On December 22, 2017, President Trump signed into law the tax reform bill commonly referred to as the “Tax Cuts and Jobs Act” (the Act), ushering in the most comprehensive tax reform legislation since 1986. The provisions in the Act will significantly impact the federal taxation of businesses, individuals, estates and trusts, and exempt organizations.
Most provisions of the Act are effective for tax years beginning after December 31, 2017. The Quarles & Brady LLP tax team has identified certain highlights of the Act below. We will continue to release more in-depth alerts as we review the final legislation and analyze its impact to our clients.
Reduction in corporate tax rate
- The corporate income tax rate is reduced from 35 percent to 21 percent, including for personal service corporations.
- The 80 percent dividends received deduction (DRD) is reduced to 65 percent and the 70 percent DRD is reduced to 50 percent.
New passthrough tax deduction
- Owners of businesses organized as passthrough entities (i.e., S corporations, partnerships, limited liability companies, and sole proprietorships) are entitled to deduct 20 percent of qualified business income, subject to certain limitations intended to prevent the conversion of wage income to qualifying business income.
- A disallowance of the deduction with respect to specified service trades or businesses is also phased in for owners with taxable income above $157,500 (for single filers) or $315,000 (for joint filers).
- A specified service trade or business means any trade or business involving the performance of service in the fields of health, law, accounting, 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.
Provisions relating to certain deductions
- Temporary 100 percent expensing:
- Taxpayers may deduct immediately the full cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100 percent “bonus depreciation” begins to phase out for property placed in service after December 31, 2022, and fully phases out for property placed in service after December 31, 2026.
- Taxpayers may elect 50 percent in lieu of 100 percent expensing for qualified property placed in service during the first tax year ending after September 27, 2017.
- The original use of the qualified property does not have to commence with the taxpayer.
- Increased 179 expensing:
- The amount that a taxpayer may expense under section 179 is increased to $1 million. The phaseout threshold is also increased to $2.5 million. Both amounts are indexed for inflation beginning after 2018.
- Eliminates the carryback of net operating losses but allows the indefinite carryforward of net operating losses which can offset up to 80 percent of taxable income.
- Repeals the domestic production activities deduction.
- Denies a deduction for the costs of settling claims related to sexual harassment or sexual abuse if the settlement is subject to a nondisclosure agreement.
- Entertainment expenses:
- No deduction is allowed for entertainment, amusement, or recreation; membership dues for a club organized for business, pleasure, recreation, or other social purposes; or a facility used in connection with any of the above.
- The deduction for 50 percent of food and beverage expenses associated with operating a trade or business generally are retained.
- Eliminates the deduction for local lobbying expenses.
Elimination of the corporate alternative minimum tax
- The corporate AMT is repealed for tax years beginning after December 31, 2017.
- Taxpayers are allowed to utilize the prior year minimum tax credit to offset their regular tax liability for any tax year, and, for tax years beginning after 2017 and before 2022, the credit is partially refundable.
New business interest expense limitation
- The Act limits the deduction for business interest expense to the sum of business interest income, plus 30 percent of the business’s adjusted taxable income (not less than zero), plus floor plan financing interest.
- Business interest not allowed as a deduction in a tax year can be carried forward indefinitely.
- Most businesses with average annual gross receipts of $25 million or less would be exempt from the limit.
- Certain businesses (an electing real property trade or business and an electing farming business) may elect out of the business expense limitation.
- The interest deduction limit would not apply to certain regulated public utilities or to certain electric cooperatives.
- The research and development credit is retained.
- The Work Opportunity Tax Credit is retained.
- The Act introduces an employer credit for paid family medical leave:
- The Act permits eligible employers (employers that allow all qualifying full-time employees at least two weeks annual paid family and medical leave and allows part-time employees a commensurate amount of leave on a pro rata basis) to claim a business credit equal to 12.5 percent of the wages paid to qualifying employees during any period in which such employees are on family and medical leave if the payment rate under the program is 50 percent of the wages normally paid to an employee.
- The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50.
- This provision is effective for wages paid in tax years beginning after December 31, 2017, but will not apply to wages paid in tax years beginning after December 31, 2019.
- There is no change to the low-income housing tax credit.
- There is no change to the new markets tax credit:
- The U.S. Treasury Department continues to be authorized to make allocations of new markets tax credits in the aggregate amount of $3.5 billion per year through 2019.
- Treasury has not yet made allocations of NMTCs for 2017, 2018, or 2019.
- Historic tax credit:
- The 20 percent credit available for certified historic structures must now be claimed ratably over a five-year period beginning in the tax year when the rehabilitated structure is placed in service instead of being claimed in its entirety in the tax year the structure is placed in service.
- The Act eliminates the 10 percent credit for pre-1936 buildings.
- The provision is generally effective for amounts paid or incurred after December 31, 2017, with a transition rule applicable to qualified rehabilitation expenditures for either a certified historic structures or pre-1936 buildings, provided the structure or building was owned or leased by the taxpayer at all times on or after January 1, 2018 through the 24-month period selected by the taxpayer (or the 60-month period selected by the taxpayer under the rule for phased rehabilitations) that is to begin not later than the end of the 180-day period beginning on the date of enactment of the Act (December 22, 2017). Note that if the taxpayer will ultimately be a partnership, it is important that an entity taxed as a partnership own the property on January 1, 2018 and not a disregarded entity.
Repeal of section 1044
- For sales after 2017, the rule permitting rollover of gains on publicly-traded securities to a specialized small business investment company is repealed.
Changes to like-kind exchange rules
- For exchanges after 2017, tax deferral will be allowed only with respect to exchanges of like-kind real property (e.g., land and buildings); exchanges of personal property will no longer be eligible for tax deferral under section 1031.
Changes to the treatment of carried interest
- For holders of profits interests in certain applicable partnerships, any long-term capital gain with respect to such interest is computed by applying a three-year (rather than one-year, under current law) holding period.
Changes to the treatment of certain intangible property
- For tax years ending after December 31, 2017, gain or loss on the sale or exchange of a patent, invention, model, design or secret formula or process held by the taxpayer that created the property or held by a taxpayer that acquired such intellectual property on a tax-free basis from the taxpayer who created the intellectual property will no longer receive capital gain treatment.
Financial statement impact of the Act
- While the Act is generally applicable for tax years beginning after 2017, certain taxpayers may be required to account for the provisions of the Act in their financial statements for the period ending December 31, 2017.
- To the extent a company has deferred tax assets or liabilities at December 31, 2017, the value of those assets or liabilities will need to be adjusted in light of the Act. These adjustments will be reflected in the income statement.
Contributions to Capital of Corporations
- For periods prior to enactment of the Act, funds provided to a corporation by a party other than a shareholder, including from a governmental entity, can in some circumstances be treated as a contribution to the capital of the corporation which is nontaxable.
- Under the Act, funds received by a corporation from a governmental entity or civic group that is not a shareholder of the recipient corporation will no longer qualify as non-taxable contributions to the capital of the corporation.
- This change will not apply to contributions made by a governmental entity pursuant to a master development plan that has been approved prior to the effective date of the Act (December 22, 2017).
Taxation of international operations
Deduction for foreign-source dividends
- The centerpiece of the Act’s international tax reform is the movement to a territorial regime.
- This is accomplished by providing for a 100 percent deduction for the foreign-source portion of dividends received from “specified 10 percent owned foreign corporations” by U.S. corporate shareholders, subject to a one-year holding period.
- A “specified 10 percent owned foreign corporation” is any foreign corporation (other than a PFIC that is not also a CFC) with respect to which any domestic corporation is a U.S. shareholder.
- The deduction for foreign-source dividends is only available to C corporations that are not RICs or REITs.
- The provision applies to distributions made after December 31, 2017.
Deemed repatriation tax on foreign earnings
- The Act imposes a one-time mandatory tax on post-1986 accumulated foreign earnings.
- The provision requires any U.S. shareholder of a specified foreign corporation to include in income its pro rata share of the accumulated post-1986 deferred foreign income of the corporation.
- Foreign earnings held in cash or cash equivalents will be taxed at 15.5 percent and foreign earnings held in illiquid assets will be taxed at 8 percent.
- The provision is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.
Repeal of indirect foreign tax credit
- The Act repeals the indirect foreign tax credit under section 902.
- No foreign tax credit or deduction will be allowed for taxes paid or accrued with respect to exempt dividends.
Subpart F modifications
- The Act modifies several provisions under subpart F, including:
- Making permanent the look-thru rule of section 954(c)(6);
- Modifying the stock attribution rules for determining CFC status;
- Modifying the definition of U.S. shareholder; and
- Eliminating the requirement that a corporation must be controlled for 30 days before subpart F inclusions apply.
Base erosion and anti-abuse tax
- Applicable taxpayers are required to pay a tax equal to the base erosion minimum tax amount for the taxable year.
- The base erosion minimum tax is effectively computed by comparing the taxpayer’s regular tax liability with 10 percent of the taxpayer’s modified taxable income. If the latter is higher, then the taxpayer owes the base erosion and anti-abuse tax.
- The provision is applicable to taxpayers which (i) are corporations other than RICs, REITs, or S corporations; (ii) have average annual gross receipts for the three year period ending with the preceding taxable year of at least $500 million; and (iii) have a “base erosion percentage” of three percent or higher.
Global intangible low-taxed income
- U.S. corporate shareholders of CFCs must include in gross income their “global intangible low-taxed income” (GILTI).
- GILTI means the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return.
- In effect, the new provision assesses a minimum tax on a U.S. multinational’s foreign earnings that exceed an amount equal to a standard rate of return on the foreign company’s assets.
- The GILTI is taxed at the full corporate tax rate of 21 percent, subject to a 50 percent deduction as well as a reduced foreign tax credit of 80 percent.
The Act’s individual tax changes are generally effective after December 31, 2017 and are scheduled to expire after December 31, 2025.
New individual income tax rates
- The Act introduces new income tax brackets and sets the rates at: 0 percent, 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.
- The dollar amounts for bracket thresholds are adjusted for inflation using the less favorable Chained Consumer Price Index for All Urban Consumers (C-CPI-U).
Increase to standard deduction
- The Act increases the standard deduction to $24,000 (for joint filers), $18,000 (for unmarried filers with at least one qualifying child), and $12,000 (for single filers).
Elimination of personal exemptions
- The Act suspends the deduction for personal exemptions.
State and local tax deductions
- Individual taxpayers may elect to deduct state and local sales, income, or property taxes up to a combined maximum amount of $10,000 per year.
- The Act attempts to prevent taxpayers from pre-paying 2018 taxes during 2017 to circumvent this limit.
- The Act reduces the mortgage interest deduction to interest on $750,000 of acquisition indebtedness ($375,000 for married individuals filing separately) for debt incurred after December 15, 2017, and eliminates the deduction for interest on “home equity indebtedness.”
- The $1 million limitation that exists under current law would remain for acquisition indebtedness incurred on or before December 15, 2017.
- The deduction will no longer be limited to interest on a taxpayer’s principal residence.
- For tax years beginning after December 31, 2025, the limitation reverts back to $1 million regardless of when the debt was incurred.
Medical expense deduction
- The Act retains the medical expense deduction.
- The deduction floor is reduced to 7.5 percent of adjusted gross income and the AMT preference is eliminated.
Additional Deduction Changes
- Repeals the miscellaneous itemized deductions subject to the 2 percent of AGI floor.
- Repeals the overall limitation on itemized deductions.
- Increases the charitable contribution limit for cash contributions from 50 percent of AGI to 60 percent of AGI.
- Repeals the deduction for alimony payments (and does not require the recipient to include alimony payment in income) for divorce decrees, separation agreements and certain modifications entered into after 2017.
Elimination of individual mandate
- The “Obamacare” individual mandate is repealed.
Enhancement of section 529 plans
- Savings plans under section 529 are now eligible to be used for elementary, secondary, and higher education.
Alternative minimum tax
- The Act increases the exemption amounts as follows: $109,400 for joint filers; $70,300 for single filers; and $54,700 for married filers filing separately.
- The exemption amount starts to be phased out at much higher income levels: $1 million for joint filers and $500,000 for single filers.
- The credit for adoption expenses is preserved.
- Child tax credit and new family tax credit:
- The child tax credit is increased to $2,000 per child.
- The Act provides a $500 nonrefundable credit for dependents other than qualifying children (generally retaining the current law definition of dependent).
- The Act increases the threshold amount where the credit begins to phase out to $400,000. This amount would not be indexed for inflation.
- The Act also indexes the maximum refundable amount ($1,400) for inflation.
- The earned income tax credit is preserved.
Estate and gift taxes
Increased exemption amount
- The federal estate and gift tax exclusion amount and the federal GST exclusion amount are increased to $10 million, subject to inflation adjustments, effective for decedents dying, gifts made, and generation-skipping transfers made after 2017 and before 2026.