President Trump signed the Tax Cuts and Jobs Act (“Act”, P.L. 115-97) on December 22, 2017, enacting the most sweeping change to the U.S. tax code in decades, lowering business and individual tax rates, and modernizing US international tax rules to be an exemption ‘territorial’ system. The Joint Committee on Taxation estimated the net revenue effect to be an increase to the federal deficit by $1.456 trillion over 10 years. Some of the business provisions from the Act are below. For highlights from the Act that impact individuals, please see our previous article, “How the Tax Reform Provisions Will Impact Individuals.”
There are still several questions remaining as to the interpretation and application of some of the provisions mentioned below so we expect further guidance to be issued. Such guidance could adjust the application of the below mentioned provisions and thus taxpayers should exercise caution. While Congress attempted to simplify the tax system by passing the bill, many tax practitioners and taxpayers believe the Act makes income taxes anything but simple, making the need for a competent tax professional increasingly important.
The Act adjusts the tax rate for corporations to a flat 21% starting in 2018, thereby permanently replacing the current 35% top corporate rate, previously the highest among advanced economies. The 21% rate also applies to Personal Service Corporations. The Act also reduces the 70% dividends received deduction to 50% and the 80% dividends received deduction to 65%.
The Act also modifies current rules for net operating losses (NOLs). The NOL carryback period has been eliminated and the carryforward period is now indefinite for these new NOLs. In addition, while all of the NOL will ultimately be deductible, NOL carryforward deductions will be limited to 80% of the current year’s taxable income for losses arising in tax years beginning after December 31, 2017.
In addition, the corporate Alternative Minimum Tax (AMT) has been repealed. Taxpayers with AMT credit carryforwards can claim a refund of 50% of the remaining credits in excess of regular tax for the tax years 2018, 2019, and 2020. Taxpayers will be able to claim a refund for any remaining 2020 AMT credit carryforward beginning on 2021 tax returns.
For tax years 2018 through 2025, noncorporate taxpayers (I.e., individuals and trusts) may deduct up to 20% of domestic qualified business income from a partnership, S corporation, or sole proprietorship. A limitation based on 50% of total wages paid by the entity with respect to the qualified trade or business, or 25% of total wages paid by the entity with respect to the qualified trade or business plus a 2.5% capital element is phased in for taxpayers with taxable income above a threshold amount ($315,000 for married filing joint). The deduction is not allowed for service trades or businesses (e.g., health, law, consulting, etc.) above the income threshold (subject to a phase-out). For individual taxpayers, the 20% deduction will not reduce adjusted gross income, but will reduce taxable income (i.e., below the line deduction).
Excess business losses of noncorporate taxpayers are not allowed for tax years beginning in 2018 through 2025. Excess business losses are defined as losses in excess of $500,000 for married filing joint returns. Such losses will now be carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years.
We expect these provisions will increase tax complexity as K-1 reporting will now need to include information for each qualified trade or business, with identification of that trade or business as being a specified service activity or not, the W-2 wages of the entity, and the unadjusted basis of depreciable assets.
Other pass-through provisions include the following:
Treatment of sale/exchanges of partnership interest by foreign persons
Repeal of technical termination of partnerships
Expanded basis limitation application to charitable contributions and foreign taxes
Permitting electing small business trusts (ESBT) to claim charitable contribution deductions and permitting ESBT to have nonresident aliens as beneficiaries
Extending the holding period to 3 years for long-term capital gain treatment for income passed through to partners with carried interests
Application of 6 year term to IRC 481(a) adjustment upon conversion of S corporation to C corporations
Overall Accounting Methods
Cash Method of Accounting
The cash method of accounting is now available to more taxpayers. Most taxpayers who meet a $25 million average annual gross receipts test will be able to use the cash method, not be required to apply the inventory or uniform capitalization (UNICAP) rules, and will not be required to use the percentage of completion method for small construction contracts. Thus, taxpayers who meet the average annual gross receipts test will need to account for inventories as either (1) non-incidental materials and supplies, or (2) how it is reported under the business’s financial accounting treatment of inventories.
The income recognition for accrual-method taxpayers has been modified through the Act’s deferred revenue provisions (codification of Rev. Proc. 2004-34). First, amounts are generally included in income no later than when the amounts are included for financial reporting purposes. Second, accrual-method taxpayers can elect to defer including certain advance payments into taxable income until the tax year after the tax year in which the payments were received, subject to limitations.
Any change to a method of accounting, including switching to cash basis or making changes to treatment of deferred revenue, would generally require the filing of a Form 3115, Application for Change in Accounting Method. Please reach out to us for further information on the filing of this form if you would like to consider whether a change in a method of accounting would make sense for your business.
Cost Recovery Systems
The Act increases the 50% bonus depreciation to 100% for qualified depreciable assets acquired and placed in service after September 27, 2017 and before January 1, 2023. An annual 20% phase-out begins in 2023, resulting in a complete phase out of bonus depreciation in 2027. The Act also adjusted the definition of “qualified property” to (1) remove the original use requirement (i.e., used equipment now qualifies), (2) exclude certain property used by regulated public utilities, and (3) include equipment used for qualified film, television, and live theatrical productions.
For those that do not wish to take advantage of the immediate expensing provisions in 2017, taxpayers will still have the ability to elect out of bonus depreciation completely, or elect to continue use of 50% bonus depreciation for qualified property acquired and placed in service after September 27, 2017 and through December 31, 2017.
Section 179 expensing
The section 179 deduction allows businesses to deduct the full purchase price of qualifying assets purchased or financed during the tax year. The Act increased the Section 179 limitation to $1 million and increased the phase-out to $2.5 million for assets placed into service in tax years beginning after 2017. The amounts will be indexed for inflation beginning after 2018.
The definition of qualified real property eligible for expensing is redefined to include improvements to the interior of any nonresidential real property (“qualified improvement property”), as well as roofs, heating, ventilation, air-conditioning property, fire protection/alarm systems, and security systems installed on such property. The exclusion from expensing for property used in connection with lodging facilities, such as residential rental property, is eliminated.
Other provisions related to assets include repeal of like-kind exchanges for assets other than real property and increasing the vehicle depreciation annual limits.
Consistent with tax law prior to the enactment of the Act, section 179 expensing is limited to taxable income and thus taxpayers cannot use section 179 to generate a taxable loss. However, bonus depreciation is not limited to income and as such may be available to more taxpayers. Companies should work with their tax professional to determine the best depreciation methods for them, considering the effects of depreciation on other tax attributes (e.g., state taxes, interest deduction limitations, net operating loss planning, etc.).
Other Deductions and Credits
Family Leave Tax Credit
The Act introduced a new credit that would allow eligible employers in 2018 and 2019 to claim a general business credit of up to 12.5% of wages for qualifying employees who are on family and medical leave, increased for employees paid beyond the minimum 50% of regular wages, subject to a maximum of 25% over 12 weeks. Additional requirements will likely apply. Inquire further with us should you have any questions or believe you may qualify for this credit.
Other provisions that relate to other deductions and credits include:
Business interest expense deduction limitations for businesses with 3 year average gross receipts greater than $25 million
5 year amortization of domestic research and experimental expenditures after 2021 (foreign research is 15 years)
Repeal of domestic production activities deduction (DPAD)
Additional provisions for rehabilitation credit and orphan drug credit
Repeal of some entertainment costs and commuting benefits
Repeal of deduction for local lobbying expenses
International Tax Implications
The Act includes many international tax provisions, mainly targeting large multinational companies. These provisions include:
Implementing a territorial tax system by providing a 100% dividends received deduction for certain qualified foreign source dividends by US corporations from foreign subsidiaries
Requiring a ‘toll charge’ on the undistributed earnings and profits of US-owned foreign corporations
Inclusion of ‘global intangible low-taxed income’ (GILTI)
Deduction for foreign derived intangible income (FDII)
Implementing base erosion and anti-avoidance tax (BEAT)
Impact on State Tax Returns
Many states have already decoupled from or modified bonus depreciation methods. Given the enhanced federal cost reco