Business Provisions of the Tax Cuts and Jobs Act
As you know, on Wednesday December 20, 2017 the Tax Cuts and Jobs Act Bill passed both the House and Senate and is on its way to the President’s desk for signature. The final Bill comes after several weeks of negotiations, with last minute changes being made along the way in order for the Bill to comply with Senate procedures, known as the Byrd Rule. The Byrd Rule allows Senators during the reconciliation process to block legislation if it would significantly increase the federal deficit. The legislation is sweeping and is the biggest rewrite to the Internal Revenue Code since the 1986 Act. The legislation is expected to be signed into law by the President in early January, 2018.
The question that all of you are asking once again is: How will this impact me? Following is an overview of the Business Provisions.
Corporate Tax Rates and the Alternative Minimum Tax (AMT)
For many years there has been a call to reduce the corporate tax rate. The day has arrived and the tax rate effective beginning in 2018 is a flat 21% of taxable income. The Bill also reduces the rate applicable to Personal Service Corporations (PSC) to 21%. The dividends received deduction that corporations receive to reduce the effective rate paid on those dividends has also been reduced to leave the effective rate on those dividends relatively unchanged.
As a result of the tax rate reduction, many corporations would have been subject to the AMT. The Bill repeals AMT for corporations beginning in 2018. For corporations subject to the AMT in the past, and as a result have AMT credit carryovers, the minimum tax credit will be allowed to offset a corporation’s regular tax. During 2018 through 2021 the refunds generated by this will be refundable in an amount equal to 50% of the excess of the credit for the tax year over the amount of the credit allowable for the year against regular tax liability. Beginning in 2022 this percentage will change to 100%.
Methods of Accounting
The Bill makes several modifications to methods of accounting that are tied to a taxpayer’s gross receipts. The key provisions impacted by this change are as follows:
- Cash Method of Accounting: Under current law, corporations and partnerships with corporate partners with more than $5 million in gross receipts were required to use the accrual method of accounting. Under the Bill, for years beginning in 2018, this limit would be increased to $25 million. In measuring the use of the new threshold, corporations will continue to use the average annual gross receipts for the prior three year period.
- Accounting for Inventories: Under current law, generally, taxpayers with inventory are required to use the accrual method of accounting unless their average gross receipts are less than $10 million. Under the Bill this limitation has been raised to $25 million, and qualifying businesses would treat the inventory as non-incidental materials and supplies. This will be deemed a voluntary change under the rules if Internal Revenue Code (IRC) Section 481.
- Uniform Capitalization (UNICAP): Under current law, certain rules related to UNICAP are tied to a gross receipts threshold. Under the Bill, this gross receipts threshold will be raised to $25 million. Generally, this will apply to manufacturers and resellers and will be a voluntary change of accounting method under IRC 481.
- Long-term Contracts: Under current law, generally, producers with long-term contracts must use the percentage of completion method to account for these contracts unless they qualify under the gross receipts threshold to use the completed contract method. Under the Bill, the threshold has been increased from $10 million to $25 million. This modification applies to contracts entered into after December 31, 2017 and is applied on a cutoff basis for all similarly classified contracts versus as a change in accounting method under IRC 481.
Cost Recovery of Asset Acquisitions
Numerous tweaks and adjustments have been made in the Bill with regard to how businesses will recover the cost of assets that they acquire. Following is an overview of the key components:
Bonus Depreciation: Under current law, taxpayers are allowed to expense 50% of the cost of qualified assets placed in service during the year. This expensing provision is set to begin to phase down over the next few years. Under the Bill:
- Property acquired before September 28, 2017 and placed in service after September 27, 2017 will continue to use the phase down rules currently in effect
- Property acquired after September 27, 2017 will qualify for the increased 100% expensing election
The new 100% expensing election will continue through the end of 2022 and will begin to phase down beginning in 2023, being reduced to zero in 2027. There are certain modifications to these dates for longer production period property such as aircrafts.
In addition to these modifications, the Bill has also adjusted the definition of qualified property so that the new expensing election now applies to both new and used property.
Luxury Autos and Personal Use Property: Under current law, luxury autos and personal use property are subject to limitations under IRC 280F resulting in lengthening the period necessary to recover the cost of the property. Under the Bill the new limits for luxury automobiles are essentially tripled with the new limitations being:
- Year 1: $10,000
- Year 2: $16,000
- Year 3: $9,600
- Year 4 and future: $5,760
The Bill also simplifies the personal use rules by excluding computers and peripheral equipment from the list of listed property that these rules apply to. These rules apply to property placed in service after 2017.
Depreciation Period – Nonresidential Real Property and Residential Rental: There was discussion regarding the reduction of the recovery period for these types of properties, however, the lives remain unchanged at 39 and 27.5 years respectively. The Bill narrowed the definition of improvement property qualifying for a shorter recovery period. Under current law there were separate definitions for:
- Qualified leasehold Improvement property
- Qualified restaurant property
- Qualified retail improvement property
These separate definitions resulted in significant benefits to the restaurant and retail sectors. In narrowing the definition to just qualified leasehold improvement property, large portions of restaurant building and building improvements currently qualifying for a shorter 15 year life will now be subject to the longer 39 year life.
Additionally, the Alternative Depreciation System (ADS) lives have been adjusted so that nonresidential rental property remains at 40 years, while residential rental is reduced to 30 years. This is especially important as real property trades or businesses that elect out of the interest deduction limitation will be required to depreciate the property using the ADS lives and methods. These rules apply to property placed in service beginning in 2018.
Section 179 Expensing: A provision that was added to the IRC to allow small taxpayers to expense small amounts of fixed assets has grown steadily over the years. Under the bill the limitations will be raised to allow the expensing of up to $1.0 million of qualifying property. The limit would be reduced as total assets placed in service exceed $2.5 million. These increases will be effective beginning in 2018. In another modification the the bill now provides that these limits, along with the $25,000 expensing limit applied to vehicles under IRC 280F, will be indexed for inflation.
Net Business Interest Expense
The Bill provides for a limitation on the deduction of business interest expense for taxpayers whose average annual gross receipts for the past three taxable year periods exceed $25 million. Business interest, beginning in 2018, will be limited to the sum of:
- Business interest income
- 30% of adjusted taxable income
- The floor plan financing interest of the taxpayer
This is a significant departure from provisions which have historically allowed business interest expense without limitation. The one area that has seen similar interest expense limitation provisions are the earnings stripping rules applicable to global businesses. In order to compute the limitation it is important to understand a few key items:
The definition of Adjusted Taxable Income is generally computed without regard to business interest expense or business interest income; the amount of any net operating loss deduction; the 20% deduction for pass-through income; and for years 2018 through 2021 the deductions for allowable depreciation, amortization, or depletion. As a result of the repeal of IRC §199, taxable income is also computed without regard to this deduction.
- This limitation under IRC §163(j) should be applied after other rules that provide for the deferral, disallowance, or capitalization of interest
- Certain real estate businesses can elect not to have the limitation apply, but by doing so would be subject to the ADS lives and methods when depreciating their real property
- Interest expense limited under this provision would be allowed an unlimited carryforward
These provisions generally apply at the filer level such as the partnership level vs. partner level. It should be noted that this is a general overview of provisions there are many nuances in the rules designed to prevent a double counting of income from pass-through entities. In addition, it is still unclear how these rules will interact with other interest disallowance and deferral provisions and how existing disallowed interest will be treated.
Domestic Production Activities Deduction (DPAD)
The DPAD or §199 deduction, which was intended to give an effective 3% tax rate deduction to domestic producers is repealed beginning in 2018.
Net Operating Loss (NOL)
Historically, an NOL was allowed to be carried back and forward to offset income in the years proceeding and following a year when a loss was generated. This was provided for early under the IRC to provide for a smoothing of business income. AMT rules generally resulted in a corporate taxpayer’s ability to offset only 90% of current year income with an NOL carryforward. Under the bill, this AMT scheme is now adopted into the regular tax law with the utilization of NOLs arising in tax years after December 31, 2017 being limited to 80% of taxable income. The bill also takes away the carryback period for NOLs arising in tax years ending after December 31, 2017 but extends the carryforward period for those same NOLs from 20 years to indefinite.
Entertainment expenses have always been an area that was seen as subject to abuse. To rectify this, the the Bill has eliminated deductions “with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation trade or business.” Essentially, this will eliminate entertainment, amusement or recreation even if there is a “substantial and bona fide business discussion.” Similar modifications are made with regard to certain club dues, and other areas that were seen as subject to abuse by taxpayers. Additionally, the 50% limitation on meals has been expanded to areas that under current law enjoy a 100% deduction.
Research and Development Expenditures (R&E)
Under current law taxpayers have the option to elect to either immediately expense or capitalize and amortize research and experimentation expenditures under IRC §174. The Bill provides that IRC §174 paid or incurred in tax years beginning after December 31, 2021 must be capitalized and amortized ratable over a five-year period, beginning with the midpoint of the tax year in which the expenditures were paid or incurred. The application of this rule would be treated as a change in accounting method and would be applied on a cutoff basis to R&E expenses paid or incurred in tax years beginning after December 31, 2021, resulting in no adjustment under IRC 481(a).
Pass-through Tax Treatment
Since its inception, a key element of the Tax Cut and Jobs Act has been a reduction in the corporate tax rate. In an attempt to provide a certain amount of parity to pass-through entities the Bill calls for a deduction of 20% of the pass-through income. The deduction is a temporary provision that applies from 2018 through 2025, unlike the corporate rate reduction which is permanent. So, while it will provide parity in the coming years, it will take additional legislation to make this permanent.
The deduction of 20% would apply to a taxpayer’s Qualified Business Income (QBI), defined as all domestic business income other than investment income, investment interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc., subject to certain limitations.
The deduction would be limited to the greater of (1) 50% of the wages paid with respect to the qualified business or (2) the sum of 25% of the wages paid plus 2.5% of the unadjusted basis of all qualified property.
- A qualified business would generally be any trade or business other than a specified service trade or business. The deduction may apply to these specified service trade or businesses if the taxpayers taxable income does not exceed $315,000 for married taxpayers filing jointly ($157,500 for other individuals). These income limitations are subject to phase out.
- Specified Service Trade or Business: generally includes services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services. Specifically excluded are engineering and architecture.
This deduction is allowed in computing taxable income, however it is not a deduction in arriving at AGI. As such, many states that begin their tax computations will not need to de-couple or modify their state law to address this change.
Technical Termination of Partnership
In order for an entity to meet the definition of a partnership, it is necessary that there are at least two partners. As such, when there are changes in the ownership of a partnership that exceed 50% the entity has historically been treated as technically terminating, thus requiring an entity to file to short period returns for the year of change. The Bill following the house proposal has eliminated this provision beginning in 2018. As such, going forward, a partnership will be treated as continuing even in the event of a sale or exchange of more than 50% of the capital and profits. As an extension of this provision, new elections will not be required or permitted.
Carried Interest or Recharacterization of Certain Gains
For many years, the treatment of certain gains in the case of Partnership Profits Interests received and held in connection with the performance of investment services has been a topic of discussion and a long-standing perceived loophole that lawmakers have discussed closing. The Bill added some modifications to begin addressing these perceived loopholes. Beginning in 2018, a three-year holding period will be required in the case of certain applicable partnership interest held by the taxpayer in order to qualify for long-term capital gain treatment, notwithstanding the rules of §83 or any election in effect under §83. Clarifying the provision’s interaction with §83 would treat as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision would take account of long-term capital losses calculated as if a three-year holding period applies.
While this is by no means all of the provisions of the Bill it does provide an overview of what are some of the most widely impactful elements of the Business Provisions. If you have questions about how you or your business may be impacted by these or other elements of the Tax Cuts and Jobs Act please contact us.