While deductions have gone mostly unchanged in recent years, the Tax Cuts and Jobs Act made some big changes beginning in the 2018 tax year. Some deductions were eliminated, while others were reduced or made less beneficial to help offset the lower tax rates. It may seem obvious, but these changes could make a big difference on your tax return. Here's what you need to know.
Dividends Received Deduction (DRD)
The DRD applies to corporations that receive dividends from related entities. The goal of this deduction is to avoid multiple levels of taxation on the dividend. It also allows a company to reduce its income tax by a percentage of the dividend amount. The amount a business can claim depends on the percentage of ownership it has in the company that's paying the dividend.
Previously, there were three options for the deduction - 70%, 80%, or 100% of the dividend amount, depending on the level of ownership the business had in the company. The Act reduced the 80% and 70% levels to 65% and 50%, respectively. So if your business owns 20% or more of the company, you can claim 50% of the dividend amount. This adjustment down is meant to counteract the 21% corporate rate.
What's the impact? If you used this deduction in the past, your taxable income will increase, but it'll be taxed at the lower 21% rate.
Business Entertainment & Membership Expenses
The deduction for entertainment, amusement, or recreation is repealed - even if the expenses directly relate to the active conduct of trade or business. Prior to the Act, businesses were able to deduct 50% of their expenses related to entertainment and meal expenses. Not anymore.
The deduction for club membership dues - which includes clubs organized for business, pleasure, recreation, or other social purposes - is also gone. And, you can't deduct the cost of a facility that's used in the event of entertainment, amusement, or recreation. However, the membership dues to a board of trade, business league, chamber of commerce, public service organization, professional organization, and trade association are fully deductible.
How does this affect you? If you have significant entertainment expenses, expect your taxable income to increase. Instead of being able to deduct 50% of the golf outing, box seats at a ball game, or trip to Disney World, now it's all nondeductible.
We recommend evaluating your previous years' business entertainment costs to help you determine whether to continue some of these activities in 2018. In the past, entertainment expenses have been tracked with meals because they were both 50% deductible. You should now track these in separate accounts.
You should also decide if you'll reimburse employees for any of these expenses. The Act eliminated the ability for individuals to deduct unreimbursed business expenses on their personal tax return. Will you reimburse them? No matter what you decide, you should communicate this law change to your employees and share your plan for reimbursing them for the cost of these activities.
Food & Beverage Expenses Deduction
Good news! You can still deduct 50% of the cost of food and beverage expenses that relate to operating a trade or business. This expense used to be 100% deductible, so though the deduction still stands, it's not as beneficial to employers.
The 50% deduction was expanded to food and beverages given to employees as a de minimis fringe benefit - a benefit that's so small it's impractical or unreasonable to account for it. Examples include holiday gifts or the occasional doughnut order. Meals offered on your business' property, meals that meet the on-premise requirement, and meals you provide to employees at your convenience are also 50% deductible.
The cost of meals with clients, coworkers, and meals while traveling are all 50% deductible. Any company-wide activities - holiday parties, picnics, anniversaries, birthday parties - are 100% deductible. You can claim and qualify for the 100% deduction if all staff members are invited to the outing.
What's the impact? If you were able to deduct 100% of meal expenses in prior years because you were providing them for your benefit (aka for the benefit of the employer), these are now only 50% deductible. Again, you can expect your taxable income to increase.
Domestic Production Activities Deduction (DPAD)
The DPAD deduction allowed certain businesses to deduct a percentage of their taxable income that was earned from qualified manufacturing and production activities. Congress created this tax break to help American manufacturers compete with foreign businesses that benefit from lower tax rates. This deduction is repealed for tax years beginning in 2018 and after.
So how does this affect you? If your business isn't involved with manufacturing or production activities, this may not make a difference at all. But if your business qualified for this deduction in the past, it's one less way to reduce your taxable income. The impact depends on how much income you earned from domestic production activities in the past and how much you expect to earn in 2018 and beyond. Is your competitive advantage damaged? Is it untouched? A tax professional can help you run projections to fully estimate the risks and liabilities.
What's the impact? C corporations will see an increased tax rate of 1.89% and pass-through entities will see an increase of 3.33%, assuming the 37% income tax rate applies.
Fines & Penalties
Before the Act passed, you couldn't deduct any fines or penalties you paid to the government for breaking the law. This limitation has been expanded. The IRS also won't allow any amounts that have been paid for investigations or settlements of a possible law violation.
You also can't deduct any settlement claims paid for sexual harassment or sexual abuse if the settlement is subject to a nondisclosure agreement. This rule went into effect on Dec. 22, 2017.
Reimbursing Employees for Riding their Bike
If any of your employees ride their bike to work, you can deduct what you pay them for purchasing, improving, repairing, or storing their bicycles. This reimbursement and deduction is limited to $20 per employee, per month. Before the Act, this was a nontaxable fringe benefit for employees and employers couldn't deduct the cost of reimbursement. It's now taxable employee compensation and a deductible cost.
Employers can't deduct expenses for any qualified transportation fringe benefits they give to their employees. They can't deduct costs of providing transportation, paying or reimbursing an employee for travel between their home and workplace, parking fees, transit, or vanpooling. Expenses required to ensure employee safety are exceptions to the rule, but the IRS hasn't provided clarification on this.
A couple of items have changed on employees' personal income tax returns too. Employees can't deduct any unreimbursed business expenses or moving expenses. Moving expense reimbursements are treated as taxable wages to the employee.
If you give employees any awards of value, it must be included in their income. These awards could be cash, gift certificates, vacations, event tickets, etc.
What's the impact? If employees are used to taking a significant deduction on their individual tax return for unreimbursed business expenses, you should make them aware of this change. This could make a big - potentially negative - impact on their 2018 tax returns.
Given all these changes, it's critical to review how each deduction will impact your business. Don't be caught off guard when you file your 2018 tax return. What's the short-term and long-term effect of each deduction? Does this mean big changes for your business? Are the changes trivial? Connect with your accountant to review your current tax strategy and determine whether you need to make any adjustments. Ask your accountant to run tax projections and estimate your upcoming tax liability. Have a conversation about how you can maximize your tax savings. Planning ahead will make all the difference now and in future years.
Have questions about these deductions and tax law changes? Let's talk!