Some analysts say the Tax Cuts and Jobs Act signed by President Trump last December will benefit businesses more than individuals. For example, although the cuts to business taxes are permanent, those for individuals expire in 2025. Moreover, the new law lowers the maximum corporate tax rate from 35 percent to 21 percent, the lowest since 1939.
Do veterinary hospital owners share in this boon to businesses?
As the partner-in-charge of Katz, Sapper & Miller's Veterinary Services Group, Terry O'Neil helps veterinary hospitals grow by providing them with business, financial, and tax advice. O'Neil says several provisions in the new tax law will likely affect veterinary hospitals and their owners. What follows is based on a white paper developed by O'Neil and his team.
Under previous tax law, income from pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) was taxed as ordinary income to individual owners. Under the new tax law, owners may be permitted to deduct up to 20 percent of their "qualified business income" from pass-through entities on their individual income tax returns.
"Qualified business income" is defined as "domestic income from a pass-through entity" and does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments. Generally, the pass-through deduction would be further limited to the greater of 50 percent of the individual's share of W-2 wages paid by the pass-through entity to its workforce, or the sum of 25 percent of the individual's share of W-2 wages paid by the pass-through entity plus 2.5 percent of the unadjusted basis of all qualified property.
As a general rule, income resulting from a "specified service trade or business" does not qualify for this deduction for pass-through income. Examples of specified service trades and businesses are those engaged in the performance of services in the fields of health, consulting, law, accounting, and financial services.
Individual taxpayers would be exempt from this provision as well as the W-2 limitation if their taxable income did not exceed $315,000 on a joint income tax return or $157,500 on a single filing.
Although the new law states that businesses engaged in health services do not qualify for the deduction for pass-through income, the IRS has yet to issue definitive guidance that makes it clear whether health services are limited to human health or extend to health services provided to animals as well. If veterinary practices are not considered qualified businesses for the purposes of this deduction, the individual owners of veterinary practices will not be entitled to the pass-through deduction.
Because the regulations are still being issued, the O'Neil team also does not yet know how the "specified service trade or business" rule will be applied to veterinary hospitals with revenue streams such as pharmacy, dietary, and ancillary products. Depending on how the rule is applied, the team believes there may be planning opportunities to separate nonservice income that might allow the 20 percent deduction to be applied to the net income generated from nonservice sales. More will come on this implication after further clarification by the IRS.
Corporate tax rate
Under prior law, federal taxes paid by personal service C corporations were based on a flat rate of 35 percent. The new tax law replaces that with a flat 21 percent income tax for all C corporations.
O'Neil's team thinks that for profitable hospitals structured as C corporations, this new corporate income tax rate will generally result in increased cash flow due to lower income tax expense. If the business interest limitation applies, these hospitals may want to consider using excess cash flow to invest in new equipment or to pay down debt.
Choice of business entity
The change in corporate tax rates has raised many questions about whether C corporation should now be the entity of choice for veterinary hospitals previously structured as pass-through entities.
Under previous law, the C corporation structure generally has not been advantageous for veterinary hospitals because of double taxation of shareholder distributions and dividends. Although the new law does lower C corporation tax rates, all cash distributed to shareholders is still subject to taxation as a dividend. The double taxation will be especially burdensome for owners who are planning to sell their hospitals. The gain on the sale of assets will be assessed at the corporate tax rate; then, the remaining proceeds distributed to the C corporation owners will also be taxed. Even with the new 21 percent C corporation tax, owners will be taxed on the remaining 79 percent of funds when the funds are liquidated at a potential 20 percent individual tax rate for long-term capital gains and a net investment income tax rate of 3.8 percent. This equates to a 39.8 percent overall tax rate.
A stock sale would be more favorable, as owners will be subject to only a 20 percent long-term capital gains tax on the sale. With increased limits for both bonus and Section 179 depreciation, however, asset purchases have become even more appealing to potential buyers and may leave no room for stock sale negotiations.
Bonus depreciation and Section 179
Hospitals will be entitled to expense 100 percent of qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Beginning Jan. 1, 2023, the amount of qualified property a business will be able to expense will decrease 20 percent per year. A notable departure from prior law is that most used property will also qualify for this 100 percent write-off.
Under the new law, veterinary hospitals can claim up to $1 million of Section 179 depreciation on qualifying property placed in service each year. This increased from $500,000 (indexed for inflation) under previous tax law. Additionally, the new law expands the definition of qualified property to include all qualified improvement property and certain improvements made to nonresidential real property. The new law also increases the threshold for phaseout to $2.5 million and indexes it to inflation.
The new law has not changed depreciation rules for either Section 179 or bonus depreciation for vehicles with a gross vehicle weight of 6,000 pounds or less. If a hospital purchases a new vehicle that has a gross vehicle weight less than 6,000 pounds and the purchase price falls within the IRS guidelines of a luxury auto (passenger auto over $18,600; trucks or vans over $19,267), the annual depreciation is limited for both Section 179 and bonus depreciation.
Hospitals will continue to have the option to immediately reduce taxable income in the year that new or used equipment or other qualifying capital assets are purchased. The additional inclusion of qualified improvement property and certain nonresidential building improvements under the Section 179 expensing rules could make qualifying hospital remodels more appealing, given the new options to accelerate depreciation.
If a veterinary hospital is in need of a new vehicle, the owner may want to focus the search on vehicles with a gross vehicle weight greater than 6,000 pounds. These vehicles will not be subject to annual bonus depreciation limits and can be completely written off in the year they are placed in service.
Meals and entertainment
Previously, a business could deduct 50 percent of expenses incurred for entertainment, amusement, or recreation. The new law eliminates this deduction, with a few exceptions. This means that unless a business qualifies for one of the exceptions, it would receive no deduction for tax purposes for these expenditures.
Nine categories of expenses are still deductible. The expenses most applicable to veterinary hospitals that are still deductible include the following:
- Recreational or social activities primarily for the benefit of employees, such as holiday parties, annual picnics, or employee outings.
- Reimbursed expenses.
- Expenses that are treated as compensation.
- Food and beverage for employees furnished on the business premises of the taxpayer facility.
- Expenses incurred by a taxpayer (i.e., hospital) that are directly related to business meetings of employees, stockholders, agents, or directors.
- Expenses includible in income of persons who are not employees (such as compensation, a prize, or an award under Section 74).
The law retains the current 50 percent deduction limitation on food and beverage expenses. Effective in 2025, however, the law disallows the deduction for meals provided for the convenience of the employer on the employer's business premises.
Veterinary hospitals should start separating the financial statement chart of accounts categories for meals and entertainment, which have historically been classified together. Separating these expenses will allow the categories to be easily identified and will help ensure that they get reported correctly for tax purposes.
Transportation and moving expenses
The new law also disallows deductions for expenses associated with providing qualified transportation fringe benefits to employees as well as any expense (or any payment or reimbursement) incurred in providing transportation for employees commuting between their residence and place of business.
Businesses will no longer be able to deduct most moving expense reimbursements provided to employees, nor can employees exclude these amounts from income if reimbursed by the employer.
Hospitals that have historically offered to reimburse moving expenses to attract veterinarians will need to report the moving expenses on the associates' W-2 wages as compensation.
Like-kind exchange transactions under Section 1031 will be limited to real property that is not held primarily for sale. The guidelines took effect Dec. 31, 2017.
Hospital owners will no longer be able to defer taxable gains when trading in business vehicles or equipment. When budgeting for new equipment as part of a trade-in, hospital owners will need to consider the trade-in value placed on the disposed asset and the possible associated tax burden.
For veterinary hospital owners, there are other, personal tax law changes that should also be considered, including the change to individual tax rates, the elimination of personal exemptions, the increase of the standard deduction, and the limitation on the state and local tax deduction, to name a few. For additional information regarding these and other key provisions found in the Tax Cuts and Jobs Act, visit www.ksmcpa.com.