On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law. The TCJA represents the most comprehensive reform to the U.S. tax code in more than 30 years and primarily took effect January 1, 2018. The provisions set forth in the TCJA were advantageous for the majority of business entities across almost all industries. The architecture and engineering (A&E) industry was no exception to this; however, it should be noted that had certain provisions of TCJA remained as drafted by the original separate House and Senate bills, the reaction may have been quite the opposite for A&E firms nationwide.
Let’s look a little closer at the top five provisions of the TCJA we believe will affect the A&E industry going forward, while noting instances where A&E firms significantly benefited from last-minute revisions.
Entities taxed as C corporations were provided a significant tax benefit with the reduction of the federal income tax rates to a flat rate of 21 percent. This replaces the graduated tax bracket system for corporations that had a top income tax rate of 35 percent. This is particularly important to the vast majority of A&E firms organized as C corps that met the definition of “personal service corporation” (PSC) under previous law and were taxed at a flat rate of 35 percent on all taxable income. In an A&E context, a PSC generally performs substantially all activities in the fields of A&E and has a stock ownership group mostly comprising individuals performing A&E services. The previous tax law did provide a significant advantage for many of these PSC A&E firms by allowing these companies to be treated as a cash-basis taxpayer regardless of any gross receipts thresholds. The TCJA didn’t modify the cash-basis taxpayer benefit provided to PSCs, and also reduced their tax rates by 14 percent.
The original bill, as introduced in the House Committee on Ways and Means on November 2, 2017, reduced the corporate tax rate for PSCs to only 25 percent. PSC A&E firms were surely pleased to see that the Senate bill passed one month later eliminated any tax rate differences between PSCs and all other corporations. Furthermore, the conference committee report aligned with the Senate on this provision, which became part of the TCJA.
As discussed above, most C corps benefit from the TCJA by way of a significant reduction in the corporate tax rate. This then begs the question: What about A&E firms organized as pass-through entities such as partnerships and S corps? The answer is they weren’t forgotten (although it was close). However, quantifying the tax benefit of the TCJA for these A&E firms isn’t quite as straightforward as the above discussion on C corps.
It should first be noted that under the previous tax law, all pass-through income was taxed at the individual’s (partner/shareholder) tax rate on ordinary income without any preferential rates. Under the TCJA in short, partners/shareholders of an A&E firm are allowed a deduction of up to 20 percent of domestic qualified business income (QBI) with several layers of limitations and phaseouts for the 2018 – 2025 tax years. Details on the limitations and phaseouts are beyond this article’s scope, but in an attempt to simplify the explanation, if your A&E firm pays a reasonable amount of W-2 wages and/or owns a reasonable amount of depreciable assets, your QBI deduction likely will be very near the 20 percent maximum.
Here’s where A&E firm pass-through owners really breathed a last-minute sigh of relief. The full QBI deduction doesn’t apply to “specified service businesses” except in the cases of taxpayers whose taxable income doesn’t exceed $315,000 for married filing jointly (MFJ) ($157,500 for single filers). Under these circumstances, the QBI deduction is fully phased out once taxable income exceeds $415,000 for MFJ and $207,500 for single filers. Under the PSC explanations above, it would stand to reason that most A&E firms would be considered a “specified service business.” Furthermore, a relatively profitable flow-through A&E firm would generate taxable income for its partners/shareholders in excess of the above thresholds and would result in the QBI deduction being fully phased out for these A&E firm pass-through owners. However, the conference committee report released on December 15, 2017, modified IRC §199A to specifically eliminate A&E from being classified as a “specified service business” for this purpose. In other words, A&E firm pass-through owners were provided with last-minute relief from being subject to taxable income thresholds and can generally qualify for the QBI deduction.
One item to note is the TCJA did repeal the domestic production activities deduction (9 percent) previously allowed under IRC §199. This previous deduction provided for under IRC §199 was computed as 9 percent of a company’s net taxable income for work performed on real property located in the United States. The new IRC §199A deduction provides for a more robust 20 percent deduction.
The historic tax credit (also known as the rehabilitation credit) has been a common tool for many architecture firms to help bridge the financing gap on difficult rehabilitation projects. According to recent statistics, on average, the credit leverages more than $5 of private investment for every $1 in federal funding, creating highly effective public-private partnerships. The original bill as drafted by the House Committee on Ways and Means eliminated this credit entirely. However, the Senate bill that passed one month later kept the historic tax credit intact with modifications to allow for a 20 percent credit claimed ratably over a five-year period starting in the year the qualified rehabilitation structure is placed in service.
The research and development (R&D) credit is another tool used by many A&E firms to recoup costs on certain projects. Similar to the historic tax credit, the R&D credit also secured a “victory” as a result of the TCJA. The R&D credit provisions were slated for expiration on several occasions recently, only to be extended retroactively on a year-by-year basis. This temporary “lame duck” status year after year made many A&E companies hesitant to invest resources for identifying potential credits. The TCJA explicitly preserves the R&D credit on a go-forward basis, which should provide A&E firms with more clarity when determining if this is a worthwhile credit for their companies.
Although the TCJA provided virtually all A&E firms with an overall tax reduction for the above-mentioned provisions, the TCJA also identified a few areas of deduction common to A&E firms that will be disallowed starting in the 2018 tax year. It’s common practice for A&E firms to incur significant business development costs to win new work. Part of this process includes incurring expenses related to entertainment, amusement or recreation for existing clients and potential prospects. Under the previous law, these expenses were generally subject to a 50 percent limitation on tax deductibility unless an exception applied. Effective January 1, 2018, entertainment expenses of this nature will generally be disallowed in full for tax purposes. Depending on the size of the A&E firm and nature of the business, this could have a significant tax effect. Many A&E firms are modifying their accounting systems and procedures to better track and identify these types of expenses for internal reporting purposes. Many practitioners think additional regulations will be issued on this topic to expand on what types of expenses are and aren’t subject to the entertainment disallowance rules, so stay tuned for further details.
The TCJA significantly affected the ways taxpayers can depreciate qualified property. Under pre-TCJA rules, taxpayers could claim a 50 percent bonus depreciation deduction of the adjusted basis of qualified property where the original use of the property began with that taxpayer before January 1, 2018 (January 1, 2019, for certain property with a longer production period). The bonus depreciation amount would be reduced to 40 percent for qualifying property placed in service before January 1, 2019, and 30 percent for property placed in service before January 1, 2020 (or January 1, 2021, for certain property with a longer production period).
The TCJA expanded the benefit to taxpayers by increasing the bonus depreciation amount to 100 percent and also included previously used property in the definition of qualified property. The 100 percent first-year deduction applies to qualified assets acquired and placed in service after September 27, 2017, and before January 1, 2023 (and before January 1, 2024, for certain longer production periods). The expansion of bonus depreciation to used property is significant as it now allow taxpayers who are acquiring the assets of a business to write off 100 percent of the qualifying assets acquired.
The first-year bonus depreciation deduction is scheduled to phase down after December 31, 2022 (include one additional year for certain long-production property):
- Corporate Tax Rate Reduction
- Pass-Through Tax Rate/QBI Deduction
- Historic Tax Credit & R&D Tax Credit
- Entertainment Expense Disallowance
- Accelerated Depreciation Provisions
- 80 percent for property placed in service after December 31, 2022, and before January 1, 2024
- 60 percent for property placed in service after December 31, 2023, and before January 1, 2025
- 40 percent for property placed in service after December 31, 2024, and before January 1, 2026
- 20 percent for property placed in service after December 31, 2025, and before January 1, 2027
In conclusion, there are several provisions of the TCJA that will significantly affect the way A&E firms are taxed starting in the 2018 tax year. Please keep in mind this isn’t a comprehensive list of provisions that affect A&E firms. Certain TCJA provisions that affect all companies regardless of industry, e.g., favorable tax depreciation rules under IRC §179 and the interest expense limitations, are addressed in more detail in other BKD Thoughtware® articles. We hope this article provides A&E firms with insight on how TCJA provisions will directly affect their industry in the coming years.
For further discussion on how this directly affects your company, contact Craig, Travis or your trusted BKD advisor.