The Tax Cuts and Jobs Act (TCJA) was signed into law in December 2017, and since then, tax advisors, attorneys and other professionals spent the winter scrambling to learn the details of the new code and how it impacts their clients.
The changes to the tax return forms under the TCJA not only affects tax professionals but also affects lenders and how they analyze those tax returns to determine their customers’ cash flows. Under the TCJA, there are an increased amount of tax adjustments that may distort the actual cash flow from operations. The many changes to various forms and returns will require consideration during the credit analysis process.
Changes to Form 1040
The 2018 Form 1040 is two pages long, with six supporting schedules. With these additional schedules, there are a few items of note when preparing your credit analysis. Page 1 of the 2018 Form 1040 is informational, similar to the 2017 Form 1040. Page 2 of the 2018 Form 1040 contains the detailed summary of the tax return. This is where the amounts of taxable wages, interest, dividends, business and farm income and other types of income will be found, most of these amounts will be supported in more detail throughout the tax return, as in years past.
One item of note on this section: similar to prior years, the Form 1040 separates total distributions and payments from IRAs, pensions, and annuities from the taxable amount. However, beginning in 2018 there are now certain instances in which the total amount included in line 4a is not the total amount of cash received, and further analysis will be needed to ensure total cash receipts are being included in the amount available to service debt.
Qualified Business Income Deduction
Under the TCJA, the corporate tax rate was reduced from 34% to 21%. In order for S-Corporations and Partnerships to receive a similar reduction in tax rate, the TCJA included a new Section 199A Deduction, called the Qualified Business Income Deduction (QBI Deduction).
The new Sec. 199A provides individual taxpayers a deduction of 20% of “qualified business income”. This deduction is available for qualified trade or business income, whether from a Schedule K-1, Schedule C, Schedule E, or Schedule F. Sole Proprietorships, partners in partnerships, and S corporation shareholders may potentially qualify for this deduction. For more detail on Qualified business income deduction, click here.
This deduction, found on the Form 1040 line 9, is not a cash expense; it essentially removes 20% of qualified business income from taxable income for purposes of computing tax. The deduction should not reduce cash flow in a credit analysis process.
Limitation on Business Interest
Another component of the TCJA is the new Section 163(j) limitation on business interest. This new law needs to be considered when calculating the debt service coverage (DSC) on certain credit files, as the interest expense amount that is deducted on the forms of the tax return may not reflect the total interest expense of the customer for the year.
Section 163(j) generally applies to taxpayers with average gross receipts greater than $25 million. This provision potentially limits deductible interest expense for a taxpayer and is based on “net” interest expense (interest paid in excess of interest income received). It is also based on a percentage of taxable income. Section 163(j) applies to “business interest expense,” which includes all interest other than investment interest and personal interest. Any interest expense not deducted because of this limitation is carried forward and can be deducted in future years subject to limitations based on the type of entity, so there is potential to distort the reported deductible interest from the cash basis interest paid by the customer in future years, as well.
When preparing an annual credit review and determining DSC for the year, there are a few places to look on a tax return to ensure that there is no limitation on business interest for the customer. If the following boxes are checked “no” on the entities tax return, further analysis will need to be determined if the interest expense was limited:
If the above boxes are checked “yes”, the interest expense of the entity was not limited, and no further analysis is required. If marked “no”, there are a few forms to analyze to ensure that the entire amount of interest paid by the customer during the year is being included in the cash flow analysis. For partnerships and S-Corporations, this information would be found on a Form 8990.
On the Form 8990, line 31 shows the disallowed business interest expense that is to be carried forward to future years and would have an impact on a cash flow analysis.
Excess Business Losses of Noncorporate Taxpayers
The Tax Cuts and Jobs Act provides that, for a tax year of a taxpayer other than a corporation beginning after Dec. 31, 2017 and before Jan. 1, 2026, the taxpayer's excess business loss, if any, for the tax year is disallowed. An “excess business loss” is the excess of the taxpayer's aggregate deductions for the tax year that are attributable to trades or businesses of the taxpayer, over the sum of: (1) the taxpayer’s aggregate gross income or gain for the tax year, which is attributable to those trades or businesses, plus (2) $250,000 for a single taxpayer or $500,000 for a joint return. Thus, business losses in excess of those amounts are disallowed and carried forward to future years, similar to how net operating losses are carried forward.
Form 461 would be included in the tax return if losses are limited. This form would list which line items are affected on the individual tax return. An example would be that business income (line 12 of Schedule 1 of the individual tax return) may show up with zero, but in fact, there may have been a large loss that was disallowed. The actual Schedule C of the tax return would need to be analyzed to determine accurate cash flow results from business operations.
There were a few other changes that could affect the credit analysis process; details are provided below:
Parking Disallowance: Under the new Section 274(a)(4), parking expenses paid or incurred after December 31, 2017, to provide employee parking are generally no longer deductible; thus, the customer may have paid for employee parking, but the deduction will not be reflected on the tax return.
Meals & Entertainment: There were significant changes in the deductibility of entertainment, meals, and transportation fringe benefits; thus, some cash expenditures may not be reflected on a tax return. Please see this article for and in-depth breakdown of the items that changed and remained the same regarding meals and entertainment disallowance.
There are several changes to the new tax code and tax return reporting presentation that will require additional understanding during the credit review process. There are also several new limitations on deductions that do not reflect the entire cash expenditures during the year for a customer, so additional procedures may be required when analyzing tax returns for customer cash flow purposes going forward. Contact your Eide Bailly professional for more information on how these changes may impact you.
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