The U. S. House of Representatives' approved the Tax Cuts and Jobs Act (TCJA, H.R. 1) on November 16. The Senate Finance Committee approved its tax reform bill on November 16, which is expected to be considered by the full Senate this week. While the House and Senate bills overlap in many important respects, there are significant differences between the two bills that will need to be reconciled. President Trump has pledged to have tax reform legislation enacted prior to the end of the year.
This client alert discusses changes made by the House bill that affect U.S. businesses. A client alert discussing changes affecting individuals and families is forthcoming. The TCJA would bring the following significant changes to tax deductions available to businesses in general:
- Taxpayers could immediately expense 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). Full expensing would not be available for any trade or business that has floor plan financing indebtedness.
- Business interest deductions 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. The “thin capitalization” limitation on interest deductions in Code § 163(j) would be repealed.
- The interest deduction limitations discussed in the preceding bullet would not apply to taxpayers that paid or accrued interest on “floor plan financing indebtedness.”
- The deduction for lobbying expenses with respect to legislation before local government bodies (including Indian tribal governments) would be eliminated.
- The deduction for domestic production activities would be repealed.
- Business entertainment deductions would be disallowed or subjected to significant new limitations.
- The 80-percent dividends received deduction would be reduced to 65 percent, and the 70-percent dividends received deduction would be reduced to 50 percent.
- No immediate deduction for litigation costs advanced by an attorney to a client in contingent-fee litigation would be allowed until the contingency is resolved. This change is intended to repeal Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995), which created a split in the U. S. circuit courts of appeal with respect to such deductions.
The TCJA would bring these other significant changes affecting businesses in general:
- The like-kind exchange rules would be modified to provide that only exchanges of real estate would qualify for nonrecognition treatment under Code § 1031.
- The amount of income that taxpayers may offset with net operating loss (NOL) carryovers and carrybacks would be limited to 90 percent of the taxpayer’s taxable income. Carrybacks of NOLs would no longer be permitted (subject to a limited exception for small businesses and farms in the case of certain casualty and disaster losses).
- Taxpayers would no longer be able to rollover gain from the sale of publicly traded securities into a specialized small business investment company on a tax-free basis.
- The current rule characterizing the transfer of a patent prior to its commercial exploitation as long-term capital gain would be repealed.
- Gain on the disposition of a self-created patent, invention, model, or design (whether or not patented) or of a secret formula or process would be taxed as ordinary income rather than capital gain.
- A new three-year holding period would have to be satisfied in order for a carried interest in certain investment entities to qualify as capital gain.
- Research or experimental expenditures paid or incurred during taxable years beginning after 2023 would be required to be capitalized and amortized over a 5-year period (15 years in the case of expenditures attributable to research conducted outside the US).
- Restricted stock units would be explicitly ineligible for Code 83(b) elections.
The following would apply only to corporations or their employees:
- Corporate taxpayers would pay tax at a top corporate rate of 20% (25% in the case of personal service corporations). The corporate alternative minimum tax would be repealed.
- Most contributions to capital of a corporation would be taxable. This change would have a significant impact on businesses that receive incentives and concessions from state or local governments.
- Certain employees who receive stock options or restricted stock units as compensation for the performance of services and later exercise such options or units would be permitted to elect to defer recognition of income for up to 5 years, if the corporation’s stock is not publicly traded.
The following changes would affect multi-national businesses:
- The U.S. would move to a territorial system of taxation. This change would be back-stopped with new base erosion rules, including a new excise tax on certain payments to foreign entities.
- U.S. companies would be subject to a one time deemed repatriation tax on untaxed foreign profits. Tax would be imposed on the deemed repatriation at a rate of 14% on liquid assets and 7% on illiquid assets.
The following would apply only to individuals or small businesses:
- The amount that small businesses would be allowed to expense under Code § 179 would be increased from $500,000 to $5,000,000. The level at which the amount of Code § 179 property placed in service during the taxable year causes the allowance to be phased out would be increased from $2,000,000 to $20,000,000.
- The TCJA would increase the number of taxpayers who could use the cash method of accounting and simplify the accounting rules applicable to small businesses.
Finally, the following would apply to selected types of business:
- A new 25% rate would be established for “qualified business income” of individuals from sole proprietorships, partnerships, and S corporations. In general, all passive income and 30% of active business income would be subject to the 25% rate, though taxpayers could elect an alternative method of calculation. Owners of certain personal services businesses (e.g., businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts) would not be entitled to claim the benefit of the 25% rate.
- The rules would be repealed that provide for technical termination of a partnership if within a 12-month period, there is a sale or exchange of 50 percent or more of the total interests in partnership capital and profits. As a result, partnerships would not be required or permitted to make new tax elections following such a sale or exchange.
- The rules on conversions of certain S corporations into C corporations would be modified. These rules would apply to entities that were S corporations prior to the enactment of the TCJA, that revoke their S elections during the two-year period beginning on the enactment date, and that have the same owners on the enactment date as on the revocation date. Distributions from such a corporation would be treated as paid from its accumulated adjustments account and from its earnings and profits on a pro-rata basis. Any section 481(a) adjustment would be taken into account ratably over a 6-year period.
- Tax-exempt entities would be taxed on the value of providing their employees with transportation fringe benefits and with on-premises gyms and other athletic facilities. The funds use to pay for such benefits would be treated as unrelated business taxable income.
- New limitations would be imposed on deductions for FDIC premiums paid by insured depository institutions such as banks.
In most cases, these changes would be effective for tax years beginning after 2017.
The TCJA makes significant revisions to other areas, including changes affecting individuals, real estate, pension and employee benefits, insurance companies, tax-exempt bonds, exempt organizations, and foreign income and foreign persons.
The proposed changes in the TCJA would radically alter the taxation of businesses. Because the provisions are generally effective for periods after 2017, clients should begin to consider how these changes would affect their businesses.