On December 20, the House and Senate passed H.R. 1, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (referred to herein as the “Tax Cuts and Jobs Act” or “TCJA”), enacting the most sweeping tax reform bill in 30 years. President Trump signed it into law just two days later on December 22.
As most of the provisions will go into effect for tax years beginning after December 31, 2017, this client alert highlights a number of the major changes made by the TCJA applicable to businesses as well as key international provisions. Key changes affecting individuals are covered in a separate client alert.
Corporate Income Tax Rates
The TCJA permanently reduces the corporate income tax rate to a 21% flat rate (reducing the top rate applicable to corporate income from 35%). As noted in the legislative history, this change is intended to bring the U.S. corporate tax rate into line with that of many other industrialized countries. The rates of the dividends-received deduction would be adjusted to reflect the new corporate income tax rate. It is reduced from 80% to 65% in the case of a corporation owning more than 20%.The corporate alternative minimum tax (AMT) is repealed.
Transition to Territorial Tax System
The TCJA permanently transitions the U.S. from a system that taxes U.S. corporations on their worldwide income, to a territorial system (i.e., essentially, and with some exceptions, a system that taxes U.S. income but not foreign income that taxes them on U.S. income). The transition is accomplished by allowing corporate U.S. shareholders to claim a 100% dividends-received deduction for the foreign-source portion of dividends attributable to 10%-owned foreign corporations. For purposes of calculating losses on the sale of these foreign corporations, basis would be reduced by the amount of the dividends-received deduction. An additional set of special rules are provided for S corporations.
U.S. shareholders of foreign subsidiaries will be subject to a one-time mandatory repatriation tax on previously untaxed foreign profits. The tax would be imposed for the foreign subsidiaries’ last taxable year beginning before January 1, 2018, and would be imposed at a rate of 15.5% on liquid assets and 8% on non-liquid assets. Taxpayers can elect to pay this tax over eight years.
The TCJA makes numerous additional changes to the U.S. international tax rules. These include numerous changes to the foreign tax credit and Subpart F, as well as significant new anti-abuse provisions intended to prevent U.S. base erosion and shifting of profits overseas.
For tax years beginning after December 31, 2017 and before January 1, 2026, individuals, trusts, and estates may deduct 20% of their share of the qualified business income (QBI) of a partnership, S corporation, or sole proprietorship. Because a 37% top rate applies to the income of such taxpayers, this results in an effective top rate of 29.6% on QBI.
The deduction is subject to a number of limitations. First, the deduction cannot exceed taxable income. Second, the deduction generally cannot exceed the greater of (i) 50% of the taxpayer’s share of W-2 wages of the passthrough, or (ii) the sum of 25% of the taxpayer’s share of the W-2 wages of the passthrough plus 2.5% of the unadjusted basis of property used in the qualified business activity. Third, income from specified service businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, financial services, or performing arts—but not architecture or engineering) is not eligible for the deduction. The second and third limitations, however, apply only to partners, shareholders, or sole proprietors with taxable income in excess of a threshold ($157,500 for single filers and $315,000 for joint filers), and will phase in over the next $50,000 of income ($100,000 for joint filers) above these thresholds.
The TCJA would also impose new limitations on loss deductions of taxpayers other than C corporations. Essentially, excess losses from business activities of S corporation shareholders and partners in partnerships would be disallowed to the extent that they exceeded $500,000 for joint filers or $250,000 for single filers. The disallowed portion of the loss may be carried forward.
New Limitations on Net Operating Losses
With limited exceptions, for tax years beginning after December 31, 2017 and before January 1, 2026, taxpayers would no longer be able to carryback net operating losses (NOLs). NOLs may still be carried forward 20 years, but carry forwards can be used to offset only 80% of taxable income in later years.
Business Interest Deductions
Business interest deductions for all businesses would be limited to 30% of adjusted taxable income, subject to an exception for certain small businesses with average gross receipts of $25 million or less. For tax years beginning prior to January 1, 2022, depreciation and amortization would be added back in calculating adjusted taxable income (i.e., adjusted taxable income would be based on EBITDA—Earnings Before Interest, Taxes, Depreciation, and Amortization). For tax years beginning after this date, depreciation and amortization would not be added back (i.e., adjusted taxable income would be based on EBIT), meaning that limitation on allowed deductions would be much lower beginning in 2022. The “thin capitalization” limitation on interest deductions in existing Code Section 163(j) is repealed.
Taxpayers may immediately deduct 100 percent of the cost of “qualified property” acquired and placed in service after September 27, 2017 and before January 1, 2023 (with an additional year for certain qualified property with a longer production period). Thereafter, the amount that could immediately be expensed would be phased down to 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026 (a slightly longer schedule would apply to certain property with longer production periods).
The amount that small businesses would be allowed to expense under Code Section 179 would be increased from $500,000 to $1,000,000. The level at which the amount of Code Section 179 property placed in service during the taxable year causes the allowance to be phased out would be increased to $2,500,000.
The like-kind exchange rules would be modified to provide that only exchanges of real estate would qualify for nonrecognition treatment under Code Section 1031.
Research and Development Expenditures
Many research and development expenditures would have to be capitalized and amortized over 5 years (15 years if carried on outside the US) for tax years beginning after December 31, 2021.
The TCJA would make numerous additional changes to taxation of businesses. These changes include the following:
- Increases in the deduction limits for luxury automobiles.
- Repeal of the deduction for domestic production activities under Code Section 199.
- Repeal of the provision allowing tax-free rollover of gain from publicly traded stock into a specialized small business investment company (SSBIC).
- Disallowance of employer deductions for entertainment expenses and transportation fringe benefits.
- Elimination of the exclusion from gross income for employee achievement awards.
- Repeal of the deduction for local lobbying expenditures.
- Reduction in the amount of the orphan drug credit.
- New limitations on the rehabilitation tax credit.
- Establishment of a new credit for amounts paid to certain employees on family or medical leave.
- Making taxable certain contributions to the capital of a corporation.
- Eliminating the commission- and performance-based compensation exceptions to the $1 million limitation under Code Section 162(m) on deductions for compensation paid to covered employees of publicly traded companies.
- Eliminating advance refunding bonds, but retaining favorable rules for certain private activity bonds.
- Providing that a carried interest must be held for three years to qualify for long-term capital gain treatment.
- Expanding the conditions in which taxpayers could use the cash method of accounting instead of the accrual method.
- Simplifying the accounting rules applicable to small businesses.
TCJA is the most sweeping revision of the Internal Revenue Code in over 30 years. In addition to the changes briefly detailed above, the TCJA makes numerous additional changes to the taxation of corporations, passthroughs, individuals, compensation, insurance companies, and tax-exempt entities, among others.
State and Local Tax Implications
The impact of the TCJA is not limited to changes to federal income tax liablity. These changes will also have numerous impacts on state and local income tax liability, and many questions that remain to be answered. Taxpayers should carefully consider the impact of these changes on their state and local tax liability.