On December 20, 2017, Congress passed a major tax package (H.R. 1) designed to cut taxes on businesses and individuals, as well as to stimulate the economy and create jobs. The tax cuts are estimated to cost nearly $1.5 trillion. Initially, the Tax Cuts and Jobs Act (TCJA) was aimed at simplification, but the changes enacted are anything but simple. The following is a look at the key provisions affecting businesses; those affecting individuals were covered in a previous CPA Journal article (“First Look at the Tax Cuts and Jobs Act of 2017: Impact on Individuals,” January 2018). All of the following provisions apply starting in 2018 unless otherwise noted. Some are permanent; others are temporary.
Tax Rate Reduction
The TCJA cuts tax rates on C corporations as well as owners of pass-through entities, although the approach differs dramatically for these entities.
Perhaps the biggest change in tax rates is the cut in the corporate tax rate from 35% to 21%, starting in 2018. Graduated tax rates have been eliminated, and the dividends received deduction has been reduced as follows [Internal Revenue Code (IRC) section 243]: the 70% deduction drops to 50%, and the 80% deduction drops to 65%.
Pass-through entities—sole proprietorships, partnerships, limited liability companies, and S corporations—are businesses that pass through income, gain, credits to their owners, who pay tax on these items on their individual 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 will be reduced starting in 2018. The seven tax rates decline from the current 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% to 10%, 12%, 22%, 24%, 32%, 35%, and 37%; the effective tax rate for some owners of pass-through entities, however, is even lower because of a new 20% deduction of “qualified business income” (IRC section 199A). This deduction does not reduce business income on an owner’s Schedule C, E, or F, or adjusted gross income; it is instead taken into account when figuring taxable income, on which the usual tax rates apply (whether or not an owner itemizes personal deductions).
Limits on the 20% deduction apply to higher-income taxpayers in certain service businesses so that owners cannot convert compensation otherwise taxed at a higher rate into business income. 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; $315,000 for joint filers). No deduction can be claimed for those with taxable income from specified service trades or businesses (including attorneys and accountants) that exceed a threshold amount.
The TCJA repeals the corporate alternative minimum tax (AMT). Owners of pass-through entities continue to face the AMT on their personal returns, but the exemption amounts have been increased.
The TCJA changes the rules for various deductions and eliminates some others, including the domestic production activities deduction (IRC section 199). The following are revisions to existing deductions:
The deduction for net interest expenses will be limited to 30% of adjusted taxable income, plus certain amounts. 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 has been increased to $1 million, an increase from $510,000 in 2017. If equipment purchases exceed $2.5 million, the dollar limit will be 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 non-residential property (e.g., roofs, heating and air conditioning, security systems).
The percentage for figuring the additional first-year depreciation allowance, called bonus depreciation, for property placed in service after September 27, 2017, has been doubled to 100% (IRC section 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 costs of qualified film, television, and live theatrical productions placed in service after September 27, 2017, as well as to certain plants bearing fruit or nuts that are planted or grafted after this date.
Limits on the 20% deduction apply to higher-income taxpayers in certain service businesses so that owners cannot convert compensation otherwise taxed at a higher rate into business income.
There are new dollar limits on the depreciation of designated “luxury automobiles,” which continue to be listed property subject to special rules on business usage and substantiation (IRC section 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, $16,000 in the second year, $9,600 in the third year, and $5,760 in the fourth and subsequent years. 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 $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 September 28, 2017, but placed in service after September 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 will be eliminated, and a single definition of qualified improvement property will apply. Such property will be 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 whether the building was in service for more than three years.
The TCJA retained the $1 million dollar limit on deducting executive compensation to “covered employees” of publicly traded companies, but it eliminated the ability to deduct performance-based executive compensation in excess of the limit; written agreements in effect November 2, 2017, and not modified thereafter are grandfathered in [IRC section 162(m)]. The definition of “covered employee” has also been modified.
The deduction for entertainment expenses has been eliminated, although the 50% deduction for business meals continues to apply. Moreover, the 50% 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 continue to offer them.
The TCJA dramatically changes how business losses can be used.
Sexual harassment settlements.
No deduction will be allowed for any payment subject to a nondisclosure agreement.
Net operating losses.
The TCJA dramatically changes how business losses can be used. The carryback has been repealed, but there continues to be a carryback for certain losses incurred in the trade or business of farming. Net operating losses (NOL) 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 90% (80% for tax years beginning after December 31, 2022) 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, the final bill included some changes to tax credits for businesses.
Family and medical leave credit.
The TCJA introduces a new tax credit for wages paid to employees while on leave (IRC section 45S). The credit, which is part of the general business credit, is 12.5% of wages paid to an employee on family or medical leave as long as these wages are at least 50% of wages normally paid to such employee. The credit amount increases if wages are higher than 50%. The credit only applies for wages paid for leave up to 12 weeks, and only runs for 2018 and 2019.
Foreign tax credit.
This credit has been modified to reflect a move toward a territorial tax system.
Cash method of accounting.
Businesses with up to $25 million in income can use the cash method of accounting, even though they are otherwise required to maintain inventory. They can treat inventory as nonincidental 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 (IRC section 1031). The TCJA provides some relief for exchanges where property has been disposed of or replacement property has been obtained by December 31, 2017.
Contributions to capital.
These amounts, which are carried on the balance sheet as equity, have generally been excludable from gross income. Contributions to capital made after December 31, 2017, however, 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; rather, they are now included in gross income.
Incentives for qualified opportunity zones.
The TCJA includes various tax incentives, including the exclusion of capital gains from the sale of an investment in a qualified opportunity fund, for qualified “opportunity zone” locations to be designated at a future date (IRC section 1400Z).
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.
Businesses are now incentivized to repatriate earnings and profits held by subsidiaries overseas through a very low tax rate (15.5% for cash assets; 8% for illiquid assets).
The Next Step: Implementation
The ball is now in the IRS’s court to provide guidance on many of the tax changes that will go into effect this year. The impact on the current filing season is unlikely to be substantial, but tax planning for 2018 and beyond is critical now.