On December 22, 2017, the President signed into law the most sweeping federal tax legislation since 1986. The new law, commonly referred to as the Tax Cuts and Jobs Act (the “Act”), substantially changes the tax rules that affect individuals, corporations, international taxpayers, and estates and trusts. Hundreds of provisions of the Internal Revenue Code (the “Code”) have been repealed or amended, and new ones have been added. Tax simplification this is not.
The provisions of the Act that affect the taxation of commercial activities will impact business strategies for years to come. While many of the new provisions are temporary (with December 31, 2025, being the most common expiration date) and are subject to different phase-in and phase-out rules (driven largely by Congressional budget-related rules rather than tax policy), others are intended to be permanent. However, because the Act was rushed through Congress and without any meaningful input or support from the Democrats in either chamber, the longevity of its more controversial provisions may be limited.
This Tax Alert covers the most significant changes affecting the taxation of domestic businesses, including the reduction of the income tax rate for subchapter C corporations, limitations on interest deductions and net operating losses of businesses, a new limitation affecting carried interests, new rules for taxation of business income from pass-through entities (such as partnerships, limited liability companies, and subchapter S corporations), and the new 100 percent expense deduction for acquisitions of certain business property.
The New Law
1. Reduction in the Corporate Tax Rate and Repeal of Corporate Alternative Minimum Tax (Code §§ 11, 55)
Prior Law. C corporations were previously subject to a four-step graduated tax rate structure on income (earned from all sources worldwide) with the highest marginal rate set at 35 percent, as well as an alternative minimum tax (AMT) which often dampened the tax benefit that would otherwise be realized from certain deductions and credits.
The Act. The corporate income tax regime has changed substantially. Specifically:
- There is no longer a graduated marginal rate structure; instead, all corporate income is taxed at a flat 21 percent rate.
- The corporate AMT has been repealed.
- The amounts of the dividends received deductions for dividends received by a C corporation from certain other domestic C corporations have been reduced to maintain the same effective tax rate as under prior law.
The new 21 percent flat rate, lower dividends received deductions, and repeal of the corporate AMT are effective for taxable years beginning on or after January 1, 2018, are not subject to any phase-ins or phase-outs, and are intended to be permanent.
- The reduction in the corporate income tax rate is consistent with recent trends in many countries and should make more cash available for business expansion and acquisitions, dividends to shareholders, and stock buy-backs. It may also encourage U.S. businesses that have moved operations offshore to return to the United States.
- The new lower corporate rate may warrant owners of S corporations or LLCs to consider converting to C corporation status. However, in most cases the double tax on dividend distributions will probably still favor the use of pass-through entities.
- For newly formed companies, the reduction in the corporate tax rate, when combined with the exemption from capital gains tax for sales of shares of qualified small business stock held for more than five years (which is currently provided by Code Section 1202), may tip the balance in favor of using a C corporation instead of a pass-through entity in many instances.
- Importantly, the Act did not change the ability of C corporations to fully deduct state and local income and property taxes. In contrast, individual taxpayers, including owners of pass-through entities, may deduct such taxes only up to a $10,000 cap. This may increase the attractiveness of using a C corporation if the owners reside or the business is conducted in high-tax states and localities.
2. Limitation on the Interest Expense Deduction (Code § 163)
Prior Law. A business taxpayer such as a C corporation, pass-through entity, or sole proprietor generally could deduct all interest paid or accrued during its taxable year.
The Act. Under the Act, a business taxpayer’s deduction for “business interest” paid or accrued is generally now limited to the sum of:
- The amount of interest includible in the taxpayer’s gross income that is allocable to a trade or business (“business interest income”), plus
- 30 percent of the taxpayer’s adjusted taxable income for the year, computed without regard to: (i) income, gain, deductions or losses that are not allocable to a trade or business; (ii) business interest or business interest income; (iii) net operating loss deductions; (iv) deductions allowed under new Code Section 199A; or (v) deductions for depreciation, amortization or depletion that are allowable for tax years before January 1, 2022.
The amount of any disallowed interest deductions can be carried forward to the next tax year and treated as paid or accrued in that year. This limitation does not apply to taxpayers whose average annual gross receipts for the three-taxable-year period ending with the prior taxable year is equal to or less than $25 million. For partnerships and S corporations, the limitation applies at the entity level, but special rules prevent double-counting for partners or shareholders who also pay or accrue business interest.
Importantly, a trade or business does not include: (i) any electing real property trade or business, which includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business; (ii) any electing farming business; or (iii) certain utility companies.
Impact. The new limitation on the interest deduction will affect many businesses and will apply to both new and existing debt arrangements, as interest paid or accrued on existing debt is not grandfathered. Highly leveraged businesses or businesses that anticipate incurring new debt should integrate these limitations into their cash flow models as soon as possible and may want to consider alternative capital structures. That said, small businesses and real estate ventures of any size are unlikely to be affected by the new limitations.
3. Carryback and Carryforward of Net Operating Losses (Code § 172)
Prior Law. Previously, a net operating loss (NOL) generally could be carried back two years and carried forward over a 20-year period to offset taxable income in those years.
The Act. Now, the use of NOLs is subject to new limitations:
- NOL carrybacks: NOLs can no longer be carried back to prior tax years (although exceptions exist for farming businesses and property and casualty insurance companies).
- NOL carryforwards: For losses arising in taxable years after December 31, 2017, the NOL carryforward deduction is limited to 80 percent of taxable income (determined without regard to the NOL deduction) for the taxable year. However, NOL carryforwards will no longer expire after 20 years (as they did under prior law).
The new rules regarding NOLs are effective for taxable years beginning on or after January 1, 2018, are not subject to any phase-ins or phase-outs, and are intended to be permanent.
Impact. An NOL is an important tax attribute of a business. The new indefinite carryforward of NOLs aside, the Act’s limitations on the use of NOLs should be carefully considered when projecting cash flows and estimating the value of a company. The limitations may also disproportionately (and adversely) affect start-up businesses, which tend to have high NOLs in their early years.
4. Limitations on Carried Interests (New Code § 1061)
Prior Law. If certain requirements were satisfied, taxpayers who received a “profits” (or a so-called “carried”) interest in a partnership in exchange for future services generally (i) were not taxed upon receipt of the interest and (ii) could qualify for favorable long-term capital gain treatment on gains arising from (a) a disposition of such interest if held for more than a year and (b) long-term capital gains passed through to such partner by the partnership.
The Act. The Act contains a constraint on carried interests, aimed generally at hedge fund managers, by requiring the service provider to hold the interest for at least three years to obtain the preferable long-term capital gain rate. New Code Section 1061, which implements this carried interests limitation, is broadly worded and applies to businesses that raise or return capital and invest in certain “specified assets,” including stocks and other securities, commodities, derivative contracts, and real estate held for rental or investment.
The new rules regarding carried interests are effective for taxable years beginning on or after January 1, 2018, are not subject to any phase-ins or phase-outs, and are intended to be permanent.
Impact. It appears that the new rule will apply to gains passed through to a service partner from the sale of a partnership’s portfolio investments, in addition to gains related to the disposition of the partnership interest itself. The Treasury Department is tasked with issuing regulations or other guidance as is necessary or appropriate to carry out the purpose of this new provision. Given that most private equity investments are held for more than three years, the Act’s new limitations will have minimal impact on private equity carried interests. In contrast, the impact on hedge fund carried interests may be greater, to the extent that many hedge fund portfolio investments are held for less than three years. But for hedge funds that rely heavily on the 60-40 long-term/short-term capital gain treatment of regulated futures contracts and other so-called “section 1256 contracts,” the new provision does not appear to affect their carried interest holders.
5. Pass-Through Taxation and “Qualified Business Income” (New Code § 199A)
Prior Law. Income earned by sole proprietors and pass-through entities was taxable at the same rates applicable to income earned from other sources (although manufacturing firms could claim a special deduction under Code Section 199).
The Act. The new rules regarding deductions for pass-through businesses are some of the Act’s most sweeping and complex changes to existing law. The Act also repealed Code Section 199.
New Code Section 199A provides a 20 percent deduction for the non-wage portion of “qualified business income” or “QBI,” which includes business income passed through from partnerships, limited liability companies and S corporations, as well as income earned by sole proprietors and reported on Schedule C of Form 1040.
The calculation of the QBI deduction involves several steps and is subject to many special rules and exceptions. The QBI deduction is limited for owners of “specified service businesses” (SSBs), which include businesses in the fields of law, accounting, health, athletics, performing arts, actuarial services, consulting, financial services, and brokerage, as well as businesses the principal asset of which is the “reputation or skill” of one or more of its owners or employees. While the scope of some SSBs (such as health, performing arts, consulting and brokerage) may be discerned by analogy to similar definitions under Code Section 448 and the related Treasury Regulations, the scope of other SSBs is unclear.
An owner of an SSB must have taxable income of less than $315,000 ($157,500 in the case of a single filer) to claim the full benefit of the 20 percent QBI deduction. The benefit then phases down over the next $100,000 ($50,000 for single filers) of taxable income. Thus, a partner in an SSB firm who (together with his or her spouse) has taxable income exceeding $415,000 will get no benefit from the QBI deduction.
The deductible amount for a trade or business other than an SSB is also modified for taxpayers with income over $315,000 (and again, $157,500 for single filers). For this limitation, as with the limitation of income from SSBs, once the taxpayer has reached the threshold amount, the benefit phases down over the next $100,000 ($50,000 for single filers) of taxable income. These taxpayers may claim a deduction for QBI in excess of the threshold amount equal to the lesser of (i) 20 percent of QBI or (ii) the greater of (A) 50 percent of the W-2 wages with respect to the qualified trade or business or (B) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the business’s aggregate acquisition cost of certain depreciable “qualified property” (limited generally, except for depreciable real property, to property acquired within the past 10 years).
Qualified property for purposes of this test is tangible property (i) held by the taxpayer at the end of the taxable year, (ii) used in the production of QBI and (iii) for which the “depreciable period” has not expired. The “depreciable period” is the greater of (i) 10 years or (ii) the applicable recovery period under Code Section 168. Thus, for depreciable commercial real property, the applicable recovery period is 39 years.
Consider the following examples:
As these examples demonstrate, an owner of an operating business with significant wages and/or significant depreciable assets can benefit from the full 20 percent QBI on all of his or her pass-through or Schedule C income.
New Code Section 199A is effective for taxable years beginning on or after January 1, 2018, is not subject to any phase-ins or phase-outs, and is intended to be permanent.
- As a matter of tax policy, the justification for taxing some service providers at higher rates than others based purely on the type of service they provide is not clear. The Act is the first tax law in U.S. history that favors some service providers over others based upon whether they earn wages versus “pass-through” income and based upon the fields in which they work.
- Furthermore, the tax policy justification for taxing a service provider who does not trade on reputation (e.g., a hair stylist who attracts customers because of his or her low prices) at a lower rate than one who does (e.g., a hair stylist who attracts customers because of his or her “skills and reputation”) is also not clear.
- New Code Section 199A is silent regarding the extent to which a taxpayer must or may elect to aggregate related businesses (e.g., a real estate investment company and an affiliated real estate management company) into a single “business” for purposes of applying the various QBI rules and limitations. Until the IRS clarifies the aggregation rules for this purpose (through formal regulations or informal notices or other guidance), it will be difficult for affiliated companies to engage in planning in order to maximize their QBI deductions.
6. Immediate Expensing for the Costs of Certain Business Assets (Code § 168)
Prior Law. Under prior law, taxpayers were required to capitalize the cost of property acquired for use in a trade or business or held for the production of income. These acquisition costs could be recovered only through yearly deductions for depreciation.
The Act. Taxpayers may now currently deduct (or “immediately expense”) 100 percent of the cost of both new and used tangible depreciable property (other than real property). There is no longer a requirement that the taxpayer be the original user of the property acquired (as was the case for “bonus depreciation” under prior law), although an exception exists for property purchased from related parties. The Act retains the existing depreciation periods of 39 years for commercial real property and 27.5 years for residential rental property. '
his new provision applies only to assets purchased over the next five years; specifically, to be eligible for immediate expensing, the asset must be placed in service after September 27, 2017, and before January 1, 2023.
Impact. The ability to immediately expense 100 percent of the cost of tangible depreciable assets is one of the Act’s most significant changes to existing law. In the mergers and acquisitions context, this new provision is likely to increase the attractiveness of asset purchases over stock purchases and encourage large-scale capital investments over the next five years.
7. Other Relevant Changes
While many of the provisions discussed above represent fundamental changes in federal tax policy, the Act also changes a variety of other rules that may be just as significant for particular taxpayers. For example, (i) tax deferral under Code Section 1031 for exchanges of like-kind property will be permanently limited to exchanges of real property, (ii) companies (and perhaps individuals) may no longer deduct legal fees associated with certain sexual harassment lawsuits, (iii) taxpayers face new limits on deductions for amounts paid to settle certain governmental investigations regarding potential violations of law, and (iv) taxpayers with “excess losses” from business activities (that is, losses exceeding $500,000, or $250,000 for single filers) in which they “materially participate” may no longer deduct those losses against wages or portfolio income. With respect to the annual limitation on losses from business activities, the excess losses can be carried forward and treated as business losses in subsequent years, but they remain subject to the same annual cap – and, unlike passive activity losses, the losses from businesses in which the taxpayer actively participates continue to be subject to the annual limitation even after the business is disposed of.
Given the scope of the Act’s revision of prior tax law, as well as uncertainty regarding how the IRS and Treasury will interpret many of the Act’s more complex provisions, domestic businesses must carefully analyze proposed transactions and business structuring in light of the changed landscape they now face.