On December 20, the House approved H.R. 1, the "Tax Cuts and Jobs Act," the sweeping tax reform measure, by a vote of 224 to 201. The Senate had passed the measure, as revised to address some procedural complications, the night before, and the bill has since made its way to President Trump for his expected signature. This article describes key business tax changes that are made under the Act, including a reduction in the corporate tax rate to a flat 21% rate; an increase in expensing to $1 million; a temporary 100% first year qualifying business asset deduction; a 5-year write-off period for R&D expenses; a limitation on the deduction for business interest, and elimination of the domestic production activities deduction. The following is a summary of some of the implications to business taxpayers:
Changes to Corporate Tax Rates
Under the Act, effective for tax years beginning after Dec. 31, 2018, the corporate tax rate would generally be a flat 21% rate, 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).
New Deduction for Pass-Through Income
New 20% deduction. The Act would generally allow a non-corporate taxpayer who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship to deduct the lesser of: (i) the "combined qualified business income amount" of the taxpayer, or (ii) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year less net capital gain.
There are significant limitations on what qualifies as QBI and additional limitations based on the W2- wages attributable to QBI.
Thresholds and exclusions. The deduction would not apply to specified service businesses (e.g., law, health, finance but excluding engineering and architecture), except in the case of a taxpayer whose taxable income does not exceed $315,000 for married individuals filing jointly ($157,500 for other individuals), both indexed for inflation after 2018. The benefit of the deduction for service businesses would be phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals).
Temporary 100% Cost Recovery Deduction of Qualifying Business Assets
Under current law, additional first-year bonus depreciation deduction is allowed equal to 50% of the adjusted basis of qualified property acquired and placed in service before Jan. 1, 2020 (Jan. 1, 2021, for certain property with a longer production period) The 50% allowance is phased down for property placed in service after Dec. 31, 2017 (after Dec. 31, 2018 for certain property with a longer production period
The Act would permit a 100% first-year deduction for the adjusted basis of qualified property placed in service after Sept. 27, 2017, and before Jan. 21, 2023 (after Sept. 27, 2017, and before Jan. 1, 2024, for certain property with longer production periods).
In subsequent years, the first year bonus depreciation deduction would phase down, as follows:
- 80% for property placed in service after Dec. 31, 2022 and before Jan. 1, 2024.
- 60% for property placed in service after Dec. 31, 2023 and before Jan. 1, 2025.
- 40% for property placed in service after Dec. 31, 2024 and before Jan. 1, 2026.
- 20% for property placed in service after Dec. 31, 2025 and before Jan. 1, 2027.
First-year bonus depreciation would sunset after 2026.
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).
"Qualified real property." The definition of Code Sec. 179 property is expanded to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. The Act would also expand the definition of qualified real property eligible for Code Sec. 179 expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
Luxury Automobile Depreciation Limits Increased
For passenger automobiles placed in service after Dec. 31, 2017, and for which the additional first-year depreciation deduction under Code Sec. 168(k) is not claimed, the maximum amount of allowable depreciation would be: $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. These dollar limits would be indexed for inflation for passenger automobiles placed in service after 2018. For passengers autos eligible for bonus first year depreciation, the maximum first year depreciation allowance would be increased by $8,000.
The Act would also remove computer or peripheral equipment from the definition of listed property. Such property would therefore not be subject to the heightened substantiation requirements that apply to listed property.
New Farming Equipment and Machinery Is 5-Year Property
The Act shortens the cost recovery period from seven to five years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer, and is placed in service after Dec. 31, 2017.
Also, effective for property placed in service after Dec. 31, 2017, in tax years ending after that date, the Act would repeal the required use of the 150% declining balance depreciation method for property used in a farming business (i.e., for 3-, 5-, 7-, and 10-year property). The 150% declining balance method would continue to apply to any 15-year or 20-year property used in the farming business to which the straight line method does not apply, or to property for which the taxpayer elects the use of the 150% declining balance method.
Recovery Period for Real Property
For property placed in service after Dec. 31, 2017, the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property are eliminated, a general 15-year recovery period and straight-line depreciation are provided for qualified improvement property, and a 20-year ADS recovery period is provided for such property.
Thus, qualified improvement property placed in service after Dec. 31, 2017, is generally depreciable over 15 years using the straight-line method and half-year convention, without regard to whether the improvements are property subject to a lease, placed in service more than three years after the date the building was first placed in service, or made to a restaurant building. Restaurant building property placed in service after Dec. 31, 2017, that does not meet the definition of qualified improvement property, is depreciable as nonresidential real property, using the straight-line method and the mid-month convention.
Five-Year Write-off of Specified Research & Experimentation ("R&E") Expenses
For amounts paid or incurred in tax years beginning after Dec. 31, 2021, "specified R&E expenses" must be capitalized and amortized ratably over a 5-year period (15 years if conducted outside of the U.S.), beginning with the midpoint of the tax year in which the specified R&E expenses were paid or incurred.
Specified R&E expenses subject to capitalization include expenses for software development, but not expenses for land or for depreciable or depletable property used in connection with the research or experimentation (but do include the depreciation and depletion allowances of such property). Also excluded are exploration expenses incurred for ore or other minerals (including oil and gas). In the case of retired, abandoned, or disposed property with respect to which specified R&E expenses are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.
Use of this provision is treated as a change in the taxpayer's accounting method under Code Sec. 481, initiated by the taxpayer, and made with IRS's consent. For R&E expenditures paid or incurred in tax years beginning after Dec. 31, 2025, the provision is applied on a cutoff basis (so there is no adjustment under Code Sec. 481(a) for R&E paid or incurred in tax years beginning before Jan. 1, 2026).
Small Business Accounting Method Reforms
The Act provides several provisions reforming and simplifying accounting methods for small businesses:
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 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.
For tax years beginning after Dec. 31, the cash method may be used by taxpayers (other than tax shelters) that satisfy a $25 million gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Under the gross receipts test, taxpayers with annual average gross receipts that do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years are allowed to use the cash method.
The exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations are retained. Accordingly, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the method clearly reflects income.
Accounting for inventories. Under current law, while, businesses that are required to use an inventory method must generally use the accrual accounting method, the cash method can be used for certain small businesses with average gross receipts of not more than $1 million ($10 million businesses in certain industries). Under the cash method, the business could account for inventory as non-incidental materials and supplies.
For tax years beginning after Dec. 31, 2017, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Code Sec. 471, but rather may use an accounting method for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer's financial accounting treatment of inventories.
Capitalization and inclusion of certain expenses in inventory costs. Under current law, the uniform capitalization (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. A business with average annual gross receipts of $10 million or less in the preceding three years is not subject to the UNICAP rules for personal property acquired for resale. The exemption does not apply to real property (e.g., buildings) or personal property that is manufactured by the business.
For tax years beginning after Dec. 31, 2017, any producer or re-seller that meets the $25 million gross receipts test is exempted from the application of Code Sec. 263A. The exemptions from the UNICAP rules that are not based on a taxpayer's gross receipts are retained.
Accounting for long-term contracts. Under current law, an exception from the requirement to use the percentage-of-completion method (PCM) for long-term contracts is provided for construction companies with average annual gross receipts of $10 million or less in the preceding three years (i.e., they are allowed to instead deduct costs associated with construction when they are paid and recognize income when the building is completed).
For contracts entered into after Dec. 31, 2017, in tax years ending after that date, the exception for small construction contracts from the requirement to use the PCM is expanded to apply to contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.
Taxable year of inclusion. Generally for tax years beginning after Dec. 31, 2017, a taxpayer is required to recognize income no later than the tax year in which such income is taken into account as income on an applicable financial statement (AFS) or another financial statement under rules specified by IRS (subject to an exception for long-term contract income.
Limits on Deduction of Business Interest
For tax years beginning after Dec. 31, 2017, every business, regardless of its form, is generally 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 is determined at the tax filer level. However, a special rule applies to pass-through entitles, which requires the determination to be made at the entity level, for example, at the partnership level instead of the partner level.
For tax years beginning after Dec. 31, 2017 and before Jan. 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion and without the former Code Sec. 199 deduction (which is repealed effective Dec. 31, 2017).
The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Business interest may be carried forward indefinitely, subject to certain restrictions applicable to partnerships.
Exemptions. An exemption from these rules applies for taxpayers (other than tax shelters) with average annual gross receipts for the three-tax year period ending with the prior tax year that do not exceed $25 million.
Alternative Minimum Tax Repealed
For tax years beginning after Dec. 31, 2017, the corporate AMT is repealed.
For a corporation, the AMT credit is allowed to offset the regular tax liability for any tax year. For tax years beginning after 2017 and before 2022, the AMT credit is refundable 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.
Modification of Net Operating Loss Deduction (NOL)
For NOLs arising in tax years ending after Dec. 31, 2017, the two-year carryback and the special carryback provisions are repealed, but a two-year carryback applies in the case of certain losses incurred in the trade or business of farming.
For losses arising in tax years beginning after Dec. 31, 2017, the NOL deduction is limited to 80% of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation, and, except as provided below, NOLs can be carried forward indefinitely.
However, NOLs of property and casualty insurance companies can be carried back two years and carried over 20 years to offset 100% of taxable income in such years.
Like-kind Exchange Treatment Limited
Generally effective for transfers after Dec. 31, 2017, 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 that is not held primarily for sale. However, under a transition rule, the pre-Act like-kind exchange rules apply to exchanges of personal property if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before Dec. 31, 2017.
Employer's Deduction for Fringe Benefit Expenses Limited
For amounts incurred or paid after Dec. 31, 2017, deductions for entertainment expenses are disallowed, eliminating the subjective determination of whether such expenses are sufficiently business related; the current 50% limit on the deductibility of business meals is expanded to meals provided through an in-house cafeteria or otherwise on the premises of the employer; and deductions for employee transportation fringe benefits (e.g., parking and mass transit) are denied, but the exclusion from income for such benefits received by an employee is retained. In addition, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees (e.g., between the employee's home and the workplace), except as provided for the safety of the employee.
For tax years beginning after Dec. 31, 2025, the Act will disallow an employer's deduction for expenses associated with meals provided for the convenience of the employer on the employer's business premises, or provided on or near the employer's business premises through an employer-operated facility that meets certain requirements.
New Credit for Employer-Paid Family and Medical Leave
For wages paid in tax years beginning after Dec. 31, 2017, but not beginning after Dec. 31, 2019, the Act allows businesses to claim a general business credit equal to 12.5% of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave (FMLA) if the rate of payment is 50% of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25%) for each percentage point by which the rate of payment exceeds 50%. All qualifying full-time employees have to be given at least two weeks of annual paid family and medical leave (all less-than-full-time qualifying employees have to be given a commensurate amount of leave on a pro rata basis).
The Act would repeal/eliminate the following:
. . . the domestic production activities deduction (DPAD) for non-corporate taxpayers, for tax years beginning after Dec. 31, 2017. The DPAD is repealed for all taxpayers, for tax years beginning after 2018.
. . . the deduction for lobbying expenses with respect to legislation before local government bodies (including Indian tribal governments), for amounts paid or incurred on or after the date of enactment.
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