The first step in Tax Reform was announced late last week. This is just a starting point in the process. There are some significant changes ahead but the initial changes announced are far from being finalized. The House Ways and Means committee is currently marking up the initial bill that is summarized below. The Senate will come out with its version later this week. We will compare the two plans to see what is similar in both plans which typically gives us a very good idea what will be in final legislation. It appears the legislation will be effective in 2018. So year end planning will be critical this year. Reach out to your Somerset advisor with any questions or concerns. Stay tuned as more updates will be forthcoming from us as the amendments to the legislation take place.

Changes to Corporate Tax Rates

1. Under the Act, the corporate tax rate would generally be a flat 20% 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)
2. The Act would provide that personal services corporations would be subject to a flat 25% corporate tax rate, rather than the current 35% rate, 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. If this provision is enacted, an analysis will need to be performed regarding 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.

100% Cost Recovery Deduction

1. Under the Act, instead of bonus depreciation for qualified property, taxpayers would 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 (with an additional year for certain qualified property with a longer production period).
2. Property would be eligible for this immediate expensing if it is the taxpayer’s first use, repealing the current requirement that the original use of the property begin with the taxpayer. The Act would provide that qualified property would not include any property used in a real property trade or business.

Somerset Observation: This provision will allow businesses to expense immediately practically all of its Fixed Asset additions including used property purchases for an operating business other than real estate rentals. If the real estate entity is owned by the same owner as the operating entity, the prudent approach would be to have the operating business entity buy the leasehold improvements and other related property other than the real estate itself.

Increased Code 179 Expensing

1. Under the Act, for purposes of Code Sec. 179 small business expensing, the limitation on the amount that could be expensed would be increased to $5 million (from the current $500,000), and the phase-out amount would be increased to $20 million (from the current $2 million), effective for tax years beginning after 2017 through tax years beginning before 2023.
2. Both amounts would be indexed for inflation. The definition of section 179 property would also include qualified energy efficient heating and air-conditioning property permanently, effective for property acquired and placed in service after Nov. 2, 2017.

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, it 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

1. 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 would be increased to $25 million and the requirement that such businesses satisfy the requirement for all prior years would be repealed.
2. Under current law, farm corporations and farm partnerships with a corporate partner may only use the cash method of accounting if their gross receipts do not exceed $1 million in any year. An exception allows certain family farm corporations to qualify if its gross receipts do not exceed $25 million. Under the Act, the increased $25 million threshold (above) would be extended to farm corporations and farm partnerships with a corporate partner, as well as family farm corporations (the average gross receipts test would be indexed for inflation).
3. Accounting for inventories. Under the Act, businesses with average gross receipts of $25 million or less would be permitted to use the cash method of accounting even if the business has 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). Under the cash method, the business could account for inventory as non-incidental materials and supplies. Under the Act, a business with inventories that qualifies for and uses the cash method would be able to account for its inventories using its method of accounting reflected on its financial statements or its books and records.
4. Capitalization and inclusion of certain expenses in inventory costs. Under the Act, businesses with average gross receipts of $25 million or less would 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. The Act’s exemption would apply to real and personal property acquired or manufactured by such business.
5. 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. Under the Act, the $10 million average gross receipts exception to the percentage-of-completion method would be increased to $25 million, effective for tax years beginning after 2017.  Businesses that meet the increased average gross receipts test would be allowed to use the completed-contract method (or any other permissible exempt contract method).

Somerset Observation: 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 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.

Limits on Deduction of Business Interest

1. Under the Act, every business, regardless of its form, would be subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income. The net interest expense disallowance would be determined at the tax filer level. 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. Adjusted taxable income is a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses (NOLs), and depreciation, amortization, and depletion. Any interest amounts so disallowed would be carried forward to the succeeding five tax years and would be an attribute of the business (as opposed to its owners).
2. Special rules would apply to allow a pass-through entity’s unused interest limitation for the tax year to be used by the pass-through entity’s owners and to ensure that net income from pass-through entities would not be double counted at the partner level. These provisions would not apply to real property trades or businesses.
3. 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 of 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 less than $25,000,000 in gross receipts. The use of preferred equity rather than debt financing should be considered for businesses that exceed the $25,000,000 threshold.

NOL Deduction Limited

1. Under the Act, taxpayers would be able to deduct a net operating loss (NOL) carryover or carryback only to the extent of 90% of the taxpayer’s taxable income (determined without regard to the NOL deduction). This would conform to the current AMT rule. The Act would also generally repeal all carrybacks but provide a special one-year carryback for small businesses and farms in the case of certain casualty and disaster losses. This provision generally would be effective for losses arising in tax years beginning after 2017.
2. In the case of any net operating loss, specified liability loss, excess interest loss or eligible loss, carrybacks would be permitted in a tax year beginning in 2017, as long as the NOL is not attributable to the increased expensing that would be allowed under the new law. In addition, the Act would allow NOLs arising in tax years beginning after 2017 and that are carried forward to be increased by an interest factor to preserve its value.

Somerset Observation: The bad news is that a net operating loss carryforward under the new law would be limited to 90% of regular taxable income causing some tax to be paid by a business or its owners. The good news is that an NOL now will now be increased by an interest factor to preserve its value. For taxpayers that may take several years to use up an NOL carryforward, this provision prevents the loss of a tax benefit due to the time value of money.

Like Kind Exchange Reform

1. Like-kind exchanges. Under the Act, the rule allowing the deferral of gain on like-kind exchanges would be 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.
2. Effective date. The provisions would generally be effective for transfers after 2017. A transition rule would 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 trade in such 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. For many equipment trade ins this could be a large gain due to the Section 179 and bonus depreciation taken on such equipment in prior years.

Contributions to Capital of a Business by Non-owners

1. Under the Act, the gross income of a corporation would include contributions to its capital, to the extent the amount of money and fair market value of property contributed to the corporation exceeds the fair market value of any stock that is issued in exchange for such money or property.
2. Similar rules would apply to contributions to the capital of any non-corporate entity, such as a partnership.
3. Under current law, the gross income of a corporation generally does not include contributions to its capital (i.e., transfers of money or property to the corporation by a non-shareholder such as a government entity).

Somerset Observation: This provision makes it clear that any contribution to capital of a business by a non-owner such as a government entity as an incentive to get such owner to bring the business to a particular city/state is taxable to the business/owners in 2018. Under current law, such contributions to capital were not taxable to a corporation if structured properly. Any potential deals by a corporation with a city or state should be completed as soon as possible as the new law will apply to any contribution made or transaction entered into after date of enactment of the law.

Entertainment and Other Expenses

1. Under the Act, no deduction would be allowed for entertainment, amusement or recreation activities, facilities, or membership dues relating to such activities or other social purposes. In addition, no deduction would 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).
2. The 50% limitation under current law also would 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. Further, no deduction would be allowed for reimbursed entertainment expenses paid as part of a reimbursement arrangement that involves a tax-indifferent party such as a foreign person or an entity exempt from tax.
3. 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 business, 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.

Self-created Property Not Treated as a Capital Asset

1. Under the Act, gain or loss from the disposition of a self-created patent, invention, model or design (whether or not patented), or secret formula or process would be ordinary in character. The election to treat musical compositions and copyrights in musical works as a capital asset would be repealed.
2. Effective date. The provision would be effective for dispositions of such property after 2017

Somerset Observation: This provision is a major negative tax impact to entrepreneurs and other business owners who have created an intangible of value. The tax rate differential between ordinary income versus capital gain could be almost 20%. So for every $1,000,000 of proceeds to the seller of such intangible nets $200,000 less than under current law. Let’s hope that this provision does not go as far as to impose ordinary income tax on the Goodwill and Going concern value of a business.

Repeal of Numerous Provisions

1. The deduction for local lobbying expenses, effective for amounts paid or incurred after 2017;
2. The deduction for income attributable to domestic production activities, for tax years beginning after 2017;
3. The rollover of publicly traded securities gain into specialized small business investment companies, effective for sales after 2017;
4. The special rule treating the transfer of a patent prior to its commercial exploitation as long-term capital gain, effective for dispositions after 2017;
5. The rule on the technical termination of partnerships; and
6. The deduction for certain unused business credits, effective for tax years beginning after 2017.

Somerset Observation: The above provisions create a mixed bag of negatives and positives for a taxpayer. However, the negatives significantly outweigh the positives. For example, the repeal of the production deduction is a major hit to affected taxpayers as this deduction is equal to 9% of a taxpayer’s income from such qualifying activities.

Nonqualified Deferred Compensation Changes

1. Under the Act, an employee would be taxed on compensation as soon as there is no substantial risk of forfeiture with regard to that compensation (i.e., receipt of the compensation is not subject to future performance of substantial services). A condition would not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates (nominally or otherwise) to a purpose of the compensation other than the future performance of services, regardless of whether such condition is intended to advance a purpose of the compensation or is solely intended to defer taxation of the compensation.
2. Effective date. The provision would be effective for amounts attributable to services performed after 2017. The current-law rules would continue to apply to existing non-qualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the Act’s provision.

Somerset Observation: This is a troubling provision. Many deferred compensation plan payouts occur over several years and include a non-compete aspect of the plan in order to receive multiple year payouts. It appears that starting in 2025 that even current in place plans will have to apply this provision. If all of deferred compensation is taxed in year of retirement, for example, the plan will need to require some type of payout to the employee in year one to cover all of the taxes that will be owed by the employee in year one of retirement even if payment is over several subsequent years. Hopefully this provision will be changed to say such compensation is not taxable until received if a non-compete is in place.