At a Glance…
On December 22, 2017, President Trump signed into law H.R. 1, the “Tax Cuts and Jobs Act.” The Act, which the House and Senate both passed two days earlier, heralds the most expansive and significant tax legislation enacted in the United States since 1986. The wide-reaching legislation – which generally will apply to taxable years beginning after December 31, 2017 – permanently reduces the U.S. corporate income tax rate to 21 percent; creates a new – albeit temporary – schedule of lower individual marginal tax rates; eliminates, limits and/or modifies many corporate, pass-through and individual tax deductions, credits and expenses; dramatically expands the estate and gift tax exemptions; converts the United States to a territorial tax system with significant new barriers to moving operations and payments out of the United States; and imposes a one-time toll charge on offshore earnings, among its many changes.
All individuals, pass-through entities (such as partnerships, LLCs, and S corporations) and corporations will be affected by this new tax legislation: the timing of income recognition, the ability to claim many deductions, and the treatment of certain expenses are just some of the many, and often complex, changes that taxpayers will face starting January 1, 2018.
This Alert provides a high-level overview of the most significant changes for corporations, partnerships, taxpayers with international operations, and individual taxpayers (including changes to estate and gift taxes). The Alert also highlights some key planning opportunities available only until December 31, 2017.
Mark Your Calendars! January 1, 2018 will mark a new era in U.S. tax planning and compliance. Because of the historical nature of this legislation, Reed Smith in the coming weeks will be hosting a series of programs to explain key provisions in the new U.S. tax code, and how all taxpayers can best plan for these changes.
Most of the changes that affect individual taxpayers will sunset after 2025, at which time the tax law will revert to the law in effect December 31, 2017. This should be contrasted with the changes that affect corporations and businesses, which are permanent.
The following is a brief list of some of the changes that will be in effect during this eight-year period:
- Tax brackets have been lowered to 10, 12, 22, 24, 32, 35 and 37%.
- The standard deduction is expanded to $24,000 from $12,700 for joint filers, while the personal exemption (currently $4,050 per person) is suspended.
- The alternative minimum tax is retained, but the exemption applies to income beginning with $109,400 for joint filers in 2018; the exemption phases out at $1 million for joint filers.
- The deduction for state and local taxes is limited to $10,000; note that individuals cannot deduct prepayments of 2018 state or local taxes on their 2017 tax returns.
- The cap on the deduction for home mortgage interest is reduced from $1 million to $750,000 of mortgage debt, and the interest deduction on $100,000 of home equity loans is suspended. The cap continues to apply to both a taxpayer’s primary residence and a second home.
- All miscellaneous itemized deductions that are subject to the 2% floor, including expenses for the production or collection of income, tax preparation fees and unreimbursed employee business expenses, are suspended.
Individual Taxpayers - Wealth Transfers (Estate & Gift Taxes)
The most significant change in the new legislation is the doubling of the estate and gift tax exemption from the existing per-person exemption ($5.5 million) to $11.2 million, or $22.4 million for married couples. The new exemption amounts apply for estates of decedents dying and gifts made after December 31, 2017, but before January 1, 2026. Under the new legislation, the unified tax credit (i.e., the current tax shelter amount for gifting during one’s lifetime and at death) under section 2010(c)(3) of the Internal Revenue Code is now $10 million, and will be indexed for inflation occurring after 2011.
Unlike many of the changes that affect partnerships, individuals, and both lifetime and post-mortem wealth transfers, the provisions in the new tax law affecting corporations do not sunset on December 31, 2025. The key corporate tax provisions in the legislation include:
- Corporate Tax Rate ReductionA reduction in the corporate income tax rate to 21% effective for tax years beginning after December 31, 2017.
- Increase in Limits for Expensing under Section 179
- An increase in the limits for expensing under section 179 of the Internal Revenue Code. Specifically, corporate taxpayers may use 100% expensing for assets other than structures for five years and then, phased out over successive years, beginning January 1, 2018.
- Limitations on Deductions for Interest and Net Operating Losses
- There are new limits on deductions of net business interest. Specifically, corporate business interest deductions are now limited to 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) until December 31, 2020, and then, to 30% of EBIT (Earnings Before Interest and Tax) after January 1, 2021.
- New limits on net operating losses. Specifically, net operating loss deductions are now limited to 80% of taxable income, and net operating loss carrybacks are eliminated.
- Other Notable Changes
- New allowances for corporations to deduct a greater portion of the compensation they pay to the CEO and three of their most highly compensated employees. Specifically, the former limits on the amounts corporate taxpayers could deduct for compensation to executive employees when they earn more than $1 million annually in performance-based compensation no longer apply.
- Elimination of the domestic production activities deduction under section 199, and elimination of section 1031 like-kind exchanges (with the exception of real property).
- Corporations must amortize research and experimental costs under section 174 starting January 1, 2022.
- Repeal of the Corporate Alternative Minimum Tax
Some of the changes that affect partnerships will sunset December 31, 2025, at which time the tax law (if unchanged) will revert to the law in effect December 31, 2017. Some of the key provisions in the legislation are as follows:
- From January 1, 2018 through December 31, 2025, individuals may deduct 20% of qualified business income from a partnership, S corporation, or sole proprietorship, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. This change effectively causes an effective tax rate reduction for partnership (LLC and S-corporation) owners who, prior to January 1, 2018, pay tax on partnership income at the applicable individual rates.
- The 20% qualified business income deduction is limited for taxpayers with adjusted gross income of more than $157,500 (single filers)/$315,000 (joint filers) who earn income from service businesses; these taxpayers are also subject to additional tests based on the business’s W-2 wages. Notably, the limitation applies to partnerships that engage in specified service trades or businesses, including: accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees..
- For purposes of quantifying the 20% deduction, qualified business income will include the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business of the taxpayer. Specifically, these items must be effectively connected with the conduct of a trade or business within the United States. These items will not include: specified investment-related income, deductions, or losses; an S corporation shareholder’s reasonable compensation; guaranteed payments; or, under certain circumstances, payments to a partner who is acting in a capacity other than his or her capacity as a partner.
- In addition to the 20% deduction, the legislation provides for new rules on the amount of losses that may be carried-forward, and expands the definition of a “substantial built-in loss.”
No area of U.S. tax law will undergo as much fundamental structural change as will the system applicable to cross-border business operations, particularly those conducted by U.S. corporations, as a result of the Tax Cuts and Jobs Act. The playing field has been dramatically changed from that which has prevailed almost since the inception of the U.S. income tax. Specific changes include:
- Establishment of a Participation Exemption System for Taxation of the Foreign Income of U.S. Corporations. For tax years that begin after December 31, 2017, U.S. C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs) will be entitled to a 100% deduction for the “foreign-source portion” of dividends received from specified 10% owned foreign corporations. This is a dramatic change that will bring the U.S. system into line with that of many of its trade partners.
- Parallel rules will impact the consequences of selling or exchanging shares in foreign corporations, and will also significantly modify the U.S. foreign tax credit system.
- One-Time Toll Charge on Foreign Earnings. To facilitate the transition to the Participation Exemption system, U.S. shareholders owning at least 10% of a foreign subsidiary generally must include in income, for the subsidiary’s last tax year beginning before 2018, the shareholder’s pro rata share of the foreign subsidiary’s earnings. The portion of the earnings comprising “cash or cash equivalents” is taxed at a reduced rate of 15.5%, while any remaining earnings are taxed at a reduced rate of 8%. To alleviate the burden of this tax on “phantom income,” the tax liability is payable over a period of up to eight years.
- Some taxpayers may be able to act prior to January 1, 2108, to reduce the “cash or cash equivalents” portion of their earnings, although not their overall earnings (i.e., they may be able to subject less of their earnings to the 15.5% tax in favor of the 8% tax).
- New Rules Related to Foreign Intangibles Income. The Tax Cuts and Jobs Act will introduce a “carrot and stick” approach to encourage U.S. taxpayers to hold intangibles (the definition of which has been significantly expanded under the Act) that generate “foreign” income in the United States and not in foreign corporate subsidiaries.
- The “stick” portion of the rules imposes the potential for U.S. shareholders of such foreign corporations to suffer a deemed dividend inclusion on “global intangible low-taxed income” (GILTI) generated by such corporations.
- An additional “stick” appears in the form of significantly tighter rules applicable to would-be transfers of intangible property and other value by U.S. taxpayers to foreign affiliates. These rules will make it harder both to execute and sustain the transfer of assets outside of the United States without incurring significant U.S. taxation.
- The “carrot” aspect of the Act will allow domestic corporations to enjoy a tax rate of only 13.5% on “foreign-derived intangible income” (FDII) that they generate in tax years that begin after December 31, 2017 and before January 1, 2026. The concessionary rate will increase, but will still provide a benefit to domestic corporations for years thereafter.
- New Base Erosion Rules and Expanded Anti-Deferral Rules. The Act will introduce rules that both will make it more difficult for U.S. taxpayers to operate outside of the United States without incurring current U.S. income taxation, and that will prevent foreign taxpayers from engaging in practices that “erode” the U.S. tax base of their investments and affiliates by means of deductible payments.
- The long-standing U.S. anti-deferral or “controlled foreign corporation” rules, which seek to treat passive income generated by foreign corporate subsidiaries as includible in the gross income of the U.S. shareholders of such subsidiaries, have generally been broadened (although certain oil-related income will now be treated more liberally).
- Certain domestic corporations with average annual gross receipts of at least $500 million will be required to pay a new tax, the “base erosion anti-abuse tax” (BEAT), with respect to “base erosion payments” paid or accrued in tax years that begin after December 31, 2017, to a foreign person that is a related party of the corporate payor. This tax, which will be in addition to the new 21% corporate tax rate, will be of particular interest to foreign corporate investors into the United States.
Tax Planning Opportunities to Consider Before the End of 2017
- Consider prepaying any remaining 2017 state and local taxes on or before December 31, 2017. While the final version of the tax overhaul specifically prohibits taxpayers from taking a deduction in 2017 for prepayment of 2018 state and local income taxes, if you pay quarterly estimated taxes, you should consider making your fourth-quarter payments by December 31, 2017 (instead of the January 16, 2018, deadline), and include those taxes paid as part of your 2017 deductions. Some taxpayers, however, could lose this deduction if subject to the alternative minimum tax (“AMT”) – therefore, you should consult your tax advisor before making any prepayment.
- The elimination of many deductions and the increase in the standard deduction is expected to reduce the number of filers who will itemize deductions. If you won’t be itemizing in 2018, consider:
- Making additional mortgage payments before the end of 2017.
- Making additional charitable contributions before the end of 2017 and prepaying any outstanding pledges.
- Paying unreimbursed employee business expenses before the end of 2017, such as professional dues and subscriptions for 2018.
- Explore payment of travel and entertainment expenses (e.g., conference registrations; ticket licenses) before the end of 2017 for 2018.
- Paying all expenses for the production or collection of income (such as investment advisory fees and safety deposit box rent) before the end of 2017, to the extent these expenses are known.
- For corporations, consider the effect of the new expensing and depreciation rules on any remaining 2017 infrastructure expenses. Consult with your trusted tax advisor as to how the changes in the new tax law could affect these investments.
- All taxpayers—both individual taxpayers and entities—should consult their tax advisors regarding whether to accelerate for 2017 or defer into tax year 2018.
- For individual taxpayers, while the final tax bill retains seven tax brackets, changes have been made to the applicable rates for each of these brackets. Some taxpayers will find themselves in a lower bracket in 2018; therefore taxpayers should consider where they may fall within these brackets in 2018 and, especially to the extent that a taxpayer may have commission-based earnings or is self-employed, they should consider whether to defer such earnings until 2018. These same questions apply to entities as well—corporations and partners should consider whether income acceleration or deferral might be an effective end-of-2017 tax strategy.