perrella says, noting that the US Treasury has yet to provide regulations regarding the changes. “My recommendation is, don’t make any structural changes you cannot undo later if it turns out after the regulations [are announced], it doesn’t work out.”
“You really want to run multiple scenarios, various compensation schemes and different entities,” adds Saglio. “And there’s often non-tax reasons for your choice. Before tax reform, if it made sense for you to be a partnership, it might still be best for you to be a partnership.”
Fed vs. State
A further wrinkle is that the provisions of the new tax code are at odds with those of the state in such areas as deductions for entertainment expenses. Presently, many such expenses cannot be deducted on federal tax forms but are deductible for NH taxes.
Carollynn J. Lear, assistant commissioner at the NH Department of Revenue Administration, says her department reports on the impact of all federal tax law changes to the state legislature, which may or may not make changes to the state tax code as a result.
On March 30, the DRA sent a 16-page analysis to the chairs of the House and Senate Ways and Means committees listing how the state’s business profits tax would be affected if state tax codes were brought into conformity with the new federal code or left as is.
The federal 20 percent deduction for pass-through companies would have no impact “because New Hampshire’s starting point for the calculation of taxable income occurs prior to the 20 percent deduction,” the report notes.
Other new federal provisions—such as those allowing up to $1 million for acquiring depreciable property as a deductible business expense, permitting deferral of the tax on capital gains if the gains are reinvested in low-income “qualified opportunity zones” and ending deductions for business-related entertainment expenses—would require action by the legislature if the state tax code were to be brought into conformity.
The legislature was tentatively scheduled at press time to consider the report during a joint session on April 13.
Some financial experts warn that there could be a downside to the federal tax revisions in the long term.
Many of its provisions expire in 2025, effectively setting up a tax hike for many Americans in 2027. The tax bill also costs $1.46 trillion over 10 years, fanning concerns about its effect on the national deficit.
“The deficit going up, I think, is a real problem,” says McGuire. “When there is not enough money flowing in federally, more burdens are placed on the state. When not enough tax funds are flowing in the state, more burdens are placed on local communities and that usually is property tax.”
A Source of Business
The new code is likely to boost business for tax lawyers and CPAs, as business owners and others try to navigate its provisions. “If you have anything to do with business, definitely your business has become more complicated,” says Wamhoff.
Says Burke, “The amount of additional compliance work that CPAs are going to have to do is significant. It’s going to be a brave new world.”
Saglio agrees. “I think a lot of people are going to need help,” he says. “Doubling the standard deduction is certainly simplifying for someone who’s not a business owner. On the other hand, the 20 percent deduction for pass-throughs has quite a bit of complexity and opportunity for planning, as do the changes for international companies and C corps.” He adds, “We’re certainly not filing our tax return on a postcard yet.”
How Does the Pass-Through Deduction Work?
Alison Perrella, co-managing partner at the Bedford-based Howe Riley & Howe accounting firm and former board president of the NH Society of Certified Public Accountants, offers this example:
Consider a sole proprietor who is married and whose only source of income is business income from the pass-through business. The business net income after all expenses (before any personal draw or compensation paid to him/herself) is $300,000. Under the old law, the taxpayer would pay income tax on $300,000 of income. Under the new law, the taxpayer would be eligible for a deduction of the lesser of 20 percent of the qualified business income ($300,000 times 0.2=$60,000) or 20 percent of taxable income in excess of net capital gain.
The result is that if the taxpayer has no other income, no dependents and does not itemize deductions, then this particular taxpayer would see a reduction in tax of more than $12,000. This is a meaningful tax saving. Unlike other deductions on a tax return, this deduction is available without any additional cash outlay or investment on the part of the taxpayer (to purchase equipment, hire new employees, etc.). Presumably this tax saving will allow the business owner to reinvest in his or her business.
“This is a very simplified example designed to illustrate the deduction in this one circumstance. We can’t make any broad statements about tax benefits available without a detailed analysis of a particular person’s circumstance,” Perrella says.