The frustration of business owners with their federal income taxes is palpable. Although no major tax legislation has been passed recently, federal income tax payments are rising sharply. With rising inflation, labor shortages and supply chain issues, businesses are faced with the prospect of downsizing and survival versus expansion and entrepreneurship. Unfortunately, federal income tax law forces many businesses to make difficult choices when deciding what items to deduct to pay their federal income tax bill.
Why are federal income tax payments increasing dramatically while tax rates have remained the same? The taxable base increases due to research and experimental (R&E) capitalization, further tightening of interest expense calculation and reduction in the percentage of applicable bonus depreciation. All three changes were included in the Tax Cuts and Jobs Act (“TCJA”), which took effect on January 1, 2018. While many businesses have been happy to implement the TCJA, the devil is always in the details. Congressional leaders at the time were forced to use the budget reconciliation process. As part of the deal, the guidelines required the House and Senate tax committees to report legislation that would increase the deficit by no more than $1.5 trillion over ten years. We are currently on the downward path of that ten-year trajectory. And while we are currently experiencing a lot of discomfort due to the changes that have already come into force, the upcoming changes, which are planned for the end of 2025, will be much more painful. The phase-out at the end of 2025 includes both the rollover deduction (ie the 199A deduction) and an increase in the individual income tax rate from 37% to 39.6%.
Do we still have your attention?
All three legislative tax changes increase taxable income, even though the overall operation and financing of the business may not have changed significantly. And therein lies the frustration. Companies with consistent operating profits see their taxable income and federal cash taxes increase by double-digit percentages. In the example below, a taxpayer owning an S corporation with the same operations from 2021 to 2023, in addition to the increased interest expense, would see their taxable income increase by 114% and their federal income tax increase by 36%. In 2026, when only 20% bonus depreciation is allowed, the carryover deduction is eliminated, and the individual income tax rate rises to 39.6%, the same S corporation will see a 198% increase in taxable income and federal income tax payments. 358%. This is an astronomical increase. It seems inevitable that this significant increase will force some streaming units to close their doors. Even worse, the increase used in the above example does not include all the proposed tax legislation related to increased federal income tax (including the application of the net investment income tax to active income holders).
The restriction of interest expenses was further tightened
With a 5% increase in the historic prime rate between tax years 2021 and 2023, and a substantial change to the interest expense cap that comes into effect in tax year 2022, it has become more difficult for businesses to claim the capital tax deduction they need.
Section 163(j) limits the amount of business interest expense to 30% of adjusted taxable income plus floor plan financing interest. For tax years beginning before January 1, 2022, taxpayers were allowed to add depreciation, amortization and depletion in determining the amount of adjusted taxable income for this calculation. This would provide a broader base, increasing the allowable business interest expense deduction. However, the addition of depreciation, amortization and depletion is no longer available beginning in the 2022 tax year. This change creates a smaller base and further limits the allowable business interest expense deduction.
Demand for research and experimental capitalization
Businesses investing in research are caught off guard by the current federal tax code, which severely limits tax incentives for innovation. The Tax Cuts and Jobs Act requires the capitalization of research and experimental (“R&E”) expenditures over a 5-year period (15-year period for foreign research) beginning with tax years beginning after December 31, 2021. During the 2022 taxable year, domestic R&E expenses not only need to be amortized over 5 years, but depreciation only begins in the middle of the taxable year, resulting in a 10% deduction. This is in stark contrast to taxable year 2022, when the entire amount of R&E expenses was able to offset taxable income.
Reduction of bonus amortization level
The devaluation of bonuses, which allows immediate spending of qualified investments in property and equipment, successfully pushed businesses to invest and expand in their business, which also helped to stimulate the economy. However, for qualified bonus depreciation property placed in service in tax year 2023, bonus depreciation is reduced from 100% to 80%. Under current law, bonus depreciation will be reduced by 20% each year until it is no longer available beginning in the 2027 taxable year.
In the example below, the taxable income of S corporations is adjusted for the rate of interest expense that increases from year to year while reflecting current and anticipated changes in federal income tax law.
The surprising result is reminiscent of the old fable about the boiling frog. The tale begins with a frog in a pot of water. If the temperature of the water rises slowly, the frog will not realize that it is boiling. However, if you put a frog in boiling water, it will jump out immediately. Are pass-through unit owners and privately owned businesses going to find themselves in hot water or will the annual surcharge increase go unnoticed? I think some congressional leaders are hoping for the latter and suspect that additional tax increases will not cause concern among many business owners. However, these taxpayers should be prepared regardless of the amount of additional tax. Cash is a priority for many businesses, and when every additional dollar earned is subject to a 40% marginal federal income tax, not including state income, real estate or sales and use taxes, the desire to expand, hire. , and community services are significantly reduced. Resentment is especially acute when C corporations can still enjoy a 21% federal income tax rate.
Back on Sunday, President Biden talked about the TCJA tax cuts in relation to the debt limit:
“Part of what I’m arguing from the beginning is the need to discuss the tax.” structure, as well as cost reduction. I am committed to spending cuts and have proposed more than a trillion dollars in spending cuts. But I believe we should also look at tax revenues. The idea that my Republican colleagues want to continue the $2 trillion in tax cuts that have had a profound negative impact on the economy from the Trump administration…”
The Pink Floyd song keeps playing in my head when I discuss the federal income tax laws. Hi, is anyone there? Or we are comfortable worrying about tax rate hikes even when it negatively affects the US economy and our global competitiveness. It is time for Congressional leaders to act and realize that such dramatic taxable income and tax rate increases are not viable options for increasing federal revenues. These increases will close small businesses, limit the economy and negatively impact communities. Positive action on the tax rate increase was recently made when the House Ways and Means Committee recently announced that an economic package is expected to be released by mid-June to restore R&E spending, the previous law calculation for IRC Section 163(j). Limiting interest deduction and phasing out bonus depreciation.
Fair warning, if you believe that the changes will happen automatically because no one would logically think that such a tax rate increase would make sense, think again. Many tax professionals were overconfident that the tax extension that would pass in December 2022 would allow immediate expensing of R&E expenses and avoid capitalization, but the extension never passed. Everyday tax professionals are forced to continue uncomfortable discussions with their clients, forcing some clients to consider closing operations because they simply do not have enough money to pay the tax bill created by R&E capitalization. The sunsetting of bonus depreciation, the carryover deduction, and the increase in individual income tax rates to 39.6% could have the same effect. April 18, before testifying at a House Small Business Committee hearinge I didn’t think the 20% transfer deduction was being seriously considered this year. My participation in the committee hearing led me to believe that the potential elimination of this deduction is absolutely under consideration.
While transitioning business owners already juggle a lot, there’s an extra item they need to add to their “to-do” list. Business owners should reach out to their congressional representatives on both sides of the aisle and explain to Congress the impact such federal tax increases could have on their businesses and communities. If you choose to take a wait-and-see approach, business owners will most likely be disappointed with the results.