Corporate Income Tax Rates
The Act permanently reduces the corporate income tax rate from 35% (the prior top corporate income tax rate) to a 21% flat rate. The Act also repeals the corporate alternative minimum tax (AMT).
Deduction Available to Owners in Pass-through Businesses
The Act allows owners of certain pass-through businesses, including partnerships, S corporations, trust and estates, sole proprietorships, real estate investment trusts (REITs), and publicly traded partnerships (PTPs), to take a deduction equal to 20% of “qualified business income” (QBI). Assuming the full 20% deduction is available to the taxpayer, the effective marginal tax rate is 29.6% with respect to those taxpayers subject to the highest individual rate. QBI includes all domestic business income except investment income (i.e., dividends, interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc.). Compensation paid by S corporations and guaranteed payments paid by partnerships are not included in QBI.
The deduction is subject to a number of complicated limits and phase-ins; it is important to note that the deduction is capped at the excess of taxable income over capital gains. In addition, the deduction is limited to the greater of (i) 50% of the taxpayer’s pro rata share of wages paid by the business, or (ii) 25% of the taxpayer’s pro rata share of the wages paid by the pass-through plus 2.5% of the unadjusted basis, immediately after acquisition, of qualified property (i.e., property subject to depreciation and used in the trade or business). This second limitation applies 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. In general, the deduction does not apply with respect to certain service businesses (e.g., accounting, law, health, financial services, etc.), except in the case of taxpayers whose taxable income does not exceed the aforementioned thresholds.
In a simplified example, we imagine that an individual has QBI of $250,000 from a partnership that paid a total of $40,000 of wages and that has no qualified property. His or her spouse has $50,000 of income. Based on the foregoing, the couple (filing jointly) has total taxable income of $300,000. In general, the deduction is the lesser of:
- 20% of QBI of $250,000 = $50,000; or
- The greater of:
- 50% of wages of $40,000 = $20,000, or
- 25% of wages of $40,000 plus 2.5% of qualified property of $0 = $10,000.
It would appear, at first blush, that the deduction should be limited to $20,000, which is the lesser of the amounts calculated above. However, in this example, the deduction will not be the lesser of because the couple (filing jointly) has total taxable income of $300,000 which is less than the threshold for applying the second limitation. As a result, the deduction is $50,000.
Bonus Depreciation and Section 179 Expensing
Prior to the Act, taxpayers could take first-year bonus depreciation equal to 50% of the adjusted basis of new “qualified property.” The Act increases bonus depreciation to 100% for both new and used “qualified property” acquired and placed in service beginning September 27, 2017 and before December 31, 2022. The accelerated recovery is reduced by 20% each year for property placed in service after December 31, 2022. In general, “qualified property” is new and used property with a recovery period of 20 years or less, certain computer software, and property used in qualified film, television and theatrical productions. A transition rule also allows businesses to elect to apply a 50% allowance instead of the 100% allowance for the taxpayer’s first taxable year ending after September 27, 2017.
In addition to the foregoing, the amount that a business is allowed to immediately expense under Code Section 179 (e.g., depreciable tangible personal property that is purchased for use in the active conduct of a trade or business, including off-the-shelf computer software and qualified real property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property)) has been increased from $510,000 to $1,000,000 and the types of real estate improvements eligible for the deduction have also been expanded (e.g., roofs, heating, air-conditioning, fire protection, etc.). The $1,000,000 is reduced (but not below zero) by the amount by which the cost of qualifying property place in service during the taxable year exceeds $2,500,000.
Interest Deduction Subject to certain exceptions, the Act limits the business interest deduction to 30% of earnings before deductions for interest, taxes, depreciation and amortization (EBITDA) for tax years beginning in 2018. For tax years beginning in 2022, the deduction is limited to 30% of earnings before deductions for interest and taxes (EBIT). This limitation does not apply to businesses with average annual gross receipts not exceeding $25,000,000 over the past three taxable years. Unused interest can be carried forward indefinitely.
Although real estate businesses are eligible to take first-year bonus depreciation equal to 100% of “qualified property,” in practice, most real estate assets (e.g., land and buildings) are not “qualified property.” As a result, unlike other industries, investors in real estate businesses are permitted to elect out of the 30% limitation. However, in exchange for the election, the real estate business will be required to use an alternative depreciation system (i.e., 40 year depreciable life for nonresidential real property (instead of 39.5 years) and 30 year depreciable life (instead of 27.5 years) for residential real property), rather than the faster depreciation periods offered under the Modified Accelerated Cost Recovery System (MACRS).
Recharacterization of Gains Associated with Carried Interests (i.e., Profits Interests)
A three-year holding period has been imposed on holders of a carried interest (i.e., profits interest) in order for them to receive long-term capital gain treatment on the sale of their interests. Previously, the holding period was one-year.
Net Operating Loss Deduction Prior to the Act, a business could carry back net operating losses (NOLs) to the two preceding years and carry them forward for up to 20 years to offset 100% of taxable income. Under the Act, the deduction for NOLs is now limited to 80% of taxable income. NOLs may not be carried back, but may be carried forward indefinitely. Importantly, existing NOLs can continue to be carried back 2 years or carried forward up to 20 years and can offset 100% of taxable income.
Like-Kind Exchanges While most types of tangible property (such as airplanes and rolling stock) were allowed non-recognition treatment under the like-kind exchange rules, the Act provides that only exchanges of real property would qualify under Code Section 1031. Non-recognition treatment will still be respected with respect to property other than real property if it was disposed of before January 1, 2018.
Entertainment and Other Employer Expenses Deductions related to entertainment, amusement or, recreation, and transportation fringe benefits have been completely eliminated. The deduction for 50% of food and beverage expenses associated with operating a trade or business would be retained. However, the Act limits deductions for the cost of food and beverages provided to workers to 50% of the cost. Beginning with tax years after December 31, 2025, this deduction will be completely eliminated.
Self-Created Intellectual Property The disposition of a self-created patent, invention, model or design, or secret formula or process will be subject to ordinary income tax treatment under the Act. Previously, the assets were included in the definition of “capital assets” under Code Section 1223(a)(3).
Denial of Deduction for Sexual Harassment Claims subject to NDA The Act denies a deduction for any settlement, payout, or attorneys’ fees with respect to sexual harassment or sexual abuse claims if the payments are subject to a nondisclosure agreement.
Qualified Opportunity Zones The Act allows for the temporary deferral of gross income for capital gains that are reinvested in qualified opportunity funds (i.e., a state created investment vehicle that invests in designated low-income communities) and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund.
Individual Rates and Deduction
Beginning in 2018, the Act reduces the maximum individual rate from 39.5% to 37%. These rate changes are set to expire January 1, 2026. In addition to these rate changes, the standard deduction has been increased from $13,000 for joint filers, and $6,500 for individuals, to $24,000, and $12,000, respectively, while the personal exemption for $4,050 has been repealed. The Act also increases the exemption (from $84,500 to $109,400 for joint filers) and threshold amounts (from $160,900 to $1,000,000 for joint filers) for individuals subject to the AMT.
Miscellaneous Itemized Deduction
The Act repeals all miscellaneous itemized deductions that were subject to the 2% floor. These include, for example, deductions for tax preparation fees, unreimbursed employee business expenses, and investment advisory fees.
Mortgage Interest Deduction
Beginning January 1, 2018, the ceiling on the mortgage interest deduction has been reduced from $1,000,000 to $750,000 for indebtedness incurred in acquiring, constructing, or improving a residence. Again, like the individual rates, this provision is scheduled to expire January 1, 2026. For mortgage indebtedness incurred before December 15, 2017, the Act permits homeowners to maintain the current $1,000,000 ceiling.
The Act also prohibits the deduction of interest on home equity indebtedness.
State and Local Taxes
The Act limits annual itemized deductions for state and local taxes (including state and local income, property, and sales taxes) to $10,000.
Medical Expense Deduction
The Act increases the deductibility of medical expenses by reducing the threshold for claiming the deduction from 10% of adjusted gross income to 7.5% for tax years 2017 and 2018.
Alimony and maintenance payments made pursuant to a divorce and separation agreement will no longer be deductible from income by the payor spouse and includible in income by the recipient spouse. In order to ensure that taxpayers have time to properly account for these changes, this new rule will apply only to divorce and separation agreements entered into after December 31, 2018.