On December 22, 2017, President Trump signed into law tax reform legislation (the “Act”), which contains many substantial changes to the Internal Revenue Code (the “Code”). This Client Alert provides a brief description of selected provisions of the Act that may be of interest to health care and nonprofit organizations, in each case qualified by reference to the more complete provisions contained in the Act.
Tax Rate Reductions
Corporate Tax Rate Reduction. The centerpiece of the Act is a reduction in the highest marginal federal income tax rate applicable to “Subchapter C” corporations, from 35 percent to 21 percent. Corporate income will generally continue to be subject to a “double tax”—once at the corporate level and then again when distributed to shareholders. Prior to the Act, the effective tax rate on corporate income received by an individual, after giving effect to the double tax, was about 44 percent. With the rate reduction, it would be about 36.9 percent, which happens to be slightly below the new 37 percent highest marginal income tax rate applicable to individuals.
|Practice Tip: Be aware that this rate reduction may provide planning opportunities making Subchapter C corporations more attractive than “pass-throughs” for certain businesses. For example, if operating as a partnership or Subchapter S corporation, income is taxed when earned at up to 37 percent. If operating as a C corporation, income is taxed initially at 21 percent when earned. The second level of tax would generally not apply until the corporation distributes the income to the shareholders, which might be years after it is earned. If a subsequent sale of the business is contemplated, remaining a pass-through may generally be advisable.|
Pass-Through Tax Deduction. A companion to the corporate tax rate reduction is a new deduction for partnerships, Subchapter S corporations, and sole proprietorships (also known as “pass-through businesses”) owned by individuals. Currently, “pass-throughs” do not pay tax on their income. The income “passes through” to the owners as earned, who pay tax. The Act reduces the highest marginal individual income tax rate from 39.6 percent to 37 percent. The pass-through deduction provision is complex, but assuming a taxpayer is entitled to the full benefit of the deduction, the highest marginal effective tax rate on pass-through business income to an individual is reduced from 37 percent to 29.6 percent.
Briefly, the Act achieves the effective rate reduction by allowing a tax deduction equal to 20 percent of the taxpayer’s “qualified business income.” Subject to complex limitations and exceptions, this deduction cannot exceed the lesser of (i) (a) 50 percent of the W-2 wages paid 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 unadjusted basis, immediately after acquisition, of all qualified property (generally depreciable property), and (ii) 20 percent of the taxpayer’s taxable income. Also, the deduction would be disallowed for individuals engaged in specified service trades or businesses with taxable income in excess of $207,500 for single filers and $415,000 for joint filers. A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, 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 or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
|Practice Tip: If you utilize a corporation or a professional corporation that has not elected Subchapter S status, perform an analysis to determine whether remaining a Subchapter C corporation, or electing Subchapter S status, is advisable. Subchapter S elections filed on or before March 15, 2018, can be retroactive to January 1, 2018. Also, if you utilize a pass-through entity that has debt outstanding held by individuals, consider converting the debt to a preferred equity, which could allow the holder the pass-through tax deduction.|
Individual Tax Rate Reduction. The highest marginal federal income tax rate applicable to individuals is reduced from 39.6 percent (income over $418,400 for single filers, and $470,700 for married couples filing jointly) to 37 percent (income over $500,000 for single filers, and $600,000 for married couples filing jointly).
100 Percent Write-Off of Business Assets. The Act allows full expensing of qualified property acquired after September 27, 2017. The provision begins to phase out for property placed in service after December 31, 2022.
Interest Expense Limitation. The Act limits the deduction for net interest expense to 30 percent of adjusted taxable income, computed without regard to depreciation, amortization, or depletion. The limitation would not apply to businesses with gross receipts of $15 million or less. Disallowed interest can be carried forward.
|Practice Tip: In the case of highly leveraged acquisitions, this provision could limit the deductibility of interest. In the event that debt is held by an individual, consideration should be given to converting the debt to a preferred equity, especially if the holder would be entitled to the pass-through tax deduction discussed above.|
Section 179 Expense. The Act increases the amount of the Code Section 179 (“Election to expense certain depreciable business assets”) expense from $500,000 to $1 million. Also, the phaseout threshold is increased from $2 million to $2.5 million.
Net Operating Loss Deduction. The Act limits net operating loss carryforwards to 80 percent of the taxpayer’s taxable income.
Entertainment Expenses. The Act disallows deductions with respect to an activity generally considered to be entertainment, amusement, or recreation; membership dues with respect to any club organized for business, pleasure, recreation, or other social purposes; or a facility or portion thereof used in connection with any of the above items. In addition, the Act disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and, except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment. Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).
Amortization of Research and Experimental Expenses. Beginning after December 31, 2021, the Act requires research and experimental expenses to be capitalized and amortized straight-line over five years (15 years if the research is performed outside the United States).
Orphan Drug Credit. The orphan drug credit under Code Section 45C would be reduced from 50 percent to 25 percent of the qualified clinical testing expenses for a tax year.
Disallowance of Deduction for Certain Sexual Harassment Settlements. The Act disallows a deduction for amounts paid or incurred in settlements related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement. This provision is effective upon enactment of the Act.
Employer Credit for Paid Family and Medical Leave. The Act permits certain employers to claim a business credit for 12.5 percent of wages paid to qualifying employees while on family or medical leave if the payment rate is at least 50 percent of normal wages. The credit increases to 25 percent based on the percentage of normal wages paid during the leave. To be eligible, an employer must allow full-time employees at least two weeks annual paid family and medical leave and a pro-rata period for part-time employees.
Disallowance of Deduction for Fines and Penalties. The Act denies a deduction for amounts paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law. An exception can apply to amounts constituting restitution or paid to come into compliance with law.
Limitations on Pass-Through Losses. The Act disallows the deduction of “excess business losses” of taxpayers other than Subchapter C corporations. An “excess business loss” is the business loss plus a threshold amount, $250,000 for single filers or $500,000 for married couples filing jointly. The limitation is applied at the partner or Subchapter S corporation shareholder level.
Carried Interests. For many years, the taxation of “carried interests” has been the subject of substantial controversy. Briefly, a “carried interest” is an interest in a partnership that allows the holder, typically a service provider, a share of capital gains realized by the partnership. The gain is typically taxed as capital gain, long-term if it relates to a capital asset held more than one year, not compensation for services. The Act extends the holding period to three years for long-term capital gain treatment. This provision may also apply to the grant of a “profits interest” in certain partnerships, a common form of equity compensation to service providers.
Denial of Deduction for Excessive Employee Compensation. The Code limits the deduction for compensation with respect to “covered employees” of publicly traded companies. Current exceptions to the provision for commissions and performance- based compensation are repealed. Covered employees would include the chief executive officer, the chief financial officer, and the three highest-paid employees. Once a person is a “covered employee,” he or she would remain such.
ACA Individual Mandate. The Affordable Care Act individual mandate is repealed.
State and Local Tax Deduction. The Act caps at $10,000 the deduction for state, local, and foreign income, property, and sales taxes. This provision is particularly punitive to high tax states, such as California, Connecticut, Illinois, Maryland, New Jersey, and New York, among others.
Charitable Contributions. The Act increases the adjusted gross income limitation on cash contributions from 50 percent to 60 percent.
Medical Expense Deduction. The Act reduces the medical expense deduction floor from 10 percent to 7.5 percent of adjusted gross income.
Unrelated Business Taxable Income. For a nonprofit corporation with more than one unrelated trade or business, the Act requires that unrelated business taxable income first be computed separately with respect to each trade or business. The corporation’s unrelated business taxable income for a taxable year is the sum of the amounts (not less than zero) computed for each separate unrelated trade or business. A net operating loss deduction is allowed only with respect to a trade or business from which the loss arose. The result of the provision is that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. Also, unrelated business taxable income may now include any expenses paid or incurred by a tax-exempt organization for qualified transportation fringe benefits, a parking facility used in connection with qualified parking, or any on-premises athletic facility.
Excise Tax on Nonprofit’s Executive Compensation. The Act imposes a 20 percent excise tax on compensation in excess of $1 million paid to a nonprofit organization’s five highest-paid employees.
Excise Tax on Investment Income of Certain Universities. The Act imposes an excise tax on an “applicable educational institution” for each taxable year equal to 1.4 percent of the net investment income of the institution for the taxable year. An “applicable educational institution” is an institution that has at least 500 tuition-paying students during the preceding taxable year, is not a state college or university, and the aggregate fair market value of the assets of which at the end of the preceding taxable year (other than those assets that are used directly in carrying out the institution’s exempt purpose) is at least $500,000 per student.
Repeal of Interest Exclusion on Advance Refunding Bonds. Prior to the Act, generally, certain types of tax-exempt bonds were permitted to be issued on a tax-exempt basis to “advance refund” other tax-exempt bonds (where the refunding bond is issued more than 90 days before the refunded bonds will be redeemed). The Act repeals the exclusion from gross income of interest on bonds issued to advance refund another tax-exempt bond.