Top Considerations for System Integrators with the Tax Cuts and Jobs Act
As more information comes out about the 2017 Tax Cuts and Jobs Act (TCJA), it is critical for system integrators to take a holistic approach to tax planning to ensure that they are among the law’s “winners.” In 2019, it makes sense to discuss some of the most important tax planning topics with your advisor, including:
- Accrual to Cash Conversion. For system integrators with average annual gross receipts below $25 million in the prior three years, making an accounting method change can result in an immediate deferral of tax. This can be an effective tool in increasing cash flow as it supports business growth.
- Pass-through Deduction. One of the most misunderstood regulations in the new tax law is section 199A, otherwise known as the pass-through deduction, which allows for a 20% deduction of business income from certain qualifying business activities. The deduction is only available to pass-through entities (S Corporation, partnerships, LLCs) and, while most system integrators should qualify, it is very important to understand how the deduction applies. If applicable, the pass-through owner could reduce their tax rate on business income from a maximum of 37% to 29.6%, or $74,000 for every $1,000,000 dollars earned.
- Tax Rates & Structure. One of the most talked about changes in the tax code is the corporate tax rate being cut to a flat 21% rate. A pass-through entity’s income is taxed at the individual tax rate, which has a maximum rate of 37%. Many clients are considering converting from a pass-through entity to a C Corporation to take advantage of the lower corporate tax rate. However, before any changes in an entity are complete, a thorough analysis of all factors to understand effective tax rate under both entity types is recommended. Again, most system integrators will qualify for the pass-through deduction, and if an entity is claiming the Research & Experimentation (R&E) Tax Credit, the corporation or individual may be able to reduce their overall federal tax rate below 10%.In addition to taxation on current business income, an analysis should be done on taxation in the event of a sale of the business. Due to the double layer of tax in a C Corporation structure, a sale structured as an asset sale will result in a higher overall tax rate in a C Corporation than a pass-through entity. Once all factors are considered, it is likely a pass-through structure is more tax-efficient than a C Corporation structure.
- NOL and Business Loss Limitation. Under tax reform, Net Operating Losses (NOL) generated in years ending prior to December 31, 2017 can be utilized without limitation in 2018 and beyond. NOLs generated in tax years ending post-December 31, 2017, however, are limited to 80% of current year taxable income. This means businesses can’t completely eliminate their current income tax liability with losses generated in 2018 and beyond. In addition to the NOL limitation, current year losses can only offset up to $500,000 (assuming married filing jointly) of other sources of income. In other words, if a taxpayer has a $1,000,000 business loss from a pass-through entity, and $600,000 of wage and investment income, the taxpayer will pay tax on $100,000 of income. The excess $500,000 business loss will carry forward to future tax years and will be subject to the 80% NOL limitation. This is an important consideration in tax planning.
- Depreciation. Assets acquired and placed in service after September 27, 2017, and before January 1, 2023, qualify for 100% bonus depreciation. For system integrators requiring large capital investments in machinery, it is very important to take advantage of these dates. Unlike Section 179 depreciation, which is limited in use, most assets with a useful life of 20 years or less will qualify for bonus depreciation.
- Research & Experimentation Tax Credits. The R&E tax credit is one of the most underutilized tax planning tools for system integrators. Clayton & McKervey has found that most system integrators qualify for the credit, however, many are not taking it, or are just taking the wage portion. Wages, supply cost and contract research all qualify when calculating the credit, and the supply cost can be significant when qualifying unique projects. For example, if a company had $2,000,000 of qualified wages, supply cost and contract research, they may be able to generate credits of approximately $100,000 – $150,000 which would offset tax liability dollar for dollar. The key takeaway is, when calculated and utilized correctly, the R&E tax credit can reduce the effective federal tax rate for all qualifying businesses activities to below 10%. Any unused credits can be carried back one year or forwarded 20 years, and can be utilized upon a sale of the business.
With the change in tax law and key court decisions in the past few years, there has never been a better time to reevaluate your ability to qualify and utilize the R&E tax credit. System integrators qualify because they are involved in the improvement of a product, process, technique, formula or invention.