Tax Cuts and Jobs Act Sunsetting in 2025

The Tax Cuts and Jobs Act (“TCJA”) introduced several tax rate cuts when it was enacted in 2017. This included a reduction in the tax rate of C corporations rate to 21% and a temporary provision that allowed owners of S corporations and partnerships to reduce their taxes by deducting an additional 20% of the qualified business income of their businesses. Business owners in many industries benefit from this extra deduction, including those in the consumer products, food, manufacturing, and restaurant industries.

The issue surrounding this additional 20% deduction means that owners of S corporations and partnerships will see an increase in their taxes when the QBI deduction expires, or sunsets, at the end of 2025. The reduction in the corporate tax rate to 21% is not subject to sunsetting, creating a tax rate differential between the rates of tax on C corporations and S corporations/partnerships. This tax rate differential provided the justification for the QBI deduction back in 2017.

As an example, owners of S corporations and partnerships currently have the potential to pay taxes up to a 37% maximum federal income tax rate. The extra 20% deduction allows their tax rate to be reduced to a maximum federal tax rate of 29.6%. If a business owner has income of $100,000, then this owner would have a federal tax of $29,600 with this extra deduction. Take that deduction away, their taxes would be as high as $37,000.

One item we have seen as a significant issue for many businesses with significant capital expenditures is the annual 20% decrease in bonus depreciation from 100% in 2022 to 0% in 2027. This phase-out means less depreciation is available earlier in the lives of assets placed in service. Depreciation has long been an item that helps to lower income taxes or to create losses for future use. The phase-out means the expense is deferred for longer periods of time and that companies will have higher taxable income in the early years.

Another issue is the interest expense limitation. Companies with significant debt may not be able to deduct all of their interest expense unless they are a small business. This means that debt could make a company’s tax situation more expensive if is subject to an interest expense deduction limitation. The TCJA allowed for favorable adjustments to permit larger interest deductions, but those adjustments have been taken away and made more restrictive. The combination of the decrease in bonus depreciation and a more restrictive interest expense limitation will significantly affect the amount of taxable income on all types of businesses.

The TCJA limitation on state and local tax (SALT) deductions to $10,000 per year caused many states to enact “workarounds” that permit partners/shareholders in partnerships/S corporations to deduct state and local taxes in excess of $10,000 per year. While each state’s workaround has its own nuances, they generally allow partnerships and S corporations to pay certain state taxes directly that their owners otherwise would have paid on their own. These workarounds allows businesses to treat the pass-through entity state tax payments as business expenses instead of a distribution. The taxpayer can then take a tax credit on their individual state tax return for the amount of these payments. The benefit to this is a workaround of the $10,000 state and local tax limit on individual returns by allowing the expense to be reported in the operations of the business. This workaround will expire in California and other states in 2025, along with the TCJA’s SALT cap.

As the dust settles on the 2024 election, we expect that Congress will address many of these items in 2025. Withum has experienced advisors to guide you through this uncertainty.