The Tax Cuts and Jobs Act (the “Act”) was enacted on December 22, 2017, and makes significant changes to the taxation of corporations and pass-through entities, as well as to other business-related tax provisions. This client alert highlights some key changes that affect closely held businesses.
Lower Corporate Tax Rate
The Act permanently changes the corporate tax rate from a four-bracket, graduated rate structure with a maximum rate of 35% to a flat 21% corporate tax rate. The Act also repeals the corporate alternative minimum tax. These changes are effective for taxable years beginning on or after January 1, 2018.
Whether a business that is currently treated as a disregarded entity, an S corporation or a partnership for federal income tax purposes should convert to a C corporation will be highly dependent on each business’s unique circumstances. It is important to note, however, that corporate dividends received by individuals remain subject to tax under the Act, and C corporations are not allowed to deduct dividends paid from income.
Pass-Through Business Deduction
Partners in a partnership, shareholders of an S corporation and sole proprietors are taxed on their shares of partnership or S corporation income, or their sole proprietorship income, as applicable, at their own tax rates. Partnerships and S corporations, known as pass-through entities, generally do not pay federal income tax at the entity level.
In an effort to provide non-corporate owners of pass-through entities and sole proprietorships a tax cut akin to the new 21% corporate tax rate, the Act provides a deduction against taxable income that is determined with respect to certain types of income from pass-through entities and sole proprietorships for taxable years beginning on or after January 1, 2018, and ending on or before December 31, 2025.
The pass-through business deduction is available to individuals, trusts and estates. The amount of the deduction is generally equal to the sum of (i) the lesser of (x) the taxpayer’s “combined qualified business income amount” for the taxable year or (y) 20% of the amount by which the taxpayer’s taxable income for the year exceeds the taxpayer’s net gain, plus qualified cooperative dividends for the year, and (ii) the lesser of 20% of the taxpayer’s qualified cooperative dividends or the taxpayer’s taxable income less his or her net capital gain for the taxable year.
The combined qualified business income amount is equal to the sum of (i) the lesser of (x) 20% of the qualified business income of a partnership, S corporation or sole proprietorship or (y) the greater of (1) 50% of the W-2 wages paid with respect to the qualified trade or business or (2) 25% of those wages plus 2.5% of the acquisition cost of certain property, plus (ii) 20% of aggregate qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income. In certain cases, the amount determined under prong (i) of the combined qualified business income amount definition phases out completely if a taxpayer’s taxable income exceeds a threshold amount plus $50,000 for single taxpayers or married taxpayers filing separately, or $100,000 for married taxpayers filing jointly. For 2018, the threshold amount is $157,500 for single taxpayers and married taxpayers filing separately, and $315,000 for married taxpayers filing jointly.
Qualified business income is the net amount of income, gain, loss and deduction with respect to a qualified trade or business of the taxpayer. Qualified business income excludes reasonable compensation, guaranteed payments and payments for services described in Section 707(a) of the Internal Revenue Code (dealing with payments for services to a partner in a partnership other than in the partner’s capacity as a partner) to the taxpayer by a qualified trade or business of the taxpayer for services rendered with respect to that trade or business. Qualified business income also excludes certain investment income items.
A qualified trade or business is generally defined under the Act as any trade or business other than health care, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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, and services related to investing, investment management, and trading or dealing in securities, partnership interests or commodities (known as “specified service trade or business” under the Act). Note that engineering and architecture are not specified service trades or businesses. In addition, the Act will not treat a specified service trade or business as such with respect to a taxpayer whose taxable income is less than the threshold amount plus $50,000 (or $100,000 in the case of married taxpayers filing a joint return). In these cases, the amount of a taxpayer’s deduction will decline as the taxpayer’s income exceeds the threshold amount.
Selected Real Estate-Related Tax Changes
Under prior like-kind exchange rules, provided that certain requirements were met, property used in a trade or business or held for investment may be exchanged for property of the same nature or character to be used in a trade or business or held for investment without recognition of taxable gain. While these exchanges have been a key tax benefit in the real estate industry, other taxpayers have used them to defer recognition of gain on transactions involving property other than real estate. The Act amends the like-kind exchange rules to provide that only property that is real property may be used in a like-kind exchange. This provision applies to exchanges completed on or after January 1, 2018. However, the Act provides an exception for any exchange if the taxpayer disposed of the property in an exchange on or before December 31, 2017, or if the taxpayer received the property in an exchange on or before such date.
Historic Tax Credits
Under prior law, the rehabilitation credit, commonly known as the historic tax credit, was a two-tiered credit providing for a 10% and 20% credit against qualified rehabilitation expenditures. The 10% credit was generally available to buildings first placed in service prior to 1936, where the rehabilitation met certain requirements regarding retention of external walls and internal framework. The 20% credit was generally available to certified historic structures, i.e., structures listed in the National Register or located in a registered historic district and certified by the Secretary of the Interior to the Secretary of the Treasury.
The Act repeals the 10% credit and modifies the 20% credit by requiring that the credit be prorated over a 5-year period. The provision applies to amounts paid or incurred beginning on or after January 1, 2018.
Depreciation Recovery Periods
Under prior law, improvements to nonresidential real property were depreciated over the same period as the underlying real property (i.e., 39 years). In addition, prior law provided that qualified leasehold improvement property and qualified retail improvement property were depreciated over a 15-year period. The Act eliminates the separate definitions for qualified leasehold improvement and qualified retail improvement, and it provides for a 15-year recovery period over which the cost of certain qualified improvements is depreciated. These amendments apply to qualified improvements placed in service after December 31, 2017.
Other Business-Related Changes
Net Operating Losses
Under prior law, net operating losses (NOLs) could be carried back two years and carried forward for up to 20 years to offset taxable income. The Act repeals the two-year carryback for NOLs (except for certain farming losses), allows for an indefinite carryforward of unused NOLs and generally limits the amount of NOLs that can be deducted to 80% of taxable income. These provisions apply with respect to losses arising after December 31, 2017.
Under prior law, a taxpayer could deduct up to 50% of the amount paid or incurred for activities generally considered to be entertainment, amusement or recreation related to the active conduct of the taxpayer’s trade or business. The Act repeals that deduction. The Act also repeals the deduction for expenses associated with providing any qualified transportation fringe (such as transit passes and parking near the employer’s business premises) to employees of the taxpayer. Furthermore, the Act repeals the deduction of any expense incurred for providing transportation for commuting between the employee’s residence and place of employment, except as necessary for ensuring the safety of the employee. However, the Act still allows taxpayers to deduct 50% of the food and beverage expenses associated with operating their trade or business. These changes generally apply to amounts paid or incurred beginning on or after January 1, 2018.
Expansion of Section 179 Expensing
Generally, taxpayers must capitalize the cost of property used in a trade or business and recover the cost over time through deductions for depreciation or amortization. However, Section 179 provides favorable treatment for businesses by allowing taxpayers to immediately deduct or expense the cost of qualifying property instead of recovering such costs through depreciation deductions. Under prior law, a taxpayer could expense up to $500,000 of the cost of qualifying property placed in service for the taxable year. The $500,000 is reduced (but not below zero) to the extent that the cost of qualifying property placed in service during the taxable year exceeds $2,000,000. The Act increases the expensing limit under Section 179 to $1,000,000 and increases the phase-out threshold amount to $2,500,000. Both the $1,000,000 and $2,500,000 amounts are indexed for inflation, and the changes are effective for taxable years beginning on or after January 1, 2018.
Amounts Paid in Connection with Sexual Harassment or Abuse Cases
While businesses are generally allowed to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business, that deduction is subject to certain exceptions. For instance, fines paid to a government for a violation of law are not deductible. The Act adds a new exception by providing that amounts paid for any settlement or payout related to sexual harassment or sexual abuse and associated attorney fees are not deductible if the settlement or payment is subject to a nondisclosure agreement. This provision is effective for amounts paid or incurred after December 22, 2017.
Under prior law, patents, inventions, models, designs, secret formulas and processes were treated as capital assets. The Act modifies the definition of a capital asset such that this intellectual property, to the extent it was self-created or acquired in a carryover basis transaction, is an ordinary income asset. As a result, gain or loss from the sale or exchange of this intellectual property is treated as ordinary income or loss. This provision applies to dispositions beginning on or after January 1, 2018.