Are you ready for tax “reform?” Thanks to the just-passed Tax Cuts and Jobs Act (TCJA), the tax rate for incorporated car washes, car care services, and other businesses will be reduced from its current 35 percent to 21 percent — for the 2018 tax year and thereafter. And, although the business tax cuts are, for the most part, permanent, the tax cuts for individuals are temporary, expiring in 2026.
Unfortunately, while regular, ‘C’ corporations will be taxed at a flat 21-percent tax rate, the majority of owners of small businesses operating as pass-through businesses will face new personal tax rates that may be higher than the new corporate tax rate.
Pass-through businesses operating as partnerships, limited liability companies (LLCs), S corporations, and sole proprietorships, pass their income to their owners who pay tax at their individual rate. The TCJA created a 20-percent deduction that applies to the first $315,000 of income (half that for single taxpayers) earned by car wash businesses operating as pass-through businesses.
All businesses under the income thresholds, regardless of whether they’re service professionals or not, can take advantage of the 20-percent deduction. For pass-through income above this level, the TCJA places limits on who can qualify for the pass-through deduction, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income.
Thus, that 20-percent deduction applies only to “business profits,” income that has been reduced by the amount of “reasonable compensation” paid the owner. Although lawmakers know what is “excessive,” “reasonable” compensation has not been defined as yet.
THE CORPORATE ALTERNATIVE MINIMUM TAX
Lawmakers long ago created a unique 20-percent tax rate as part of a parallel tax system that limited tax benefits to prevent large-scale tax avoidance. Under this system, incorporated businesses were required to calculate both their ordinary tax and the AMT, paying whichever was higher. Fortunately, the corporate AMT has been eliminated, lowering taxes and ending the confusion and uncertainty that surrounded it in the past.
COST RECOVERY — INCREASED EXPENSING
Unlike in past years when car wash operations and businesses were required to spread the recovery of their equipment costs over a number of tax years, many businesses will be able to fully and immediately deduct those costs. What’s more, this provision has been made retroactive to September 27, 2017.
Of course, the faster write-off of equipment costs is only temporary. It is at the 100-percent level for expenditures between September 27, 2017 and January 1, 2023. After 2023 and before 2025, the amount deductible drops to 60 percent with a further decrease to 40 percent after 2025 and to 20 percent after 2026. On January 1, 2027, the equipment cost write-off disappears.
Despite the narrowing of differences between bonus depreciation and the tax law’s Section 179, first-year expensing, with both offering 100-percent write-offs for both new and used property, Section 179 remains an improved option. The immediate write-off, or “expensing” of capital assets is appealing because, unlike so-called “bonus” depreciation, the use of equipment doesn’t have to begin with the car wash business.
Section 179 allows up to $1 million (up from $500,000 in 2017) of expenditures for business equipment and property to be treated as an expense and immediately deducted. The ceiling after which the Section 179 expensing allowance must be reduced dollar-for-dollar has also been increased from $2 million to $2.5 million.
And now, improvements including roofs, heating, ventilation, air conditioning systems, fire prevention, alarms, and security systems qualify under the new Section 179 rules, providing another opportunity for car wash operations that actually need equipment.
In the past, with a few exceptions, our tax laws protected the ability of small businesses to write off the interest on loans. In an attempt to “level the playing field” between businesses that capitalize through equity and those that borrow, the TCJA caps the interest deduction to 30 percent of the car wash’s adjusted taxable income.
A special rule applies to pass-through entities that requires the 30-percent determination to be made at the entity level rather than at the tax filer level. In other words, at the partnership level instead of the partner level.
Other exceptions exist for small businesses, generally those with gross receipts that have not exceeded a $25-million threshold for a three-year period, protecting their ability to write off the interest on loans that help them start or expand a business, hire workers, and increase paychecks.
LIKE-KIND EXCHANGES, SWAPS, AND TRADE-INS
The tax law’s Section 1031 governing like-kind exchanges currently allow car wash operators to defer the tax bill on the built-in gains in property by exchanging it for similar property. Although more a strategy for deferring a tax bill when business assets are sold or otherwise disposed of, with multiple exchanges gains can be deferred for decades and ultimately escape taxation entirely.
Under the TCJA, like-kind exchanges will be limited to so-called “real” property (but not for real property held primarily for sale). The provision redefines like-kind exchanges and includes language that would limit Section 1031 exchanges to exchanges of like-kind “real” property. This ensures real estate investors maintain the benefit of deferring capital gains realized on the sale of property.
Largely ignored by the massive TCJA, leases continue to offer far more favorable terms than traditional loans when acquiring equipment. Even under the new U.S. accounting rules, car wash businesses with an operating lease will find the capialized asset cost is lower when compared to a loan or cash purchase. The reason? Operating leases reflect only the present value of the rents and, as a result, it is still partially off-balance sheet.
Unfortunately, unlike earlier when leases were treated as off-balance sheet transactions, newly adopted international accounting standards will soon require many leases to be reported as a front-end loaded expense on an operation’s balance sheets. Surprisingly, however, the result, under both standards, is that leasing — compared to borrowing to purchase — will be more favorably reflected on the books of many car washes.
Although leases will soon show up on a business’s financial statements as a liability and affect the operation’s credit, many car care operations can continue to deduct the cost of leased equipment and other business property. The tax benefits inherent in tax-advantaged leases are passed along to the lessee through lower pricing. Lessees will also enjoy lower tax rates that will help them expand their business.
SMALL BUSINESS ACCOUNTING METHOD AND SIMPLIFICATION
The simplification of the rules governing the method of accounting that must be used for taxes is a welcome option. Businesses with average annual gross income of less than $25 million may now use the simple cash-basis accounting method.
Accrual-basis taxpayers include amounts in income when all the events have occurred that fix the right to receive income can be determined with reasonable accuracy. Cash-basis taxpayers generally include amounts in income when actually or constructively received. Also, under the new law, the average gross receipts test will now be indexed to inflation.
For vehicles provided by or used in the car wash operation, new write-off limits for the cost of so-called “luxury” automobiles and personal-use property were included in the TCJA. For passenger automobiles and light trucks placed in service after December 31, 2017, where the additional first-year depreciation deduction is not claimed, the maximum amount of allowable depreciation is increased to $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period.
For passenger automobiles placed in service after 2018, these dollar limits are indexed for inflation. And for those eligible for bonus first-year depreciation, the maximum first-year depreciation allowance remains at $8,000.
One of the main benefits of net operating losses (NOLs) was the fact that they could be carried back to more prosperous years to create a refund of taxes paid in those earlier years and provide an immediate infusion of badly needed cash. Today, the NOL deduction has been severely limited. The write-off is now limited to 80 percent of taxable income and only in special cases will a NOL carryback be permitted. There is no limit on how far forward NOLs may be carried.
MORE, OH, SO MUCH MORE
Obviously, there are many more changes contained in the massive Tax Cuts and Jobs Act. For instance, the newly passed law provides immediate relief from the so-called “Death Tax” by doubling the estate tax exemption so it applies to fewer estates.
S corporations attempting to convert to regular C corporations will face new rules; an employer’s deduction for fringe benefits has been limited; the deduction for local lobbying expenses has been eliminated; and partnerships will no longer terminate upon the death or exit of a partner.
All in all, however, the Tax Cuts and Jobs Act appears to favor businesses over individuals with longer-lived tax savings. Unfortunately, with few exceptions, car care business operators won’t see the potential savings until the tax bill for 2018 comes due.
Mark E. Battersby is an Ardmore, PA-based freelance writer, specializing in finance and tax issues.