Overview of Key Changes to Business Taxation Under the Tax Cuts and Jobs Act
Two of the most visible features of the Tax Cuts and Jobs Act, now passed by Congress and expected to be quickly signed into law by President Donald Trump, are the large reduction in the statutory corporate rate (from 35 to 21 percent), and the elimination of the corporate Alternative Minimum Tax. Both of those changes become effective on January 1, 2018.
However, there are a number of other – and less well-reported – aspects of this new tax regime that will affect business owners and leaders starting next year. Here’s a quick overview of the main changes:
Accounting. The tax cut legislation contains three main shifts from current accounting practices. These include:
- New allowances for cash accounting. New rules will allow businesses with $25 million or less in average gross receipts in the last three tax years (including farmers organized as C corporations or in partnership with a C corporation) to use the cash accounting method. Moving forward, the $25 million benchmark will be indexed for inflation. Meanwhile, the law will continue to allow most non-C corporation business entities to use cash accounting, rather than the accrual method.
- Eased inventory accounting. Starting in 2018, business entities with $25 million or less in gross receipts are exempted from having to apply Section 471 General Rule for Inventories. The change allows those businesses to account for inventories as non-incidental materials or supplies, or conform to the organization’s financial accounting treatment of inventories.
- Simplified capitalization rules. In another win for smaller businesses, companies with $25 million or less in gross receipts are exempted from Section 263A Capitalization and Inclusion in Inventory Costs of Certain Expenses. This eases the burden on many smaller firms to uniformly capitalize certain direct and indirect costs associated with a real or tangible personal property. Current exemptions for many smaller businesses remain in place.
Compensation. Under current law, Section 162(m) Deductibility of Executive Compensation limits how much compensation expense a public company can deduct on pay to a company’s CEO and top four other highest paid officers. The new tax law changes the definition of covered employees to include both the chief executive officer and chief financial officer, while reducing the pool of other highest paid officers from four to three. Unlike current law, commissions and performance-based compensation will be included for deductibility purposes for covered employees.
Credits. There are three significant changes to business credits that are included in the final tax legislation. First, the so-called “orphan drug credit,” which currently allows drug manufacturers to write off 50 percent of clinical testing expenses for medications designed to treat rare diseases or conditions, is reduced to 25 percent starting in 2018. For companies engaged in historic restoration work, the new tax rules remove a 10 percent credit for rehabilitating pre-1936 buildings and replace it with a 20 percent credit for work on historic structures that cannot be claimed up-front, but spread over a five-year period. And, in both the 2018 and 2019 tax years, certain eligible employers can claim a 12.5 percent credit on wages paid to employees taking time off under the Family and Medical Leave Act (FMLA), provided that the wages paid are at least half of normal compensation.
Depreciation. The new tax regime extends bonus depreciation first enabled under Section 168k Additional First Year Depreciation, allowing companies to immediately deduct the full cost of the eligible property when placed into service. The full deduction will extend into 2022, after which it will be reduced by 20 percent each year through 2026. In addition, the available deduction under Section 179 Election to Expense Certain Depreciable Business Assets will increase to $1 million next year, with a phaseout limit raised to $2.5 million. Depreciation limits for business use of luxury automobiles have been also been increased in the new tax law, from the current cap of $2,560 to $10,000 in the first year the vehicle is placed into service.
Expensing and deductions. The new tax law makes a number of changes to current rules in this area. Examples include:
Carried interest. In one of the most contentious debates on tax law, the final legislation continues the tax treatment of carried interest at the capital gains rate, provided that the investment has been held for at least three years. If the investment is held for a shorter time period, it will be taxed as ordinary income.
- Business interest deductions. Deductions for interest paid on business expenses will now be capped at the sum of business interest income, 30 percent of adjusted taxable income, and the company’s floor plan financing interest for a given tax year. However, businesses with $25 million or less in gross receipts are exempt from this limitation.
- Domestic production deductions. The new tax law repeals Section 199 Domestic Production Activities Deduction, effective after the current tax year for all filers except C corporations (where the deduction ends after the 2018 tax year).
- Entertainment expenses. Beginning in 2018, companies will no longer be able to deduct “entertainment, amusement or recreation” activities, dues for memberships in “any club organized for business, pleasure, recreation or other social purposes,” or the use of facilities connected to those items.
- Like-kind exchanges. For qualifying exchanges completed after December 31, 2017, the new law will limit Section 1031 like-kind transactions to exchanges of real property not primarily held for sale.
- Meals. As a general rule, business operators retain the ability to deduct 50 percent of food and beverage expenses, provided that those expenses are related to operating their trade or business. In addition, the new tax regime extends this deduction to employers that offer food and beverages via an eating facility, provided that the service is considered a de minimis fringe benefit for employees. This deduction is effective beginning in 2018, and ending December 31, 2025.
- Net operating losses. Deductions for net operating losses will be capped at 80 percent under the new tax legislation, though property/casualty insurance carriers are exempt from this limitation. Companies will be able to carry net operating losses forward indefinitely.
International Provisions
- Implementation of Territorial Tax System. The key international tax feature of the Bill is the implementation of a territorial tax system whereby foreign corporate earnings (not related to low taxed intangibles) will be exempt from U.S. tax. The Bill authorizes the Treasury to issue regulations implementing the Bill, but as it stands, the U.S. tax exemption for foreign earnings will be applied via a 100% dividend received deduction (DRD) on distributions from a 10 percent owned foreign corporate subsidiary to a U.S. parent company. There is a 6 month holding requirement and no foreign tax credit or deduction will be allowed for any taxes (including withholding taxes) paid or accrued with respect to a dividend that qualifies for the DRD. The provision applies to distributions made after December 31, 2017.
- Implementation of Territorial Tax System. The key international tax feature of the Bill is the implementation of a territorial tax system whereby foreign corporate earnings (not related to low taxed intangibles) will be exempt from U.S. tax. The Bill authorizes the Treasury to issue regulations implementing the Bill, but as it stands, the U.S. tax exemption for foreign earnings will be applied via a 100% dividend received deduction (DRD) on distributions from a 10 percent owned foreign corporate subsidiary to a U.S. parent company. There is a 6 month holding requirement and no foreign tax credit or deduction will be allowed for any taxes (including withholding taxes) paid or accrued with respect to a dividend that qualifies for the DRD. The provision applies to distributions made after December 31, 2017.
For more details on domestic or international tax issues, contact our tax services team.
