On Dec. 20, 2017, Congress passed a major tax package (H.R. 1) designed to cut taxes on businesses as well as individuals, and to stimulate the economy and create jobs. The tax cuts are estimated to be nearly $1.5 trillion. Initially, the package was aimed at simplification, but the changes enacted are anything but simple. The following is a roundup of the key provisions impacting businesses. Those impacting individuals were in a previous column. All of the following provisions apply starting in 2018 unless otherwise noted. Some are permanent; others are temporary.
Tax Rate Reduction
Tax rates are cut on C corporations as well as owners of pass-through entities, although the approach to rate reduction differs dramatically for these entities.
C corporations. Perhaps the biggest change in tax rates is the cut in the corporate tax rate from 35 percent to 21 percent, starting in 2018. Graduated tax rates are eliminated. And the dividends-received deduction is reduced as follows (Code §243): the 70 percent deduction drops to 50 percent and the 80 percent deduction drops to 65 percent. The maximum corporate tax rate on net capital gain is removed. There is no special rate for personal service corporations.
Pass-through entities. Pass-through entities—sole proprietorships, partnerships, limited liability companies, and S corporations—are businesses that pass through income, gain, credits, etc. to owners who pay tax on these items on their returns. For owners who are individuals, the tax rates on business income are the same as for other types of income (e.g., wages, interest income), which are reduced starting in 2018. The seven tax rates decline from the current 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, and 39.6 percent to 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. However, the effective tax rate for some owners of pass-through entities is even lower because of a new 20 percent deduction of “qualified business income” (Code §199A). This deduction does not reduce business income on an owner’s Schedule C, E, or F or adjusted gross income; it is taken into account in figuring taxable income on which the usual tax rates apply (whether or not an owner itemizes personal deductions).
Limits on the 20 percent deduction apply to higher-income individual taxpayers in certain services businesses so that owners cannot convert compensation otherwise taxed a higher rate into business income effectively taxed at a lower rate. More specifically, there is a limitation based on W-2 wages that phases in when a taxpayer’s taxable income exceeds a threshold amount ($157,500, or $315,000 for joint filers). No Code §199 deduction can be claimed for those with taxable income from specified services trades or businesses (including attorneys and accountants) that exceeds a threshold amount.
AMT. The corporate alternative minimum tax (AMT) is repealed. Owners of pass-through entities continue to face the AMT on their personal returns, but exemption amounts have been increased.
The rules for various deductions have been changed and some, including the domestic production activities deduction (Code §199), have been eliminated. The following are revisions to existing deductions:
Interest expense. A deduction for net interest expenses of a business, as specifically defined under this rule, is generally limited to interest income plus 30 percent of adjusted taxable income. However, small businesses (those with average annual gross receipts of $25 million or less) and certain contractors and realty developers are not subject to this limitation.
Section 179 deduction. The dollar limit on first-year expensing is increased to $1 million (up from $510,000 in 2017). If equipment purchases exceed $2.5 million, the dollar limit is reduced. These dollar limits, as well as the $25,000 dollar limit on heavy SUVs, will be indexed for inflation after 2018. Property eligible to be expensed now includes depreciable tangible personal property used predominantly to furnish lodging and certain improvements to nonresidential property (e.g., roofs, heating and air conditioning, security systems).
Bonus depreciation. The percentage for figuring the additional first-year depreciation allowance, called bonus depreciation, for property placed in service after Sept. 27, 2017, is doubled to 100 percent (Code §168). This percentage continues through 2022, but declines through 2026. An additional year applies for certain property with a longer production period. The write-off can now be claimed for both new and pre-owned property; previously only new property qualified. Bonus depreciation applies to the costs of qualified film, television, and live theatrical productions placed in service after Sept. 27, 2017, as well as to certain plants bearing fruit or nuts that are planted or grafted after Sept. 27, 2017.
Listed property. So-called “luxury vehicles,” which continue to be listed property subject to special rules on business usage and substantiation, have new dollar limits on depreciation (Code §280F). For vehicles placed in service after 2017 for which bonus depreciation is not claimed, the dollar limits have increased to $10,000 for the first year the vehicle is placed in service; they will be $16,000 in the second year, $9,600 in the third year, and $5,760 in the fourth and subsequent years in the recovery period. These dollar limits will be indexed for inflation for vehicles placed in service after 2018. For vehicles eligible for bonus depreciation, the additional dollar limit remains at $8,000 (it had been scheduled to phase down in 2018). Thus, the first year limit for a vehicle placed in service in 2018 is $18,000 ($8,000 bonus depreciation plus the basic dollar limit of $10,000). Vehicles acquired before Sept. 28, 2017, but placed in service after Sept. 27, 2017, are subject to the old limits. Computers and peripheral equipment have been removed from the definition of listed property.
Recovery period for real property. Until now there have been separate definitions for qualified leasehold improvements, qualified restaurant improvements, and qualified retail improvements. Starting in 2018, the separate definitions are eliminated and a single definition of qualified improvement property applies. Such property is subject to a 15-year recovery period. This means costs can be deducted ratably over 15 years (subject to a half-year convention) without regard to whether the property is subject to a lease or that the building was in service for more than three years.
Executive compensation. The $1 million dollar limit on deducting executive compensation to “covered employees” of publicly-traded companies remains, but the ability to deduct performance-based executive compensation in excess of the limit is ended; written agreements in effect Nov. 2, 2017, and not modified thereafter are grandfathered in (Code §162(m)). The definition of “covered employee” has also been modified.”
Fringe benefits. No deduction can be claimed for entertainment expenses, although the 50 percent deduction for business meals continues to apply. What’s more, the 50 percent limit now applies to meals on employer premises (e.g., in-house cafeterias). The ability to deduct tax-free transportation fringe benefits, such as free parking and monthly transit passes, has been eliminated, although employees can still exclude these benefits from income if businesses that continue to offer them.
Sexual abuse or harassment settlements. No otherwise deductible business expense is allowed for any payment subject to a nondisclosure agreement.
Net operating losses (NOLs). There is a dramatic change in how business losses can be used. The carryback has been repealed, but there continues to be a two-year carryback for certain losses incurred in the trade or business of farming. NOLs can still be carried forward for up to 20 years. NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80 percent of taxable income determined without regard to the deduction for NOLs.
There had been proposals to repeal the work opportunity credit and the credit for plug-in electric drive motor vehicles, but these proposals were not enacted. Still, there have been some changes to tax credits for businesses:
Family and medical leave credit. There is a brand new tax credit for wages paid to employees while on leave (Code §45S). The credit, which is part of the general business credit, is 12.5 percent of wages paid to an employee on family or medical leave as long as these wages are at least 50 percent of wages normally paid to such employee. The credit amount increases as wages are higher than 50 percent. The credit only applies for wages paid for leave up to 12 weeks. The credit only runs for 2018 and 2019.
Foreign tax credit. This credit is modified to reflect a move toward a territorial tax system.
Cash method of accounting. Qualifying businesses whose average gross revenues for the three-taxable year period ending as of the preceding taxable year does not exceed $25 million in income or $25 million in the current taxable year can use the cash method of accounting, even though they are otherwise required to maintain inventory. They can treat inventory as non-incidental material and supplies.
Like-kind exchange treatment. The ability to defer gain from an exchange of like-kind property is now restricted to realty; exchanges of tangible personal property no longer qualify (Code §1031). There is some relief for exchanges where property is disposed of or replacement property is obtained by Dec. 31, 2017.
Contributions to capital. These amounts, which are carried on a balance sheet as equity, generally are excludable from gross income. However, contributions to capital made after the effective date of the new law in aid of construction or any other contribution as a customer or potential customer, or any contribution by a government entity or civic group are not treated as contributions to capital; they are included in gross income. Fortunately, the Congress did not repeal the earlier House proposal to subject contributions to capital of a corporation or partnership as includible in gross income.
Incentives for qualified opportunity zones. Various tax incentives, including exclusion of capital gains from the sale of an investment in a qualified opportunity fund, apply for certain locations to be designated (Code §1400Z).
Territorial system. There is now a dividend-exemption system for taxing a U.S. corporation on its foreign earnings of foreign subsidiaries. The exemption applies when dividends are distributed.
Repatriation. Businesses are incentivized to repatriate earnings and profits held by subsidiaries overseas by providing a very low tax rate (15.5 percent for cash assets; 8 percent for illiquid assets).
The ball is now in the IRS’s court to provide guidance on many of the tax changes that will go into effect in the New Year. The impact on the 2018 filing season is likely not substantial, but tax planning for 2018 and beyond is critical now.
Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.