The Senate has come out with its version of the 2017 Tax Reform Act. This version has some similar provisions to the House bill and some are very different. As we mentioned upon issuing the House summary last week, if a provision is in both the House bill and the Senate bill, the likelihood of passage is good.
You will see in the summaries below that we provide a “Somerset Observation” and a “House Bill Comparison .” The House is scheduled to vote on it’s bill on Thursday. The Senate will deliberate and hopefully vote on it’s bill sometime next week. There are still many differences to iron out. In order for the bill to be passed under the reconciliation procedure, the deficit aspect of the bill cannot exceed $1.5 trillion. The importance of the reconciliation procedure is that a majority vote prevails in the Senate rather than the typical 60 vote requirement.
Once both houses have passed their versions, the two bills go to the Joint Committee on Taxation to iron out the differences to create the final legislation. The Republicans are under tremendous pressure to pass the Tax reform before the end of the year. There have been comments made by the President as well as Republican members of Congress that the final legislation will be signed before the end of the year. Time will tell and we will be following it closely so stay tuned.
Business Tax Proposed Changes Starting in 2018 or Later Years
Changes to Corporate Tax Rates
- Under the Act, the corporate tax rate would generally be a flat 20% beginning in 2019, 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 of 35%, effective for tax years beginning after 2018. 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.
House Bill Comparison: The Senate Bill implements lower tax rates starting in 2019 compared to House Bill which starts in 2018.
100% Cost Recovery Deduction
- 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).
- 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 immediately practically all of its Fixed Asset additions.
House Bill Comparison: Very similar to House Bill.
Increased Code 179 Expensing
- 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 $1 million (from the current $500,000), and the phase-out amount would be increased to $2.5 million (from the current $2 million), effective for tax years beginning after 2017.
- Both amounts would be indexed for inflation. The definition of section 179 property would 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 benefits in the year of acquisition. The only issue of concern for a taxpayers is that in future years, if taxpayer cuts back on their 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.
House Bill Comparison: The Senate Bill is not nearly as generous as the House bill. The Senate bill could still prevent larger companies in growth mode from being able to take Section 179 due to excess Fixed Asset additions. The House bill phase out starts at $20,000,000 of Fixed Asset additions compared to Senate bill of $2,500,000.
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 would be increased to $15 million for the three prior tax-year period.
- 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 $25 million threshold (above) would be retained, but would use the $15 million gross receipts test. Also, the plan would expand permissible use of the cash method by farming C corporations to include any farming C corporation (and farming partnership with a C corporation partner) that meets the $15 million gross receipts test (the average gross receipts test would be indexed for inflation).
- Accounting for inventories. Under the Act, businesses with average gross receipts of $15 million or less would 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 $15 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.
- 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 would 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 would be increased to $15 million, effective for tax years beginning after 2017. Contracts within this exception would be contracts for the construction or improvement of real property that meet the increased average gross receipts test and is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract. If exception is met, then 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.
House Bill Comparison: The Senate bill is not nearly as generous as the House bill. The House bill uses 25 million in place of Senate bill of 15 million which means many more companies will qualify for the above favorable exceptions under the House bill.
Limits on Deduction of Business Interest
- Under the Act, in the case of every business, the deduction for business interest would be limited to the sum of business interest income plus 30% of the adjusted taxable income of the taxpayer for the tax year. The limitation would be determined at the taxpayer 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), any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, and the 17.4 % deduction for certain pass through income. 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.
- 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
- Under the Act, businesses with average gross receipts of $15 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 then than $15,000,000 in gross receipts. The use of preferred equity rather than debt financing should be considered for businesses that exceed the 15 million threshold.
House Bill Comparison: The Senate bill is not near as generous as the House bill. The House bill uses 25 million in place of Senate bill of 15 million which means many more companies will be subject to these interest deduction limitation rules under the Senate bill.
NOL Deduction Limited
- 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 two-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. 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 90% of regular taxable income causing some tax to be paid by a business or its owners.
House Bill Comparison: Very similar to House bill.
Like Kind Exchange Reform
- 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.
- 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.
House Bill Comparison: Very similar to House bill.
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 Senate plan would shorten the recovery period for determining the depreciation deduction with respect to nonresidential real and residential rental property to 25 years. It would also eliminate the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property, and would provide a general 10-year recovery period for qualified improvement property and a 20-year ADS recovery period for such property.
Somerset Observation: This provision is favorable for taxpayers in that it accelerates non-residential real estate depreciation from 39 years to 25 years and residential real estate depreciation from 27.5 years to 25 years.
House Bill Comparison: No such provision in the House bill.
Entertainment and Other Expenses
- 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).
- 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.
- 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.
House Bill Comparison: Very similar to House bill.
Repeal of Numerous Provisions
- The deduction for income attributable to domestic production activities, for tax years beginning after 2018;
- The deduction for certain unused business credits, effective for tax years beginning after 2017.
Somerset Observation: 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.
House Bill Comparison: The House bill repeals the domestic production activity deduction starting in 2018 while the Senate bill defers repeal until 2019.
Nonqualified Deferred Compensation Changes
- 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.
- 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 2027, 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 2026, 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 to cover all of the taxes that will be owed to the employee in year 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.
House Bill Comparison: The House bill created a late amendment that took out the “non-compete” language referenced above which was a welcome relief. Unfortunately, the Senate leaves the “non-compete” language in its bill. Let’s hope the Senate follows the House with an amendment to delete the “non-compete” language.
Elimination of Catch-up Provision for High Wage Employees
- Under the proposal, an employee may not make catch-up contributions for a year if the employee received wages of $500,000 or more for the preceding year.
- The proposal is effective for plan years and taxable years beginning after December 31, 2017.
Somerset Observation: The is a very unfavorable provision for high wage employees who are age 50 or older as it does not allow such an employee to put more retirement money away on a pre-tax basis when they are approaching retirement. For 2017 the amount is $6,000.
House Bill Comparison: There is no such provision in the House bill.