On December 20, 2017, both houses of Congress passed H.R. 1, a comprehensive tax reform bill commonly known as the “Tax Cuts and Jobs Act,” (the Act) and was signed into law by President Trump on December 21, 2017. The Act makes major changes to federal income and estate tax law, including, among other things, numerous changes affecting businesses, individuals, tax-exempt organizations, the taxation of compensation arrangements, and fundamental aspects of U.S. international taxation. The Act is the largest overhaul of the Internal Revenue Code since 1986 and will have substantial effects on taxpayers across all industries.
This Alert addresses key business tax changes under the Act and is one of a series of Alerts that our firm will be issuing on select topics of the Act. Except as otherwise indicated, the provisions summarized below would generally be effective for tax years beginning after December 31, 2017.
21 Percent Corporate Tax Rate
The centerpiece of the Act is a substantial corporate income tax rate cut. The Act replaces the graduated income tax rates for corporations (currently having a maximum rate of 35 percent) with a permanent flat 21 percent tax rate and repeals the corporate alternative minimum tax. While the reduction of the corporate tax rate is expected to be beneficial to many corporations, some corporations have paid a lower effective tax rate on their income due to, among other things, depreciation and interest deductions and cross-border/intercompany transactions. The benefit to a particular corporation of the reduced tax rate will depend on its operations and the effects of other provisions of the Act, including the new business interest deduction limitations discussed below. Given the disparity between the highest individual income tax rate of 37 percent, as revised under the Act, and the 21 percent corporate income tax rate, new planning opportunities may arise to convert income otherwise taxable to individuals at ordinary income tax rates to lower taxed corporate profits.
Dividends Received Deduction
Under the Act, a corporation may only deduct (i) 65 percent (down from 80 percent) of dividends received from U.S. corporations in which it owns 20 percent or more (but less than 80 percent) of the stock and (ii) 50 percent (down from 70 percent) of dividends received from U.S. corporations in which it owns less than 20 percent of the stock. As a result of these changes, such dividends will be taxed at a maximum rate of 7.35 percent (35 percent of 21 percent) and 10.5 percent (50 percent of 21 percent). The 100 percent dividends received deduction for dividends received from 80 percent or more owned corporations is not affected.
Pass-Through Income Deduction
The Act provides, subject to certain exceptions, noncorporate taxpayers, including trusts and estates, a 20 percent deduction for “qualified business income” earned from pass-through business entities, such as partnerships (including LLCs taxed as partnerships), S corporations, and sole proprietorships, which will result in the top tax rate on such income of 29.6 percent (based on the highest individual tax rate of 37 percent). The deduction is generally capped at the greater of either (a) 50 percent of the taxpayer’s allocable share of W-2 wages paid by the business or (b) the sum of the taxpayer’s allocable share of (i) 25 percent of the W-2 wages paid by the business plus (ii) 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. The tax deduction with respect to specified service businesses is phased out unless the taxpayer’s taxable income does not exceed $315,000 for joint filers ($157,500 for individual filers). Such deduction is phased out over the next $100,000 of taxable income for joint filers ($50,000 for individual filers). Specified service businesses include trades or businesses in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, financial or brokerage services, or other trade or businesses where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners or, which consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Dividends from real estate investment trusts and publicly traded partnerships are covered by this deduction. Consistent with other individual tax rate reductions, this deduction expires for tax years beginning in 2026. The pass-through income deduction and related tax matters will be discussed further in a future Tax Alert.
Temporary 100 Percent Expensing
The Act permits taxpayers to immediately “write-off” or expense 100 percent of the cost of “qualified property” that is placed in service after September 27, 2017, and before January 1, 2023 (or, in the case of certain property having a longer production period, 2024). For this purpose, qualified property includes, among other items, tangible property with a MACRS recovery period of 20 years or less, certain off-the-shelf computer software, and qualified improvement property. The 100 percent depreciation deduction is phased down by 20 percent per year beginning with property placed in service after December 31, 2022 (or in the case of longer-lived property, December 31, 2023). Importantly, the Act applies to used property acquired during the relevant period that is acquired from an unrelated taxpayer. Intangible property and real property are generally not eligible for immediate expensing. For the first tax year ending after September 27, 2017, a taxpayer can elect to claim 50 percent bonus first-year depreciation (instead of claiming a 100 percent first-year depreciation allowance).
The expansion of qualified property to include “used” property may be extremely attractive to buyers in actual (or deemed) asset acquisitions (e.g., IRC Sections 336(e) or 338(h)(10) or the purchase of 100 percent of the interests in a partnership or LLC). In an asset purchase transaction, buyers will now be permitted to immediately deduct the portion of the purchase price allocated to eligible acquired assets. This change may have a significant effect on the pricing of the transaction. Further, in the case of a C corporation seller, gain will be subject to the new, lower 21 percent corporate tax rate. Under pre-Act law, C corporations were reluctant to sell assets due to the high corporate tax rate and potential double tax on the payment of dividends to its shareholders, the cost of which often exceeded the buyer’s benefit from a tax basis step-up. As a result, these changes may lead to an increase in M&A transactions, and in particular, actual (or deemed) asset acquisitions.
Repeal Of Domestic Production Activities Deduction
The Act repeals the deduction for income attributable to domestic production activities for noncorporate taxpayers for tax years beginning after December 31, 2017 (or, in the case of C corporations, after December 31, 2018).
Small Business Expensing (Section 179)
Prior to the Act, a taxpayer could elect under IRC Section 179 to expense up to $500,000 of qualifying property placed into service in a given year. The deduction was phased out if the taxpayer placed more than $2 million of property in service. The Act increases these amounts to $1 million and $2.5 million, respectively. In addition, the Act expands the Section 179 deduction to include certain specified improvements to nonresidential real property (including roofs, HVAC property, alarm systems, among others) and certain depreciable tangible personal property used predominantly to furnish lodging.
Effective for tax years beginning after December 31, 2021, the Act would require taxpayers to capitalize and amortize certain research and experimental expenditures which, under current law, are immediately deductible. The cost recovery period for these expenditures would be five years if related to research conducted within the United States and 15 years if conducted outside of the United States.
Business Interest Deductions
Under the Act, taxpayers, regardless of their form, are generally subject to a disallowance of a deduction for net business interest expense in excess of 30 percent of the taxpayer’s adjusted taxable income. For this purpose, adjusted taxable income is reduced by non-business income, any net operating loss deductions, business interest income, and the 20 percent pass-through deduction (described above). For taxable years beginning after December 31, 2017, and before January 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, and depletion (EBITDA). Beginning in 2022, depreciation, amortization, and depletion are not added back when computing adjusted taxable income (EBIT). Business interest excludes investment interest.
The business interest deduction limitation is generally determined at the taxpayer level. However, for pass-through entities, the limitation on the deductibility of interest expense would generally be determined at the entity level. Special rules are provided to prevent double counting at the pass-through entity and owner levels. In the case of affiliated corporations that file a U.S. federal consolidated tax return, the limitation on interest deductions applies at the consolidated tax return filing level.
The business interest limitation does not apply to taxpayers with average annual gross receipts of less than $25 million for the immediately preceding three-taxable-year period or to certain regulated public utilities. Also, importantly, certain real property trades or businesses that use the alternative depreciation system may elect out of this limitation. The Act also maintains an exemption for floor plan financing indebtedness (e.g., motor vehicles).
Interest deductions disallowed due to this limitation may be carried forward indefinitely but would remain subject to the overall calculation of the limitation on deductibility. There is no grandfathering for existing debt instruments.
The net interest expense limitation will likely have a significant impact on companies primarily relying on interest deductions to reduce taxable income. The limitation may be particularly adverse to financially troubled companies experiencing a decline in adjusted taxable income, resulting in a reduction in deductible interest. In fact, businesses could become less profitable, but have a minor (or no) reduction in income tax liability. Starting in 2022, because depreciation and amortization is not added back to adjusted taxable income, the Act may significantly reduce allowable interest deductions for companies with substantial depreciation deductions. The potential cost of interest expense disallowance to C corporations, however, may be mitigated due to the reduced corporate tax rate.
Net Operating Loss (NOL) Deductions
The Act generally repeals the two-year carryback for NOLs arising in tax years ending after December 31, 2017, but permits NOLs to be carried forward indefinitely (as opposed to 20 years under pre-Act law). However, the Act limits the use of such NOLs to 80 percent of the taxpayer’s taxable income (determined without regard to the deduction). The 80 percent limit applies to NOLs arising from tax years beginning after December 31, 2017, and the new carry-forward period applies to NOLs arising in tax years ending after December 31, 2017. Property and casualty insurance companies retain the current two-year carryback and 20-year carryforward provisions.
The repeal of NOL carrybacks could have an adverse effect on cyclical businesses that would otherwise claim tax refunds attributable to losses following profitable tax years or to companies generating losses in a sale transaction, which may no longer be carried back (e.g., from sale bonuses or option exercise or cancellation payments).
Limitation on Excess Business Losses
Individuals A (single) and B (married) each contribute $1,000,000 to a partnership in which they materially participate and the partnership has a net loss of $800,000 in 2018, each reporting a $400,000 net loss. A’s excess business loss is $150,000 ($400,000-$250,000) and results in an NOL carryforward subject to NOL limitations. B, a married taxpayer, would not have an excess business loss due to the higher threshold and may be permitted to use the full $400,000 loss in 2018 to offset other income, including income from B's spouse.
For taxable years beginning after December 31, 2017, and before January 1, 2026, “excess business losses” of a non-corporate taxpayer are not allowed for the taxable year, but rather are carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years. This provision has the effect of disallowing active net business losses, except for the threshold. As noted above, NOL carryovers are allowed up to 80 percent of taxable income.
An excess business loss is the excess of aggregate deductions of the taxpayer attributable to the taxpayer’s trades and businesses (determined without regard to this limitation) over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount is $500,000 for married individuals filing jointly, and $250,000 for other taxpayers. In the case of a pass-through entity, the provision applies at the owner level after application of the passive loss rules. This limitation expires after December 31, 2025.
The Act imposes a new three-year holding period (rather than the one-year period under current law) to qualify for long-term capital gains rates in respect of profits interests in certain investment partnerships received in exchange for services. This rule generally applies to partnerships engaged in businesses that raise or return capital and either invest in, dispose of, or develop certain specified assets, including securities, commodities, options, derivatives, real estate for rent or investment, and an interest in a partnership to the extent attributable to specified assets. An applicable partnership interest does not include any interest held by a corporation, or any capital interest allowing the partner to share in partnership capital commensurate with the amount of capital contributed (determined upon receipt of such partnership interest). This rule may apply to gains arising from either the partner’s disposition of its partnership interest or the disposition of assets by the partnership. Amounts denied long-term capital gain treatment pursuant to this provision are treated as short-term capital gain. This provision applies notwithstanding any election in effect under IRC Section 83(b). Special rules apply to related party transfers.
Accelerated Tax Income Recognition
The Act would make various changes to tax accounting rules, including (i) requiring a taxpayer on the accrual method of accounting to recognize income no later than the taxable year in which such income is taken into account as income on an applicable financial statement, or another financial statement under rules specified by the IRS (including, among others, any GAAP financial statement, Form 10-K annual statement, audited financial statement or a financial statement filed with a federal agency for non-tax purposes). Income recognized based on special methods of accounting, such as the long-term method of accounting, would be exempt from this rule. The Act also codifies the current deferral method of accounting for certain advance payments for goods or services under Revenue Procedure 2004-34 if such income is also deferred for financial statement purposes.
Cash Method Accounting
Prior to the Act, corporations and partnerships with corporate partners generally could not use the cash method of accounting unless they had average gross receipts of less than $5 million for the prior three years. The Act increases the $5 million average gross receipts threshold to $25 million. Businesses that are permitted to use the cash method of accounting without regard to average annual gross receipts (e.g., personal service companies) will continue to be able to use the cash method. The Act also simplifies inventory accounting and provides exemptions from the uniform capitalization rules for businesses eligible to use the cash method of accounting.
The Act disallows deductions for qualified transportation fringe benefits, entertainment expenses, club membership dues, and facilities associated with entertainment or clubs. Under the Act, taxpayers may still generally deduct 50 percent of food and beverage expenses related to a trade or business (e.g., meals consumed during work travel) and until 2026, expands the 50 percent limitation to expenses for meals provided to employees for the convenience of the employer or through employer-operated eating facilities meeting. For tax years beginning after December 31, 2025, the Act will disallow an employer’s deduction for expenses associated with meals provided for the convenience of the employer on the employer’s business premises, or provided on or near the employer’s business premises through an employer-operated facility that meets certain requirements.
The Act generally limits non-recognition treatment under IRC Section 1031 to like-kind exchanges of real property used in a trade or business or for investment, eliminating like-kind exchange treatment for other property such as artwork or equipment. The change is effective for taxable years beginning after December 31, 2017, with grandfathered treatment for any deferred exchange where property was disposed of or received by the taxpayer prior to the end of 2017. While this change eliminates the ability to engage in like-kind exchanges of personal property, the impact of this change may be mitigated somewhat by the ability to immediately expense the cost of replacement property that is qualified property for 100 percent depreciation (e.g., equipment).
The Act makes various other changes that will impact businesses generally, including, among others, limitations on a public company’s ability to deduct compensation under IRC Section 162(m), the elimination of deductions for local lobbying expenses and certain fines and penalties, modifications to business and energy tax credits, and significant changes to the taxation of insurance companies.
Given the breadth of the Act, this Alert highlights only the major changes impacting businesses. As indicated above, we will be issuing additional Alerts on select topics and periodically provide updates.