The frustration of business owners with their federal income tax payments is palpable. Though no major tax legislation has recently been passed, federal income tax payments are increasing dramatically. With rising inflation, workforce shortages, and supply chain woes, businesses are coming face to face with the prospects of retraction and survival versus expansion and entrepreneurship. Unfortunately, the federal income tax legislation is causing many businesses to make difficult choices when deciding what 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 is increasing due to research and experimental (R&E) capitalization, further tightening of the interest expense calculation, and the reduction of the applicable bonus depreciation percentage. All three changes were embedded in the Tax Cuts and Jobs Act (“TCJA”), effective January 1, 2018. While many businesses were elated to have the TCJA implemented, the devil is always in the details. The 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-writing committees to report legislation increasing the deficit by no more than $1.5 trillion over ten years. We are currently on the downward bend of that ten-year trajectory. And while we are experiencing great discomfort currently due to the adjustments that have already taken effect, futured changes scheduled to occur at the end of 2025 will be far more painful. Items to be phased-out at the end of 2025 include both the removal of the pass-through deduction (i.e. 199A deduction) and an increase in the individual income tax rate from 37% to 39.6%.
Do we have your attention yet?
All three legislative tax changes increase taxable income even though a business’s overall operating and financing may not have significantly changed. And therein lies the frustration. Companies with consistent operational profit are seeing their taxable income and federal cash tax payments grow by double-digit percentages. In the example below, a taxpayer owning an S corporation with the same operations from 2021 to 2023, with the exception of increased interest expense, will see their 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 increases to 39.6%, the same S corporation will see a taxable income increase of 198% and federal income tax payments of 358%. These are astronomical increases. It seems inevitable that these significant increases will force some pass-through entities to close their doors. Even worse, the increases utilized in the above example don’t include all the proposed tax legislation related to increased federal income tax (including application of the Net Investment Income Tax on pass-through owners with active income).
Interest Expense Limitation Tightened Further
With the historical prime rate increasing 5% between the 2021 and 2023 taxable year, and a substantial modification to the limitation of interest expense taking effect in the 2022 taxable year, it has become harder for businesses to receive a tax deduction for needed capital.
Section 163(j) limits the amount of business interest expense to 30% of adjusted taxable income plus floor plan financing interest. For taxable 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 provided a broader base, increasing the allowable business interest expense deduction. However, starting in the 2022 taxable year, the addback of depreciation, amortization, and depletion is no longer available. This change creates a smaller base and further limits the allowable business interest expense deduction.
Research and Experimental Capitalization Requirement
Businesses investing in research are baffled with the current federal tax code which severely limits tax incentives for innovation. The Tax Cuts and Jobs Act requires the capitalization of research and experimental (“R&E”) expenditures over a 5-year period (a 15-year period for foreign research) starting with taxable years beginning after December 31, 2021. For the 2022 taxable year, domestic R&E expenditures are not only required to be amortized over a 5-year period, but the amortization only begins at the midpoint of the taxable year, resulting in a 10% deduction. This is a stark contrast to the 2022 taxable year, when the entire amount of R&E expenditures were able to offset taxable income.
Bonus Depreciation Tiered Decrease
Bonus depreciation allowing for the immediate expensing of qualified investments in property and equipment has successfully motivated businesses to invest and expand in their businesses which has also had a hand in helping to stimulate the economy. However, for qualified bonus depreciation property placed in service in the 2023 taxable year, bonus depreciation is reduced from 100% to 80%. Based on the current legislation, bonus depreciation will continue to decrease by 20% each year until it is no longer available starting in the 2027 taxable year.
In the below example, an S corporations’ taxable income is adjusted for the increasing interest expense rate from year to year, while reflecting the impact of current and impending changes in federal income tax legislation.
Example:
S Corporation TCJA Sunset Example
Interest Expense Limitation Calculation
The startling result reminds us of the old fable with the boiling frog. The fable starts with a frog in a pot of water. If the temperature of the water is slowly increased, the frog will not realize it is boiling. However, if the frog is placed into boiling water, it will immediately jump out. Are pass-through entity owners and privately owned businesses going to sense the boiling water or will the incremental tax increase year over year go unnoticed? I assume some congressional leaders would hope for the latter and suspect incremental tax increases will not raise the alarms amongst many business owners. However these taxpayers should be on alert regardless of the amount of incremental tax. Cash is a priority to many businesses, and when the amount of every additional dollar earned is subject to a 40% marginal federal income tax rate, not including any state income, real property, or sales and use taxes, the desire to expand, employ, and service the community significantly diminishes. Discontent is especially heightened when C corporations could still be enjoying a 21% federal income tax rate.
As recently as Sunday, President Biden reflected on the TCJA tax cuts in regards to the debt limit:
“part of what I’ve been arguing from the beginning is a need to consider the tax structure as well as — as well as cutting spending. I’m willing to cut spending, and I proposed cuts in spending of over a trillion dollars. But I believe we have to also look at the tax revenues. The idea that my Republican colleagues want to continue the $2 trillion tax cut that had profound negative impacts on the economy from the Trump administration … “
The Pink Floyd song keeps playing in my head when reviewing current and sunsetting federal income tax legislation. Hello, is there anybody out there? Or are we becoming comfortably numb to tax rate increases even when it negatively impacts the U.S. economy and our global competitiveness. It is time for Congressional leaders to act and realize that such dramatic taxable income and tax rate increases are not a viable option to increase federal revenue. These increases will close small businesses, restrict the economy, and negatively impact communities. A positive action regarding the tax rate increases was recently provided when the House Ways and Means Committee recently reported an economic package is expected to be released before mid-June to restore R&E expensing , the prior-law calculation for the IRC Section 163(j) interest deduction limitation, and the bonus depreciation phasedown.
Fair warning, if you believe that changes will be made automatically as no one could logically think such tax rate increases make sense, think again. Many tax professionals were overly confident on a tax extender passing in December of 2022 to continue immediate expensing of R&E expenditures and avoiding capitalization but the extender was never passed. Everyday tax professionals are forced to continue to have uncomfortable discussions with their clients, with some clients forced to consider shutting down operations as they simply don’t have enough cash to pay the tax bill created by R&E capitalization. The sunsetting of bonus depreciation, the pass-through deduction, and increase in 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 18th this year, I did not think that the removal of the 20% pass-through deduction was seriously being considered. My involvement in the committee hearing made me realize that potential elimination of this deduction is absolutely under consideration.
While pass-through business owners are juggling so much already, there is an additional item they must add to their “to-do” list. Business owners must reach out to 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 chose a wait and see approach, business owners most likely will be disappointed with the results.