Client Alert
The Tax Cuts and Jobs Act Makes Significant Changes to Taxation of Business Operations
January 08, 2018
By Andrew Short & Christopher Fulle
The Tax Cuts and Jobs Act Makes Significant Changes to Taxation of Business Operations
On December 22, 2017, President Trump signed into law tax legislation formerly known as the Tax Cuts and Jobs Act (the “Act”). This most comprehensive tax overhaul since 1986 creates significant opportunities to minimize a business entity’s overall tax burden. Set forth below are some of the key business taxation provisions of the Act:
Corporate Tax Rate
The cornerstone of the legislation is the reduction of the corporate income tax rate from 35 percent to a flat 21 percent. The corporate dividends-received deduction is also reduced from 70 percent to 50 percent generally, and from 80 percent to 65 percent for dividends received from corporations 20 percent or more owned by the dividend recipient.
As a result of the significant gap between the corporate and individual income tax rate, a C corporation may be more desirable for businesses that do not expect to make significant dividend distributions. Additionally, a C corporation may continue to deduct state and local taxes, whereas an individual cannot deduct more than $10,000 in state and local taxes for federal income tax purposes. Taxpayers considering operating through a C corporation and retaining earnings should consider the potential applicability of the accumulated earnings tax.
These changes are effective for tax years beginning after December 31, 2017.
Corporate Alternative Minimum Tax (“AMT”)
Under prior law, corporations were subject to a 20 percent AMT if the AMT liability exceeded a corporation’s regular income tax liability. For example, AMT liability might exceed regular income tax liability as a result of accelerated depreciation which the AMT disallowed. A corporation was allowed AMT credits to the extent its AMT liability exceeded its regular income tax liability.
The new law repeals the corporate AMT. Taxpayers with AMT credit carryforwards can claim a refund of 50 percent of the remaining credits in tax years beginning in 2018, 2019, and 2020. For a tax year beginning in 2021, taxpayers may claim their remaining AMT credits.
These changes are effective for tax years beginning after December 31, 2017.
Section 168(k) Bonus Depreciation
Under prior law, businesses were allowed a 50 percent bonus depreciation deduction for qualified property placed in service before January 1, 2020 (January 1, 2021, for certain property with longer production periods), which deduction was phased down for property placed in service after December 31, 2017 (after December 31, 2018, for certain property with longer production periods). Qualified property was property the first use of which was in the taxpayer’s trade or business and included (i) most machinery, equipment, or other depreciable tangible property; (ii) “off-the-shelf” computer software; and (iii) qualified improvement property. Qualified improvement property was any improvement to an interior portion of a building that was nonresidential real property if the improvement was placed in service after the date the building was first placed in service, except for any improvement for which the expenditure was attributable to (i) enlargement of the building, (ii) any elevator or escalator, or (iii) the internal structural framework of the building. Qualified property did not include buildings or property that must be depreciated under the alternative depreciation system (the “ADS”).
The new law maintains the prior law phase-out of 50 percent bonus depreciation for property acquired before September 28, 2017, and placed in service after September 27, 2017. For qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (after September 27, 2017, and before January 1, 2024, for certain property with longer production periods), the new law allows a 100 percent bonus depreciation deduction. The 100 percent allowance is phased down by 20 percent per calendar year for qualified property placed in service after 2022 (2023 for certain property with longer production periods)—the bonus depreciation sunsets after 2026 (2027 for certain property with longer production periods). For qualified property placed in service during the first taxable year ending after September 27, 2017, taxpayers may elect to take 50 percent bonus depreciation.
The original use requirement for property to qualify for bonus depreciation is repealed—certain used property acquired from an unrelated taxpayer in an arm’s length transaction now qualifies for 100 percent bonus depreciation. Certain qualified film, television, and live theatrical productions now qualify for bonus depreciation. Certain businesses are not eligible for bonus depreciation, such as public utilities and businesses incurring floor plan financing.
Section 179 Expensing
Under prior law, businesses could expense up to $500,000 of the cost of Section 179 property placed in service during a taxable year. The $500,000 limitation was reduced by the amount by which the total cost of Section 179 property placed in service during the taxable year exceeded $2,000,000. Section 179 property was depreciable tangible personal property that was purchased for use in the active conduct of a trade or business, as well as qualified real property. Qualified real property was (i) qualified leasehold improvement property, (ii) qualified restaurant property, and (iii) qualified retail improvement property.
The new law increases the maximum amount a taxpayer may expense under Section 179 to $1,000,000 and increases the phase-out threshold amount to $2,500,000. The Act also expands the definition of qualified real property in the following ways: (i) by replacing the three categories of qualified real property with “qualified improvement property” (defined above); (ii) by including depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging; and (iii) by including roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
These changes are effective for property placed in service in tax years beginning after December 31, 2017.
Recovery Period for Real Property
Under prior law, the accelerated cost recovery periods for real property were 39 years for nonresidential real property and 27.5 years for residential rental property. The ADS recovery period for nonresidential real property and residential rental property was 40 years.
The new law maintains the accelerated cost recovery periods of 39 years and 27.5 years for nonresidential real property and residential rental property, respectively. The ADS period remains at 40 years for nonresidential real property and is reduced to 30 years for residential rental property.
A real property business that elects to not be subject to the 30 percent limitation on deductibility of interest described below must use the ADS recovery periods and not the accelerated recovery periods.
The new law provides for a general 15-year MACRS recovery period and a 20-year ADS recovery period for “qualified improvement property” (described above).
These changes are effective for property placed in service after December 31, 2017.
Pass-Through Deduction
The Act adds a new qualified business income (“QBI”) deduction for noncorporate taxpayers applicable to income derived through a tax pass-through entity, and also to qualified REIT dividends and PTP distributions. The QBI deduction is limited to the lesser of (i) 20 percent of the taxpayer’s QBI and (ii) the greater of (a) 50 percent of the taxpayer’s share of W-2 wages relating to the business and (b) the sum of 25 percent of the W-2 wages and 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. The addition of the 2.5 percent of unadjusted basis calculation was intended to benefit capital intensive businesses with few employees.
The W-2 wage and qualified property cap does not apply to the 20 percent deduction for qualified REIT dividends. As a result, REIT classification may be desirable for certain real estate businesses. Additionally, REIT dividends appear to be QBI even if the underlying income received by the REIT would not have been QBI.
The QBI deduction is phased out if the taxpayer’s income exceeds $157,500 ($315,000 in the case of a joint return) for taxpayers in the following service businesses: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. The inclusion of any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees adds uncertainty to the determination of whether a service business would be eligible for the deduction.
Net Operating Loss (“NOL”)
Under prior law, NOLs could offset 100 percent of taxable income for regular income tax purposes, and 90% of alternative minimum taxable income for AMT purposes and could be carried back two years and carried forward 20 years.
Under the new law, NOLs arising in tax years beginning after December 31, 2017 can offset only 80 percent of taxable income and generally cannot be carried back, but may be carried forward indefinitely. NOLs arising in tax years beginning before January 1, 2018 are not affected by the new law.
Like-Kind Exchange
Under prior law, a taxpayer could effect a tax-free like-kind exchange of real property or a tax-free like-kind exchange of tangible personal property.
The new law repeals like-kind exchanges other than for real property. A transition rule is provided for personal property if the taxpayer has either disposed of the relinquished property or has acquired the replacement property on or before December 31, 2017.
This change is effective for transfers after December 31, 2017.
Research and Experimentation (R&E) Expenses
Under prior law, taxpayers could deduct current R&E expenses associated with an asset having a useful life in excess of one year.
The new law requires R&E expenses paid or incurred in tax years beginning after 2021 to be capitalized and amortized ratably over a 5-year period.
Interest Expense Deduction Limitation
The new law generally disallows a deduction for net interest expense in excess of 30 percent of the business’s adjusted taxable income. For tax years beginning after December 31, 2017 and before January 1, 2022, adjusted taxable income is computed without reduction for depreciation, amortization, or depletion. For tax years beginning after December 31, 2021, adjusted taxable income is reduced by deductions allowable for depreciation, amortization, or depletion. The change to the adjusted taxable income computation could significantly impact a business’s ability to deduct interest expense. Businesses with significant expenditures eligible for immediate expensing may want to consider purchasing such assets before 2022 when the interest limitation is calculated without regard to deductions attributable to such expensing.
Existing debt will not be grandfathered—interest on existing debt is subject to the new limitation. Any interest expense not deductible in a tax year because of the limitation may be carried forward indefinitely.
Taxpayers with average annual gross receipts for a three-year period of less than $25 million are generally exempt from the new limitation.
A real property business can elect out of the interest expense limitation if it uses the ADS to depreciate applicable real property used in its business.
These changes are effective for tax years beginning after December 31, 2017.
Section 451 Taxable Year of Inclusion
Under prior law, accrual method taxpayers included amounts in gross income for tax purposes when all the events had occurred that fixed the right to receive such amounts and such amounts could be determined with reasonable accuracy. Generally, an amount satisfied this all-events test at the earlier of when it (i) became due to, (ii) was paid to, or (iii) was earned by the taxpayer.
The new law requires taxpayers subject to the all-events test to recognize such income no later than the tax year in which such income is taken into account as revenue in an audited financial statement or another financial statement under rules specified by the Treasury Department. Exceptions are provided for gross income attributable to mortgage service rights and items of gross income for which a special method of accounting is required, such as for long-term contracts covered by Section 460 of the Internal Revenue Code of 1986, as amended. The new law accelerates the recognition of revenue to the extent it eliminates instances in which taxpayers may have been eligible to recognize revenue later than when recognized for financial statement purposes, for example, unbilled receivables for services or licensed property where revenue is not earned for tax purposes.
These changes are effective for tax years beginning after December 31, 2017, but for income from a debt instrument having original issue discount, tax years beginning after December 31, 2018.
Entertainment Expenses
Under prior law, taxpayers could deduct 50 percent of entertainment expenses that were directly related to or associated with the taxpayer’s trade or business. Expenses for recreational, social or similar activities primarily for the benefit of the taxpayer’s employees, other than highly compensated employees, were fully deductible.
The new law does not allow a deduction for entertainment expenses, regardless of whether such expenses are directly related to or associated with the taxpayer’s trade or business. Expenses for recreational, social, or similar activities primarily for the benefit of the taxpayer’s employees continue to be deductible consistent with prior law.
These changes are effective for amounts incurred or paid after December 31, 2017.
Employer-Provided Fringe Benefits
Under prior law, taxpayers generally could deduct up to 50 percent of meal expenses directly related to or associated with the taxpayer’s trade or business, and 100 percent of expenses related to employer-operated eating facilities that qualified as a de minimis fringe benefit.
Taxpayers may still generally deduct 50 percent of meal expenses directly related to or associated with the taxpayer’s trade or business. Taxpayers may now deduct only 50 percent of the expenses associated with employer-operated eating facilities that meet the requirements for a de minimis fringe benefit. This new limitation applies to expenses incurred or paid between December 31, 2017, and December 31, 2025. After 2025, expenses associated with employer-operated eating facilities will not be deductible.
Contributions to Capital
Under prior law, gross income of a corporation generally did not include any contribution to its capital. A contribution to the capital of a corporation did not include any contribution in aid of construction or any other contribution from a customer or potential customer. There was an exception for contributions in aid of construction by customers of regulated public utilities.
The new law repeals the regulated public utility exception for contributions in aid of construction. This change is effective for contributions made after December 22, 2017.
The new law also removes from the definition of contribution to capital contributions by governmental entities or civic groups (other than a contribution made by a shareholder in its capacity as such). This means that property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or to enable the corporation to expand its facilities, is taxable to the corporation. This change does not apply to any contribution made after December 22, 2017, by a governmental entity under a master development plan that has been approved before December 22, 2017, by a governmental entity.
Partnership Technical Termination
Under prior law, a partnership was considered to have terminated if, within any 12-month period, there was a sale or exchange of 50 percent or more of the total interest in partnership capital and profits (a “technical termination”). Partnership terminations required the filing of returns for short taxable years and terminated many partnership level elections.
A partnership will still be considered as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
This change is effective for partnership tax years beginning after December 31, 2017.
Rollover of Publicly Traded Securities Gain into Specialized Small Business Investment Company (“SBIC”)
Under prior law, a corporation or individual could elect to roll over tax-free a certain amount of capital gain realized on the sale of publicly traded securities to the extent of the taxpayer’s cost of purchased common stock or a partnership interest in an SBIC within 60 days of the sale.
For sales after December 31, 2017, this election is repealed.
FDIC Premiums
Under prior law, FDIC premiums were treated as an ordinary and necessary business expense and were generally fully deductible.
The new law does not allow a deduction for the applicable percentage of an FDIC premium. Taxpayers with total consolidated assets of $50 billion or more cannot deduct any of their FDIC premiums. Taxpayers with total consolidated assets of $10 billion or less are exempted from this limitation and may deduct the full amount of their FDIC premiums.
This change is effective for tax years beginning after December 31, 2017.
Nondeductible Penalties and Fines
Under prior law, no deduction was allowed for fines or similar penalties paid to a government for the violation of any law. Taxpayers could deduct amounts paid as compensatory damages.
The new law expands the denial of a deduction to include payments made to, or at the direction of, a government or specified nongovernmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law. The expansion of nondeductible payments to those made at the direction of the government or specified nongovernmental entity raises questions about the deductibility of payments to whistleblowers under the False Claims Act.
Instead of allowing a deduction for compensatory damages, the new law allows a deduction if (i) the taxpayer establishes either a payment was for restitution (including remediation of property) or was required to come into compliance with any law that was violated or involved in the investigation or inquiry, and (ii) the court order or settlement agreement identifies the payment as restitution, remediation, or required to come into compliance. In another change from prior law, reimbursement of government investigative or litigation costs are no longer deductible.
These changes are effective for amounts paid or incurred on or after December 22, 2017.
Limitation on Excessive Employee Compensation
Under prior law, publicly traded corporations could deduct up to $1 million for compensation for certain employees. Exceptions to the $1 million limit included amounts paid for (i) commissions, (ii) performance-based remuneration, (iii) payments to a tax-qualified retirement plan, and (iv) amounts that are excludable from the employee’s gross income.
The new law repeals the exceptions to the $1 million deduction limitation for commissions and performance-based remuneration. Under a transition rule, the changes do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect after that date.
These changes are effective for tax years beginning after December 31, 2017.
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