Business Tax Changes Starting in 2018
Changes to Corporate Tax Rates
- Under the Tax Cuts and Jobs Act, the corporate tax rate will generally be a flat 21% rate beginning in 2018, eliminating the current graduated rates of 15% (for taxable income of $0-$50,000), 25% (for taxable income of $50,001-$75,000), 34% (for taxable income of $75,001-$10,000,000), and 35% (for taxable income over $10,000,000)
- The Act eliminates the special tax rate for personal service corporations, effective for tax years beginning after 2017. A personal service corporation is a corporation the principal activity of which is the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and such services are substantially performed by the employee-owners
Somerset Observation: This provision is a significant benefit to C-Corporation taxpayers. The reduced rate gives the company much more money with which to grow the business. This provision will require an analysis of current S-Corporation versus C-Corporation set up. Given the 2nd level of tax at the individual level upon payment of a dividend to the owner, the S-Corporation set up is still going to make S-Corporation set up very attractive despite the lower C-Corporation tax rate.
Alternative Minimum Tax Repealed
- For tax years beginning after December 31, 2017, Corporate AMT is repealed.
- For tax years beginning after 2017 and before 2022, the AMT credit is refundable and can offset regular tax liability in an amount equal to 50% (100% for tax years beginning in 2021) of the excess of the minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability. Accordingly, the full amount of the minimum tax credit will be allowed in tax years beginning before 2022.
Somerset Observation: This provision is very favorable to larger C-Corporations who want to take advantage of business credits like the Research and Development Credit that can be limited by the AMT.
This provision is favorable to Contractors who qualify to use the completed contract method of accounting. The law prior to the act required certain contractors to use the percentage of completion method for AMT purposes even though completed contract was allowed for regular tax purposes. Many contractors are thrown into the AMT due to this rule. That concern disappears under the Act.
100% Cost Recovery Deduction
- Under the Act, instead of bonus depreciation for qualified property, taxpayers will be able to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023. It is allowed for new and used property which was not the case prior to the Act.
- A transition rule would provide that, for a taxpayer’s first tax year ending after Sept. 27, 2017, the taxpayer may elect to apply a 50% allowance.
Somerset Observation: This provision will allow businesses to expense practically all of its Fixed Asset additions. Also, since the provision is effective for assets placed in service after September 27, 2017, this provision will apply favorably to taxpayers with December 31, 2017 year-ends.
Increased Code 179 Expensing
- Under the Act, for purposes of Code Sec. 179 small business expensing, the limitation on the amount that can be expensed will be increased to $1 million (from the current $500,000), and the phase-out amount will be increased to $2.5 million (from the current $2 million), effective for tax years beginning after 2017.
- Both amounts will be indexed for inflation. The definition of section 179 property will also include qualified energy efficient heating and air-conditioning, fire protection and alarm systems; and security systems.
Somerset Observation: This provision should allow most businesses that are not able to expense their fixed assets per the rule above to expense such property under this 179 provision. These expensing provisions provide great tax benefit in the year of acquisition. The only issue of concern for taxpayers is that in future years, if taxpayer cuts back on its Fixed Asset additions, then a significant tax liability could result given no depreciation to take since all Fixed Asset additions have been previously expensed in year of acquisition.
Small Business Accounting Method Reforms
- Cash method of accounting. Under current law, a corporation or partnership with a corporate partner may only use the cash method of accounting if its average gross receipts do not exceed $5 million for all prior years (including the prior tax years of any predecessor of the entity). Under the Act, the $5 million threshold for corporations and partnerships with a corporate partner will be increased to $25 million for the three prior tax-year period.
- Accounting for inventories. Under the Act, businesses with average gross receipts of $25 million or less will not be required to account for inventories under Code Sec 471, but rather would be allowed to use a method of accounting for inventories that either treats inventories as non-incidental materials and supplies, or conforms to the taxpayer’s financial accounting treatment of inventories. In contrast, under current law, the cash method can be used for certain small businesses with average gross receipts of not more than $1 million (for businesses in certain industries whose annual gross receipts do not exceed $10 million).
- Capitalization and inclusion of certain expenses in inventory costs. Under the Act, businesses with average gross receipts of $25 million or less will be fully exempt from the uniform capitalization (UNICAP) rules. The UNICAP rules generally require certain direct and indirect costs associated with real or tangible personal property manufactured by a business to be included in either inventory or capitalized into the basis of such property.
- Accounting for long-term contracts. Under current law, an exception from the requirement to use the percentage-of-completion method is provided for certain businesses with average annual gross receipts of $10 million or less in the preceding three years. The act will expand the exception for small construction contracts from the requirement to use the percentage-of-completion contract. The $10 million average gross receipts exception to the percentage-of-completion method will be increased to $25 million, effective for tax years beginning after 2017.
- Domestic Production Activities Deduction (DPAD) Repealed
Somerset Observation: Except for the DPAD, all of the above provisions are terrific changes for all taxpayers as the provisions will allow for accelerated deductions and deferral of income recognition until the cash is received or until the construction project is complete. Plus, the provision in the law that eliminated Corporate AMT is an excellent benefit under this provision in that under current law many contractors are still required to use percentage-of-completion method for AMT purposes, negating much of the benefit of completed contract accounting. Repeal of AMT takes that negative impact out of the equation. Unfortunately, the Individual AMT was not repealed, so the completed contract method will have to be analyzed carefully for flow-thru entities as individual owners of the flow thru entities still have to deal with AMT.
Limits on Deduction of Business Interest
- Under the Act, in the case of every business, the deduction for net interest expense will be limited to 30% of the adjusted taxable income of the taxpayer for the tax year. The net interest expense disallowance is determined at the tax filer level. A special rule applies to pass-through entities. For example, it would be determined at the partnership level rather than the partner level. It would be determined at the S-Corporation level rather than the owner level. For tax years beginning after Dec. 31, 2017 and before Jan 1, 2022, adjusted taxable income is a business’s taxable income computed without regard to deductions allowable for depreciation, amortization or depletion. The amount of any business interest not allowed is treated as business interest paid or accrued in the succeeding taxable year. Business interest may be carried forward indefinitely.
- Under the Act, businesses with average gross receipts of $25 million or less would be exempt from the above interest limitation rules.
Somerset Observation: This provision would hurt leveraged businesses as the interest expense on debt would be limited. There is a carryforward which prevents interest expense from being lost. However, close analysis of debt structuring will be critical to make sure that interest expense deductions are not lost. Lost deductions create an effective higher interest rate on the debt and hurts cash flow due to more tax being owed by the business or its owners if a pass-thru entity. The good news is that the rule does not apply for small businesses with $25,000,000 or less of average annual gross receipts. The use of preferred equity rather than debt financing should be considered for businesses that exceed the $25,000,000 threshold.
Real property trades or businesses can elect out of the provision if they use Alternative Depreciation System (ADS) to depreciate applicable real property used in a trade or business. For non-residential real estate, this provision is attractive if necessary as the ADS life is 40 years compared to 39 years under normal method. So minimal depreciation lost for the year but potentially significant additional interest expense can be deducted. For residential real estate, this ADS alternative needs to be analyzed more closely as the normal method is over 27.5 years compared to 30 years under ADS.
NOL Deduction Limited
Under the Act, taxpayers will be able to deduct a net operating loss (NOL) carryover only to the extent of 80% of the taxpayer’s taxable income (determined without regard to the NOL deduction). The Act generally repeals all carrybacks, but provides a special two-year carryback for small businesses and farms in the case of certain casualty and disaster losses. This provision generally will be effective for losses arising in tax years beginning after 2017. Carryovers to other years would be adjusted to take account of the NOL deduction limitation and would be able to be carried forward indefinitely.
Somerset Observation: The bad news is that a net operating loss carryforward under the new law would be limited to 80% of regular taxable income causing some tax to be paid by a business or its owners. Plus, no carryback to earlier profitable years to get a quick refund.
Like Kind Exchange Reform
- Like-kind exchanges. Under the Act, the rule allowing the deferral of gain on like-kind exchanges is modified to allow for like-kind exchanges only with respect to real property. Under current law, a special rule provides that no gain or loss is recognized to the extent that property—which includes a wide range of property from real estate to tangible personal property—held for productive use in the taxpayer’s trade or business, or property held for investment purposes, is exchanged for property of a like-kind that also is held for productive use in a trade or business or for investment.
- Effective date. The provision is generally effective for transfers after 2017. A transition rule does allow like-kind exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before Dec. 31, 2017.
Somerset Observation: This provision limits the like-kind exchange of personal property. Many taxpayers have used this provision to trade in equipment and vehicles for new such assets needed in the business without triggering any gain. If a taxpayer is considering a trade-in of a piece of equipment for another new piece of equipment, such a trade-in should be completed before the end of 2017 to prevent the gain recognition for the value of the trade-in that is in excess of its tax basis. The good news is that under the Act, even if gain is recognized, the 100% cost recovery deduction may allow all of the gain to be offset by the 100% deduction of the acquired property.
Recovery Period for Real Property
- Under current law, there are a number of different recovery periods for real property, including separate recovery periods for qualified leasehold improvement, qualified restaurant, and qualified retail improvement property.
- For property placed in service after Dec. 31, 2017, the Act eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and provides a general 15-year recovery period for qualified improvement property and a 20-year ADS recovery period for such property.
- The Act maintains the present law general MACRS recovery periods of 39 and 27.5 years for nonresidential real and residential property.
Entertainment and Other Expenses
- Under the Act, no deduction will be allowed for entertainment, amusement or recreation activities, facilities, or membership dues relating to such activities or other social purposes. In addition, no deduction will be allowed for transportation fringe benefits, benefits in the form of on-premises gyms and other athletic facilities, or for amenities provided to an employee that are primarily personal in nature and that involve property or services not directly related to the employer’s trade or business, except to the extent that such benefits are treated as taxable compensation to an employee (or includible in gross income of a recipient who is not an employee).
- The 50% limitation under current law also will apply only to expenses for food or beverages and to qualifying business meals under the Act provision, with no deduction allowed for other entertainment expenses.
- Effective date. The provision would be effective for amounts paid or incurred after 2017.
Somerset Observation: This provision basically takes away any deduction related to non-food or non-beverage activities of a taxpayer. For many businesses, this could be a significant tax cost as sporting event tickets, arts and cultural events, etc., would no longer be deductible under the 50% rule. If there is a renewal opportunity for such events before the end of the year, such amounts should be paid before the end of 2017 to have an argument that the deduction still applies for 2017 under the 50% rule even if some of the events paid for occur in 2018. In 2018 and beyond, amounts business spend in the community may need to be more in the form of sponsorships for name recognition that is considered advertising which is 100% deductible versus entertainment or amusement. The complicated aspect of such an argument is how is the deduction determined for such sponsorships if tickets/seats to the events are included as part of the sponsorship.
The Act imposes a 3-year holding period requirement in order for certain partnership interests received in connection with the performance of services to qualify as long term capital gain rather than ordinary income.