The Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law by President Donald Trump on December 22, 2017. The Act changes many provisions of the Internal Revenue Code, from individual and business provisions, to matters affecting pass-through and tax-exempt organizations. The Act is generally effective starting in 2018.
In this summary, we address the major issues that will affect our clients in the manufacturing, distribution and retail industry.
Summary of Tax Cuts and Jobs Act
I. INDIVIDUAL TAX CHANGES
Modifications to capital gain provisions. The Act generally retains present-law maximum rates on net capital gains and qualified dividends. The adjusted net capital gain of an individual, estate, or trust is taxed at maximum rates of 0%, 15%, or 20%. It retains the breakpoints that exist under pre-Act law, but indexes them for inflation using C-CPI-U. The change is effective after Dec. 31, 2017. Barring further legislation, these changes will expire after 2025.
Certain gains from partnership profits interests held in connection with performance of investment services are short-term capital gains if held for three years or less. Before the Act, gains from a profits interest in a partnership (sometimes referred to as a carried interest) typically passed through an investment partnership as long-term capital gains and, thus, were taxed in the hands of the taxpayer at more favorable rates. Thus, for the wealthiest citizens who fell into the 39.6% bracket, long-term capital gains were generally taxed at a rate of 20%.
The Act changes the tax treatment of gains from a profits interest in a partnership (carried interest) held in connection with the performance of services by providing that if one or more “applicable partnership interests” are held by a taxpayer at any time during the tax year, the excess (if any) of (1) the taxpayer’s net long-term capital gain with respect to those interests for that tax year, over (2) the taxpayer’s net long-term capital gain with respect to those interests for that tax year by substituting “three years” for “one year,” will be treated as short-term capital gain. Thus, the Act provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. If the three-year holding period is not met with respect to an applicable partnership interest held by the taxpayer, the taxpayer’s gain will be treated as short-term gain taxed at ordinary income rates. These changes are effective beginning after Dec. 31, 2017.
II. BUSINESS TAX CHANGES
Corporate tax rate drops to a flat 21%. Under current law, the corporate tax rate is graduated starting at 11% up to a top rate of 35%. The Act reduces the income tax rate for corporations to a flat 21%, beginning in 2018. Due to the change in these rates, certain businesses may want to evaluate whether converting into a corporation would offer tax advantages.
Reduction of dividends-received deduction percentages. Current law provides a corporate deduction of 80% of dividends received if the corporation owns at least 20% of the distributing corporation, and 70% otherwise. These deductions are reduced to 65% and 50%, respectively.
Corporations no longer subject to the AMT. The current AMT system applies a 20% tax rate to a C corporation’s alternative minimum tax base. This tax does not apply to “small corporations,” defined as a corporation with average annual gross receipts for the previous three tax years that do not exceed $7,500,000. The Act repeals the corporate AMT effective January 1, 2018. Unlike many other provisions of the Act, there is no “sunset” provision for the repeal of the corporate AMT.
Section 179 deduction limits increased. For tax years beginning after December 31, 2017, the annual deduction limit for Section 179 property has been increased from $500,000 to $1 million, and the limit on purchases has been increased to $2.5 million (from $2 million). These amounts are now indexed for inflation beginning in 2018. The definition of Section 179 property has been expanded to include certain tangible personal property used in furnishing lodging as well as roofs, heating, air conditioning, and ventilation systems, fire protection, alarm and security systems installed on non-residential real property that has already been placed in service.
Temporary 100% cost recovery of qualifying business assets. For qualifying business assets acquired and placed in service after September 27, 2017, and before January 1, 2023, a 100% deduction for the adjusted basis of the assets is allowed. This repeals the current 50% deduction previously scheduled to go into effect after December 31, 2017. Starting on January 1, 2023 through December 31, 2027, this temporary bonus first year depreciation rate is reduced by 20% each year (80% for 2023, 60% for 2024, etc.) until it sunsets for years after 2026.
Limits for "luxury" automobile depreciation increased. For passenger automobiles placed in service after December 31, 2017 (and for which the first-year depreciation deduction under Section 168(k) is not claimed), the maximum depreciation deduction is increased from $3,160 to $10,000 in the year in which the car is placed in service, from $5,100 to $16,000 in the second year, from $3,050 to $9,600 in the third year, and from $1,875 in the fourth and later years to $5,760. These new limits are indexed for inflation.
Deduction for business interest limited. For tax years beginning after December 31, 2017, net interest expense is generally limited to 30% of the business’s adjusted taxable income. Although this limitation is generally determined at the tax-filer level, in the case of pass-through entities, the determination is made at the entity level. For purposes of applying these limitations through January 1, 2022, adjusted taxable income is computed without regard to depreciation, amortization, or depletion deductions.
NOL deduction modified. For NOLs arising in tax years after December 31, 2017, the two-year carryback rule is repealed, other than in cases involving certain losses incurred in a farming-related trade or business. Moreover, for NOLs arising in tax years after December 31, 2017, the NOL deduction is generally limited to 80% of taxable income. NOLs may generally be carried over to future years without limitation.
Like-kind exchange treatment to be limited to real property. For transactions consummated in 2018 and later, tax-free exchange treatment under Section 1031 no longer includes personal property and is limited to real property.
Five-year write-off of specified research and experimentation (“R&E”) expenses. For amounts paid or incurred in tax years beginning after December 31, 2021, “specified R&E expenses” must be capitalized and amortized ratably over a 5-year period (15 years if conducted outside the United States), beginning with the midpoint of the tax year in which the specified expenses were paid or incurred. These expenses include, for example, expenses for software development, as well as exploration expenses incurred for ore or other minerals, including oil and gas.
Nondeductible penalties and fines. For amounts paid or incurred on or after the date of enactment of the Act, no deduction is allowed for any otherwise deductible amount paid (or incurred) to, or at the direction of, a government or specified nongovernmental entity if that payment relates to the violation of any law or the investigation by such governmental entity into the potential violation of any law. Certain exceptions may apply, but only if the taxpayer establishes that the payments are either restitution (including remediation of property) or are required to come into compliance with any law that was violated or involved in the investigation, and that are so identified in the court order or settlement agreement. Government agencies are required to report to the IRS and to the taxpayer the amount of each settlement agreement or order entered in which the aggregate amount to be paid or incurred to the government is at least $600.
“Excessive employee compensation” deduction limitation. For tax years beginning after December 31, 2017, exceptions to the $1 million deduction limitation for certain employee compensation are repealed. The applicability of the limitation is applied against the principal executive officer, the principal financial officer, and the three other highest-paid officers, as well as any employee that was considered a “covered employee” as of a tax year starting after December 31, 2016.
III. PASS-THROUGHS
New deduction for certain pass-through income. Currently, income that “passes through” a partnership, S corporation or sole proprietorship to a partner, shareholder or sole proprietor is taxed at that individual’s marginal income tax rate. The Tax Act adds a new section to the code, Section 199A, which provides a 20% deduction from individual income tax rates for “qualified business income” ("QBI") from a partnership, S corporation or sole proprietorship to non-corporate taxpayers, including trusts and estates. QBI is generally the net income from a business minus any reasonable compensation, guaranteed payments, or other payments to partners/owners that are for services other than as a partner/owner. QBI is determined on a per-business (not individual) basis.
Generally, for businesses whose owners have individual income of less than $157,500 or file jointly with income below $315,000 (the threshold amounts), the deduction is simply 20% of QBI. For owners with income above these amounts, how the deduction is treated depends on the type of business they are in. For those in a “specified service trade or business,” which includes service businesses in healthcare, law, consulting, athletics, financial services, or where the principle asset of the business is the reputation or skill of the business’s owners or employees, such owners will see their deduction begin to be reduced starting at the threshold amounts until completely phased-out (and no deduction available) for individual income of $207,500 or $415,000 for married filing jointly. The formula for determining the reduction in the deduction calculation is based on W-2 wages paid by the business and a portion of the business’s capital assets.
For businesses that are not in a specified service trade or business, the wage and capital limits also begin to apply at the threshold income amounts and apply fully at $207,500 for individuals and $415,000 for married filing jointly. However, unlike for specified service trades or businesses, the deduction is not eliminated above these amounts. This section will be effective for tax years starting after December 31, 2017 and before January 1, 2026.
IV. ACCOUNTING METHOD CHANGES
Taxable year of inclusion. Generally, for tax years beginning after December 31, 2017, a taxpayer is required to recognize income no later than the tax year in which such income is taken into account on an applicable financial statement or other financial statement under rules specified by the IRS (subject to an exception for long-term contract income under Section 460).
Cash method of accounting changes. For tax years beginning after December 31, 2017, taxpayers whose average gross receipts for the three prior tax years do not exceed $25 million (indexed for inflation for tax years beginning after December 31, 2018) may use the cash method of accounting, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Qualified personal service corporations, partnerships without C corporation partners, S corporations and other pass-through entities may use the cash method of accounting without regard to whether they meet the gross receipts test, so long as the use of the method clearly reflects income.
Acounting inventories modified. For tax years beginning after December 31, 2017, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Section 471, but may instead 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 certian expenses in inventory costs. The Act expands the gross receipts exemption from the uniform capitalization ("UNICAP") rules by providing that, for tax years beginning after December 31, 2017, any producer or re-seller that meets the $25 million gross receipts test (up from $10 million under current law) is exempted from the application of Section 263A. Exemptions not based on a taxpayer’s gross receipts are retained.
Accounting for long-term contracts. Under current law, construction companies with average annual gross receipts of $10 million or less in the preceding three years are exempted from the requirement to use the percentage-of-completion (“PCM”) method. The Act expands that exemption by providing that, for contracts entered into after December 31, 2017 in tax years ending after that date, use of the PCM is not required for contracts for the construction or improvement of real property if the contract (1) is expected (at the time it is entered into) to be completed within two years of its commencement; 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.
Exclusions from contributions to capital. Under current law, if property is contributed to a corporation by someone other than a shareholder as such, the basis of the property is zero. If the contribution consists of money, the corporation must reduce the basis of any property acquired with that money within the following 12-month period, and must then reduce the basis of other property held by the corporation.
The Act amends Section 118 to provide that, effective for contributions made after the date of enactment, the term “contributions to capital” does not include (1) any contribution in aid of construction or any other contribution as a customer or potential customer; and (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
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