Business owners’ frustration with their federal income tax payments is palpable. While no major tax legislation has been passed recently, federal income tax payments are increasing dramatically. With inflation rising, staff shortages and supply chain issues, companies are facing the prospects of withdrawal and survival versus expansion and entrepreneurship. Unfortunately, federal income tax laws leave many businesses making difficult choices when deciding which items to cut to pay their federal income tax bill.
So why are federal income tax payments increasing dramatically while tax rates have remained the same? The taxable base increases due to research and experimental (R&E) capitalization, further tightening of the interest expense calculation and the reduction of the applicable bonus amortization percentage. All three changes were enshrined in the Tax Cuts and Jobs Act (“TCJA”), which went into effect January 1, 2018. While many companies have been excited about implementing the TCJA, the devil is always in the details. Congressional leaders at the time were forced to use the budget reconciliation process. As part of the agreement, the instructions required the House and Senate tax committees to report legislation that would increase the deficit by no more than $1.5 trillion in a decade. We are currently in the downward curve of that ten-year trajectory. And while we are currently experiencing a lot of discomfort from the adjustments already in place, future changes planned for late 2025 will be much more painful. At the end of 2025, both the abolition of the passing-on deduction (ie 199A deduction) and the increase in the personal income tax rate from 37% to 39.6% will be phased out.
Do we have your attention yet?
All three tax changes in the law increase taxable income, even though a company’s overall operation and financing may not have changed significantly. And therein lies the frustration. Companies with consistent operating profit see their taxable income and federal cash tax payments grow at double-digit percentages. In the example below, a taxpayer who owns an S corporation with the same operations from 2021 to 2023, except for increased interest expenses, sees his taxable income increase by 114% and federal income tax payments increase by 36%. In 2026, when only 20% of bonus depreciation is allowed, the pass-through deduction is eliminated, and the individual income tax rate rises to 39.6%, the same S corporation will see taxable income rise 198% and federal income tax payments of 358%. These are astronomical increases. It seems inevitable that these hefty increases will force some pass-through entities to close their doors. Even worse, the increases used in the example above do not include all proposed tax legislation related to increased federal income tax (including application of the net investment income tax to active income pass-through owners).
Interest cost limitation further tightened
With the historic prime rate rising 5% between tax year 2021 and 2023 and a substantial change to the interest expense limitation that goes into effect in tax year 2022, it has become more difficult for businesses to get a tax deduction for the required capital.
Section 163(j) limits the amount of business interest expense to 30% of adjusted taxable income plus plan financing interest. For tax years beginning before January 1, 2022, taxpayers were allowed to add back depreciation, amortization, and depletion when determining the amount of adjusted taxable income for this calculation. This created broader support and increased the allowed business interest deduction. However, from tax year 2022, the addition of depreciation, amortization and depletion will no longer be available. This change creates a smaller basis and further limits the permitted arm’s length interest deduction.
Requirement for research and experimental capitalization
Companies that invest in research are stunned by current federal tax laws that severely limit tax incentives for innovation. The Tax Cuts and Jobs Act requires the capitalization of research and experimentation (“R&E”) expenditures over a 5-year period (a 15-year period for foreign research), beginning with tax years beginning after December 31, 2021. For the taxable year, domestic R&E expenses must not only be amortized over a period of 5 years, but the amortization does not begin until midway through the taxable year, resulting in a 10% deduction. This is in stark contrast to taxable year 2022, when the full amount of R&E expenses could offset taxable income.
Bonus amortization Stepped purchase
Bonus depreciation that allows for the immediate expenditure of qualified investments in real estate and equipment has successfully motivated companies to invest and expand in their businesses, which has also helped stimulate the economy. However, for qualified bonus depreciation that came into use in tax year 2023, the bonus depreciation is reduced from 100% to 80%. Based on current legislation, the amortization of the bonus will continue to decrease by 20% each year until it is no longer available from assessment year 2027.
In the example below, an S corporation’s taxable income is adjusted for rising interest expenses from year to year while reflecting the impact of current and pending changes in federal income tax law.
The surprising result reminds us of the old fable about the boiling frog. The fable begins with a frog in a pot of water. If the temperature of the water is slowly increased, the frog will not notice that it is boiling. However, if the frog is placed in boiling water, it immediately jumps out. Will owners of continuing entities and private companies feel the boiling water or will the incremental tax increase from year to year go unnoticed? I assume some congressional leaders are hoping for the latter and suspect that incremental tax hikes will not alarm many business owners. However, these taxpayers should be alert, regardless of the amount of the additional tax. Cash is a priority for many businesses, and when the amount of every additional dollar earned is subject to a 40% marginal federal income tax rate, not including state income, property, or sales and use taxes, the desire to expand, employ , and community service declines significantly. Discontent is especially heightened when C corporations can still enjoy a federal income tax rate of 21%.
As recently as Sunday, President Biden reflected on TCJA’s tax cuts related to the debt limit:
“Part of what I’ve argued from the beginning is the need to factor in the tax structure and – as well as cuts. I’m willing to make cuts, and I’ve proposed cuts in excess of a trillion dollars. But I think we also need to look at tax revenue. The idea that my Republican colleagues want to continue the $2 trillion tax cut that the Trump administration has had a major negative impact on the economy…”
The Pink Floyd song keeps playing in my head as I review current and expiring federal income tax laws. Hello, is anyone there? Or will we become comfortably numb to tax increases, even if it negatively impacts the U.S. economy and our global competitiveness. It is time for congressional leaders to act and realize that such dramatic increases in taxable income and tax rate are not a viable option for increasing federal revenues. These increases will close small businesses, limit the economy and negatively impact communities. Positive action on the tax rate increases was recently provided when the House Ways and Means Committee recently reported that an economic package is expected to be released before mid-June to restore R&E spending, the calculation of the earlier law for the IRC section 163(j) interest deduction limitation and bonus amortization phasing out.
Fair warning, if you think changes will be made automatically since no one could logically think such tax rate increases make sense, think again. Many tax professionals were too confident that a tax extender would be passed in December 2022 to proceed with the immediate release of R&E expenses and avoid capitalization, but the extender was never approved. Everyday tax professionals are forced to continue having uncomfortable discussions with their clients, with some clients forced to consider going out of business because they simply don’t have enough money to pay the tax bill created by R&E capitalization. Ending bonus amortization, the pass-on deduction and raising individual income tax rates to 39.6% could have the same results. Prior to testifying at the House Congressional Small Business Committee hearing on April 18e this year I didn’t think any serious consideration was being given to abolishing the 20% passing-on deduction. My involvement in the committee hearing made me realize that possible abolition of this deduction is definitely being considered.
While pass-through business owners already juggle so much, there’s one additional item they should add to their “to-do” list. Entrepreneurs should contact their congressional representatives on both sides of the aisle and explain to Congress the impact such federal tax increases could have on their businesses and communities. If you take a wait-and-see approach, business owners will most likely be disappointed with the results.