Analysis of the Tax Cuts and Jobs Act for Businesses
No one wants uncertainty in their business, and the Tax Cuts and Jobs Act (the Act) recently signed into law by President Trump has instituted many changes to tax law affecting businesses. As such, we’ve attempted to boil it down to the items we feel will be most impactful to you and your business.
Previous Rules: C corporations currently are subject to graduated tax rates of 15% for taxable income up to $50,000, 25% (over $50,000 to $75,000), 34% (over $75,000 to $10,000,000), and 35% (over $10,000,000). Personal service corporations pay tax on their entire taxable income at the rate of 35%. (The benefit of lower rate brackets was phased out at higher income levels.)
New Rules: Beginning with the 2018 tax year, the Act generally makes the corporate tax rate a flat 21%. It also eliminates the corporate alternative minimum tax.
Analysis: This can certainly be a big benefit to large corporations which are very profitable. However, the issue of double taxation remains. Some may consider converting their S. Corporation to a C. Corporation; however, with the double taxation, the benefit of an S. Corporation and its related pass-through deduction could possibly outweigh the lower corporate tax rate. As with any strategy, careful consideration and planning with your tax advisor is crucial.
Basis of Accounting:
Previous Rules: One limit concerning the ability for a business to use the cash method of accounting is the rule that generally requires taxpayers to account for purchases and sales using the accrual method if the taxpayer must use an inventory method with respect to those purchases and sales. There were certain tests such as $5,000,000 average gross receipts which allowed a taxpayer to be precluded from this rule, should they qualify.
New Rules: The gross-receipts test is satisfied if, during the three-year testing period (above), average annual gross receipts doesn’t exceed $25 million subject to adjustment for inflation for tax years beginning after Dec. 31, 2018.
Analysis: The Tax Cuts and Jobs Act expands the universe of taxpayers that can use the cash method of accounting. These changes may have an impact on your choice of accounting method, and cause you to want you to review and, possibly, revise those choices, so consult your tax advisor.
Net Operating Loss:
Previous Rules: A net operating loss (NOL) deduction is allowed in computing taxable income for a tax year in an amount equal to the aggregate of the NOL carryovers and NOL carrybacks to that year. Under pre-Tax Cuts and Jobs Act law, the NOL deduction wasn’t subject to a limitation based on taxable income. Also, a net operating loss (NOL) for any tax year was generally carried back two years, and then carried forward 20 years.
New Rules: The Tax Cuts and Jobs Act limits the NOL deduction to 80% of taxable income, determined without regard to the NOL deduction itself. Carryovers to other years are adjusted to take account of the 80% limitation. The Tax Cuts and Jobs Act repeals the general two-year NOL carryback and the special carryback provisions, but provides a two-year carryback for certain losses incurred in a farming trade or business. The Act also provides that NOLs may be carried forward indefinitely.
Analysis: This provision limits the value of NOLs, because they can no longer completely eliminate the taxable income in a given year. It’s worth noting that losses that began before January 1, 2018, won’t be subject to the 80% limitation, so taxpayers will have to distinguish between the two. The repeal of the NOL carryback rule will hurt those who would like to have access to refunds quicker; however, the ability to carryforward these indefinitely might help corporations with large NOLs relative to their income.
Business Interest Deduction:
Previous Rules: Generally, interest paid or accrued during the taxable year is deductible whether or not it is incurred in a trade or business.
New Rules: Under the new law, every business, regardless of its form, is limited to a deduction for business interest equal to 30% of its adjusted taxable income. For pass-through entities such as partnerships and S corporations, the determination is made at the entity, i.e., partnership or S corporation, level. Adjusted taxable income is computed without regard to the repealed domestic production activities deduction and, for tax years beginning after 2017 and before 2022, without regard to deductions for depreciation, amortization, or depletion. Any business interest disallowed under this rule is carried into the following year, and, generally, may be carried forward indefinitely. The limitation does not apply to taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three-year period ending with the prior tax year. Real property trades or businesses can elect to have the rule not apply if they elect to use the alternative depreciation system for real property used in their trade or business. Certain additional rules apply to partnerships. Floor plan financing interest is fully deductible under this provision.
Analysis: For most small businesses, this limitation will not apply due the average gross receipts test noted above. However, for partnerships in which the limited partner receive a majority of losses (i.e. those holding apartment complexes) they will need to make sure they are electing to be taxed under the ADS in order to not limit interest deductions (which typically are large). For large businesses which are not exempt, they will want to consider the effect of this provision on their debt strategy.
Domestic Production Activity Deduction:
Previous Rules: Under pre-Tax Cuts and Jobs Act law, the domestic production activities deduction (“DPAD”), which was allowed for certain qualifying U.S.-based activities, was equal to 9% of the lesser of the taxpayer’s qualified production activities income or the taxpayer’s taxable income (determined without regard to the DPAD) for the tax year.
New Rules: Domestic production activities deduction (“DPAD”) repealed. The new law repeals the DPAD for tax years beginning after 2017.
Analysis: The DPAD deduction has provided substantial benefit for many businesses during its existence. While the reduced tax rates will certainly help offset this loss, certain industries might see less of benefit of the tax reform as a result.
Previous Rules: Entertainment expenses were allowed if they were directly related to or associated with the active conduct of the taxpayer’s trade or business or income-producing activity.
New Rules: The new law eliminates the 50% deduction for business-related entertainment expenses. The pre-Act 50% limit on deductible business meals is expanded to cover meals provided via an in-house cafeteria or otherwise on the employer’s premises. Additionally, the deduction for transportation fringe benefits (e.g., parking and mass transit) is denied to employers, but the exclusion from income for such benefits for employees continues. However, bicycle commuting reimbursements are deductible by the employer but not excludable by the employee. Lastly, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees except as provided for the employee’s safety.
Analysis: This one is interesting. Many progressive businesses are constantly looking for ways to create community and loyalty with their employees. Often times these take the form of entertainment (i.e. sporting events, golf outings, etc.). The removal of this provision could force businesses to seek alternative ways to reward employees in lieu of the traditional methods noted above.
Previous Rules: Under pre-Tax Cuts and Jobs Act law, there was no employer tax credit for paid family and medical leave. Thus, that credit wasn’t one of the credits composing the current year business credit, nor could it be used to reduce a taxpayer’s AMT.
New Rules: A new general business credit is available for tax years beginning in 2018 and 2019 for eligible employers equal to 12.5% of wages they pay to qualifying employees on family and medical leave if the rate of payment is 50% of wages normally paid to the employee. The credit increases by 0.25% (up to a maximum of 25%) for each percent by which the payment rate exceeds 50% of normal wages. For this purpose, the maximum leave that may be taken into account for any employee for any year is 12 weeks. Eligible employers are those with a written policy in place allowing qualifying full-time employees at least two weeks of paid family and medical leave a year, and less than full-time employees a pro-rated amount of leave. A qualifying employee is one who has been employed by the employer for one year or more, and who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.
Analysis: As noted above, certain employers are constantly looking for ways to increase the employee experience. One way that is gathering steam is to continue to pay an employee’s wages (or portion thereof) during their time off for FMLA. This credit definitely incentivizes this move. A taxpayer can’t take both a credit and a deduction for amounts for which the paid family and medical leave credit is claimed. Thus, a taxpayer can’t deduct that portion of the wages or salaries paid or incurred for the tax year which is equal to the sum of the credits; however, this should be a great benefit for the next couple of years.
Qualified Rehabilitation Credit:
Previous Rules: Pre-Tax Cuts and Jobs Act law provided a two-tier tax credit (10% and 20% based on certain criteria) for qualified rehabilitation expenditures (QREs) for older buildings which was available to the taxpayers in the year the qualified rehabilitation building was placed in service.
New Rules: The new law repeals the 10% credit for qualified rehabilitation expenditures for a building that was first placed in service before 1936, and modifies the 20% credit for qualified rehabilitation expenditures for a certified historic structure. The 20% credit is allowable during the five-year period starting with the year the building was placed in service in an amount that is equal to the ratable share for that year. This is 20% of the qualified rehabilitation expenditures for the building, as allocated ratably to each year in the five-year period. It is intended that the sum of the ratable shares for the five years not exceed 100% of the credit for qualified rehabilitation expenditures for the building. The repeal of the 10% credit and modification of the 20% credit take effect starting in 2018 (subject to a transition rule for certain buildings owned or leased at all times after 2017).
Analysis: Prior to the final bill being released, it appeared the Historic Tax Credit might be on the chopping block. The final bill did cut the 10% credit; however, the 20% credit used by many to rehab dilapidated, but historic buildings was maintained. Stay tuned on these credits as the longer period for claiming credits will certainly affect the ROI for its investors.
Previous Rules: Under pre-Tax Cuts and Jobs Act law, a taxpayer’s annually allowable Section 179 expense couldn’t exceed $500,000 as adjusted for inflation (the annual dollar limit). The dollar limit had to be reduced (i.e., phased down, but not below zero) by the amount by which the cost of section 179 property placed in service by the taxpayer during the tax year exceeded $2,000,000 adjusted for inflation (the annual beginning-of-phase-down threshold).
New Rules: The new law increases the maximum amount that may be expensed under Section 179 to $1 million. If more than $2.5 million of property is placed in service during the year, the $1 million limitation is reduced by the excess over $2.5 million. Both the $1 million and the $2.5 million amounts are indexed for inflation after 2018. The expense election has also been expanded to cover (1) certain depreciable tangible personal property used mostly to furnish lodging or in connection with furnishing lodging, and (2) the following improvements to nonresidential real property made after it was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; security systems; and any other building improvements that aren’t elevators or escalators, don’t enlarge the building, and aren’t attributable to internal structural framework. Also, definition of section 179 property has been expanded to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with the furnishing of lodging. Examples of this property are beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or any other facility (or part of a facility) where sleeping accommodations are provided and let.
Analysis: The increase in the annual dollar limit and annual beginning-of-phase-down threshold, along with expansion of what is section 179 property considerably increases the availability of expensing under this provision. Of particular note is the widened definition of improvement property as noted above, this should open up opportunities for considerable write-offs not previously available. A word of caution; however, that the increase in this definition could potentially lead to a total investment in 179 property in excess of the investment limitation which could cause the tax payer to lose the ability to expense some of the 179 property. Close monitoring of spending on these asset types should be performed by the taxpayer and their advisor. Finally, opening up certain types of residential property to Section 179 could help holders of real estate; however, this will need to be analyzed in conjunction with the Bonus Depreciation provisions noted below.
Previous Rules: Pre-Act law provided for a 50% allowance first-year deduction for qualifying new property, which was to be phased down for property placed in service after 2017.
New Rules: Under the new law, a 100% first-year deduction is allowed for qualified new and used property acquired and placed in service after September 27, 2017 and before 2023. The 100% allowance is phased down starting after 2023.
Analysis: There are some significant changes here that are worth noting, and could be extremely impactful for taxpayers. Certainly, increasing the immediate expensing percent from 50% to 100% is extremely beneficial and will create a nice incentive for capital investment. However, just as important, in our opinion, is the availability for used property to qualify for immediate expensing. In order for used assets to apply, they must be purchased from an unrelated third party.
Other New Rules for Depreciation and Asset Sales:
- Depreciation of qualified improvement property. The new law provides that qualified improvement property is depreciable using a 15-year recovery period and the straight-line method. Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property placed in service after the building was placed in service. It does not include expenses related to the enlargement of the building, any elevator or escalator, or the internal structural framework. There are no longer separate requirements for leasehold improvement property or restaurant property.
- Depreciation of farming equipment and machinery. Under the new law, subject to certain exceptions, the cost recovery period for farming equipment and machinery the original use of which begins with the taxpayer is reduced from 7 to 5 years. Additionally, in general, the 200% declining balance method may be used in place of the 150% declining balance method that was required under pre-Act law.
- Luxury auto depreciation limits. Under the new law, for a passenger automobile for which bonus depreciation (see above) is not claimed, the maximum depreciation allowance is increased to $10,000 for the year it’s placed in service, $16,000 for the second year, $9,000 for the third year, and $5,760 for the fourth and later years in the recovery period. These amounts are indexed for inflation after 2018. For passenger autos eligible for bonus first year depreciation, the maximum additional first year depreciation allowance remains at $8,000 as under pre-Act law.
- Computers and peripheral equipment. The new law removes computers and peripheral equipment from the definition of listed property. Thus, the heightened substantiation requirements and possibly slower cost recovery for listed property no longer apply.
- Like-kind exchange treatment limited. Under the new law, the rule allowing the deferral of gain on like-kind exchanges of property held for productive use in a taxpayer’s trade or business or for investment purposes (1031 exchanges) is limited to cover only like-kind exchanges of real property not held primarily for sale. Under a transition rule, the pre-TCJA law applies to exchanges of personal property if the taxpayer has either disposed of the property given up or obtained the replacement property before 2018.
Previous Rules: Before the new law, partnerships experienced a “technical termination” if, within any 12-month period, there was a sale or exchange of at least 50% of the total interest in partnership capital and profits. This resulted in a deemed contribution of all partnership assets and liabilities to a new partnership in exchange for an interest in it, followed by a deemed distribution of interests in the new partnership to the purchasing partners and continuing partners from the terminated partnership. Some of the tax attributes of the old partnership terminated, its tax year closed, partnership-level elections ceased to apply, and depreciation recovery periods restarted. This often imposed unintended burdens and costs on the parties.
New Rules: The new law repeals this rule. A partnership termination is no longer triggered if within a 12-month period, there is a sale or exchange of 50% or more of total partnership capital and profits interests. A partnership termination will still occur only 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
Analysis: This is a win for partnerships which hold substantial depreciated assets (i.e. apartment complexes). Prior to this law, depreciation had to be restarted on the residual asset balance, often substantially decreasing the depreciation deduction. It also eliminates the burden of an additional tax filing and the necessity to revisit partnership elections.
Mandatory Basis Adjustments
Previous Rules: Under pre-Tax Cuts and Jobs Act law, the basis of partnership property was not adjusted as a result of a transfer of a partnership interest unless the partnership made a Section 754 basis adjustment election or there was a substantial built-in loss with respect to the transfer of a partnership interest. The partnership had a substantial built-in loss with respect to a transfer of a partnership interest if the partnership’s adjusted basis in the partnership property exceeded by more than $250,000 the fair market value of the property.
New Rules: The Act added a provision to the Mandatory Basis Adjustment Rules that a partnership has a substantial built-in loss with respect to a transfer of a partnership interest if the transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their fair market value immediately after the transfer.
Analysis: On the surface, this would seem to apply in the situation whereby items of losses were specially allocated in accordance with provisions of the partnership agreement. Accordingly, the partnership agreement should be monitored on a potential transfer, and dual calculation of the $250,000 should be performed to determine any mandatory adjustments.
Previous Rules: Under pre-Tax Cuts and Jobs Act law, a partner was allowed to deduct his distributive share of partnership loss only to the extent of the adjusted basis of the partner’s interest in the partnership at the end of the partnership year in which such loss occurred. However, in applying the basis limitation on partner losses, the regs didn’t take into account the partner’s share of partnership charitable contributions and foreign taxes paid or accrued.
New Rules: The Tax Cuts and Jobs Act provides that in determining the amount of the partner’s loss, the partner’s distributive shares of partnership charitable contributions and taxes paid or accrued to foreign countries or U.S. possessions are taken into account. However, in the case of a charitable contribution of property with a fair market value that exceeds its adjusted basis, the partner’s distributive share of the excess is not taken into account.
Analysis: With a partner’s share of charitable contributions now being taken into consideration in addition to a partner’s loss, basis limitation could come into play. However, the ability to only consider the assets adjusted basis (and not fair market value) will help. Careful monitoring of partner’s capital accounts is critical.
As you can see from this overview, there is a lot here. The bill which passed was far from perfect, and many technical corrections will have to be made to shore up unclear language and unintended consequences. Analyzing the effect with your tax advisor is crucial. If you would like more information or to discuss the impact of the law on your particular situation, give us a call!
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