This is a summary of some of the changes to federal tax law that have been made by the Tax Cuts and Jobs Act, passed in December of 2017. These changes are effective for tax years beginning in 2018 unless otherwise noted.
Corporate Tax Rates Have Been Reduced. The corporate income tax rate is now set at a flat 21%. Previously, rates were graduated across four income brackets.
Dividends Received Deduction Has Been Reduced. This deduction is available to corporations that receive dividends from other corporations. Corporations that own 20% or more of a company that pays them dividends may now deduct only 65% of those dividends, reduced from the previous 80%. Corporations that own less than 20% of the dividend payor will see their DRD shrink from 70% to 50%.
Corporate AMT Repealed. The Alternative Minimum Tax, as it applies to corporations, has been repealed.
Alternative Minimum Tax Credit. The elimination of the corporate AMT notwithstanding, the corporate AMT credit remains. For tax years beginning after 2017 and before 2022, the credit is refundable is an amount equal to 50% of the excess of the AMT credit for the year over the credit allowable for the year against regular tax liability. Hence, the full amount of the credit will be available in tax years beginning before 2022.
Modification of the NOL Deduction. Net Operating Losses arising in tax years ending after 2017 may only be carried forward, no longer back. Nonetheless, a two-year carryback for certain farming losses is allowed. NOLs may now be carried forward indefinitely, whereas they formerly expired after 20 years. This can be taken into account as a useful tax planning tool, especially in connection with indefinitely carried-forward deferred tax liabilities, such as amortization of goodwill. For losses incurred after 2017, the NOL deduction is limited to 80% of taxable income, determined without regard to the deduction. NOL carryovers are adjusted to take the 80% limitation into account.
New Limitation on Business Interest Deduction. Every business, regardless of its form (corporation, LLC, etc), is limited to a deduction for business interest equal to 30% of its adjusted taxable income. For pass-through entities, such as partnerships and S-corporations, the limit determination is made at the entity level. Adjusted taxable income is computed without regard to the repealed domestic production activities deduction and, for tax years beginning after 2017 and before 2022, without regard for deductions for depreciation, amortization, or depletion. Any business interest disallowed under this rule is carried into the following year, and, generally, may be carried forward indefinitely. The limitation does not apply to taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three-year period ending with the prior tax year. Real property trades or businesses can opt out of the rule by electing to use the alternative depreciation system for real property used in their trades or businesses. Partnerships are affected by additional rules.
Domestic Production Activities Deduction is Repealed. The DPAD previously allowed taxpayers 9% (or, in the cases of certain oil and gas activities, 6%) of the lesser of the taxpayer’s (a) qualified production activities income (QPAI) or (b) taxable income for the year, limited to 50% of the W-2 wages paid by the taxpayer for the year. QPAI was, under the former rules, the taxpayer’s receipts, minus expenses allocable to the receipts, from: i) property manufactured, produced, grown, or extracted within the United States; ii) qualified film productions; iii) production of electricity, natural gas, or potable water; iv) construction activities performed in the U.S.; and v) certain engineering or architectural services.
New Business Expense and Fringe Benefit Rules. The new law eliminates the 50% deduction for business entertainment expenses. The previous law’s 50% limit on deductible business meals is now expanded to include meals purchased from an in-house cafeteria or other food service establishment on the employer’s business premises. Also, the deduction for transportation fringe benefits (such as parking and public transportation subsidies) is now eliminated. Note, however, such subsides remain excluded from income for employees. On the other hand, reimbursements to employees for bicycle commuting are deductible by the employer but not excludible from income by the employee. No deduction is allowed for transportation expenses that are the equivalent of commuting for employees, except as may be provided for the safety of the affected employees.
Penalties and Fines. Under prior law, deductions were not allowed for fines and penalties paid to a government for the violation of any law. Now, the tax law provides that no deduction is allowed for any otherwise deductible amount paid or incurred by suit, agreement, or otherwise to, or at the direction of a government or specified nongovernmental entity in relation to the violation of any law or investigation or inquiry by the government or entity into potential violations of any law. There is an exception for any payment the taxpayer establishes as either restitution (including property remediation), or an amount required to establish compliance with any law that was violated or involved in the investigation or inquiry that is identified in the court order or settlement agreement as such a payment. There is also an exception for amounts paid or incurred as taxes due.
Sexual Harassment. The new law, effective for amounts paid or incurred after December 22, 2017 provides that no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement.
Lobbying Expenses. The law now disallows deductions for lobbying expenses paid or incurred after the date of enactment with respect to lobbying expenses related to legislation before local government bodies, including Indian tribal governments. Previously, such expenses were deductible.
Family and Medical Leave Credit. A new general business credit is available to eligible employers for tax years beginning in 2018 and 2019. The credit is equal to 12.5% of wages such employers pay to qualifying employees on family and medical leave if the rate of payment is 50% of wages normally paid to that employee. The credit increases by .25%, up to a maximum of 25% for each percentage point by which the payment rate exceeds 50% of regular wages. For this purpose, the maximum leave that may be taken into account for any employee for any year is 12 weeks. Eligible employers are those with with a written policy in place allowing a qualifying full-time employee at least two weeks of paid family and medical leave a year, and employees who are less than full time a prorated amount of leave. A qualifying employee is one that has been employed by the employer for one year or more and who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.
Qualified Rehabilitation Credit. The TCJA repeals the 10% credit for qualified rehabilitation expenditures for a building that was first placed in service before 1936 and modifies the 20% credit for qualified rehabilitation expenditures for a certified historic structure. The 20% credit is available during the five-year period starting with the year the building was placed in service in an amount equal to the ratable share for that year. This is 20% of the qualified rehabilitation expenditures for the building, as allocated ratably to each year in the five-year period. It is intended that the sum of the ratable shares for the five years not exceed 100% of the credit for qualified rehabilitation expenditures for the building. The repeal of the 10% credit and modification of the 20% credit takes effect starting in 2018, subject to a transition rule for certain buildings owned or leased at all times after 2017.
Orphan Drug Credit Reduced and Modified. The tax law now reduces and modifies the business tax credit for qualified clinical testing expenses for certain drugs for rarer diseases or conditions, often known as “orphan” drugs. The credit was equal to 50% of qualified clinical testing expenses, and is now equal to 25% of such expenses, beginning after 2017. Qualified Clinical Testing Expenses are costs incurred to test an orphan drug after it has been approved by the FDA for human testing but before it has been approved for sale. Amounts used in calculating this credit are excluded from the computation of the separate research credit. The law now modifies the credit by allowing a taxpayer to elect to take a reduced orphan drug credit in lieu of reducing otherwise allowable deductions.
Increased Code Section 179 Expensing. The new tax law increases the maximum amount that may be expensed under Code Section 179 to $1 million. If the taxpayer places more than $2.5 million of Section 179 property into service during the year, the $1 million limitation is reduced by the excess over $2.5 million. Both the $1 million and the $2.5 million amounts are indexed for inflation after 2018. The expense election has also been expanded to cover (a) certain depreciable, tangible personal property used mostly to furnish lodging or in connection with furnishing lodging, and (b) listed improvements to nonresidential real property made after it was first placed in service: roofs; heating, ventilation and air conditioning equipment; fire protection an alarm systems; security systems; and any other building improvements that are not elevators or escalators, do not enlarge the building, and are not attributable to the building’s internal structural framework.
Bonus Depreciation. The law now provides for a 100% first year deduction for qualified new and used property acquired and placed in service after September 27, 2017 and before 2023. Prior law allowed a 50% deduction, phased out for property placed in service after 2017. The new 100% deduction begins to phase out after 2023.
Depreciation of Qualified Improvement Property. Qualified improvement property is now depreciable using a 15-year recovery period and the straight-line method. Qualified improvement property is any is any improvement to an interior portion of a building that is nonresidential real property placed in service after the building was placed in service. It does not include expenses related to the enlargement of the building, any elevator or escalator, or the internal structural framework. There are no longer separate requirements for leasehold improvement property or restaurant property.
Depreciation of Farming Equipment and Machinery. The tax law now provides, subject to certain exceptions, the cost-recovery period for farming equipment and machinery the original use of which begins with the taxpayer is reduced from 7 to 5 years. Now, in general, the 200% declining balance method may be used in place of the 150% declining balance method that had previously been required.
Luxury Automobile Depreciation Limits. The tax law now provides that, for an automobile for which bonus depreciation is not claimed (see above), the maximum depreciation allowance is now as follows:
| Year |
Depreciation Allowance |
| One |
$10,000 |
| Two |
$16,000 |
| Three |
$9,000 |
| Four or Later |
$5,760 |
These amounts are indexed for inflation after 2018. For passenger automobiles eligible for bonus first year depreciation, the maximum additional first year depreciation allowance remains at $8,000, as provided by prior law.
Computers and Peripheral Equipment. The new law removes computers and peripheral equipment from the definition of listed property. This means that the heightened substantial requirements and often slower cost recovery for listed property no longer apply.
New Rules for Post-2021 Research and Experimentation Expenses. Specified R&E expenses paid or incurred after 2021 in connection with a trade or business will have to be capitalized and amortized ratably over a 5-year period, or 15 years if the business is conducted outside the U.S. The affected expenses include expenses for software development, but do not include expenses for land or depreciable or depletable property used in connection with R&E activities. Note, however, that affected R&E expenses do include the depreciation and depletion allowance for such property. Prior law had provided that, for R&E expenses paid or incurred before 2022, such expenses were, at the taxpayer’s election, currently deductible, capitalized and recovered over the shorter of the useful life of the research or 60 months, or ten years.
Like-Kind Exchange Treatment Limited. Now, the deferral of gain on like-kind exchanges of property held for productive use of property held for productive use in a taxpayer’s trade or business or for investment purposes is limited to like-kind exchanges of real property not held primarily for sale. A transition rule provides that prior law applies to like-kind exchanges of personal property if the taxpayer has either disposed of the property given up or obtained the replacement property before 2018.
Excessive Employee Compensation. Prior law allowed a deduction for compensation paid or accrued with respect to a covered employee of a publicly traded corporation up to $1 million per year. The law provided exceptions for commissions, performance-based pay, stock options, payments to a qualified retirement plan, and amounts excludable from the employee’s gross income. The new law repeals the exceptions for commissions and performance-based pay. It also revises the definition of “covered employee” to include the principal executive officer, principal financial officer, and the three highest paid officers. An individual who is a covered employee for a tax year beginning after 2016 remains a covered employee for all future years.
Clarification of Employee Achievement Awards. An employee achievement award is tax free to the extent the employer can deduct its cost, generally limited to $400 per employee or $1600 for a qualified plan award. An employee achievement award is an item of tangible personal property given to an employee in recognition of length of service or a safety achievement and presented as part of a meaningful presentation. The new law amends the definition of “tangible personal property” to exclude cash, cash equivalents, gift cards, gift coupons, gift certificates (other than from an employer pre-selected limited list), vacations, meals, lodging, theater or sports tickets, stocks, bonds, or similar items, and other non-tangible personal property.
New Deduction for Pass-Through Income. Tax law now provides a 20% deduction for “qualified business income,” defined as income from a trade or business conducted within the U.S. by a partnership, S corporation, or sole proprietorship. Recall that limited liability companies being treated, for tax purposes, as partnerships, fall within this category. Investment items, reasonable compensation paid by an S corporation, and guaranteed payments from a partnership, are excluded. The deduction reduces capital income but not adjusted gross income. For taxpayers with taxable incomes above $157,500 ($315,000 for joint filers), (a) a limitation based on W-2 wages paid by the business and the basis of acquired depreciable tangible property used in the business is phased in, and (b) the deduction is phased out for income from certain service-related trades or businesses, such as health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Partnership Technical Termination Rule Repealed. Under prior law, a partnership faced a technical termination, for tax purposes, if, within any 12-month period, there was a sale or exchange of at least 50% of the total interest of partnership capital and profits. This resulted in a deemed contribution of all partnership assets and liabilities to a new partnership in exchange for an interest in it, followed by a deemed distribution of interests in the new partnership from the purchasing partners and continuing partners from the terminated partnership. Some of the tax attributes of the old partnership terminated, its tax year closed, partnership-level elections ceased to apply, and depreciation recovery periods restarted. This often imposed unintended burdens and costs on the parties. The new law repeals this rule. A partnership termination is no longer triggered if, within a 12-month period, there is a sale of 50% or more of total capital and profits interests. A partnership termination will still occur only if no part or any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
Partnership Loss Limitation Rule. A partner can only deduct his share of partnership loss to the extent of his basis in his partnership interest as of the end of the partnership tax year in which the loss was incurred. IRS has ruled, however, that this loss limitation rule should not apply to limit a partner’s deduction for his share of partnership charitable contributions and foreign taxes paid. However, in the case of partnership charitable contributions of property with a fair market value that exceeds its adjusted basis, the partner’s basis reduction is limited to his share of the basis of the contributed property.
Look-Through Rule on Sale of Partnership Interest. The new tax law provides that gain or loss on the sale of a partnership interest is effectively connected with a U.S. business to the extent the selling partner would have had effectively connected gain or loss had the partnership sold all of its assets on the date of the sale. Such hypothetical gain or loss must be allocated in the same way as is non-separately stated partnership income or loss. Unless the selling partner certifies that he is not a nonresident alien or foreign corporation, the buying partner must withhold 10% of the amount realized on the sale. This rule applies to transfers on or after November 22, 2017 and will cause gain or loss on the sale of an interest in a partnership engaged in a U.S. trade or business by a foreign person to be foreign source.
Change in Tax Treatment of a Profits Interest in a Partnership. Taxation of carried interest held in connection with the performance of services is now calculated on the excess of:
The taxpayer’s net long-term capital gain with respect to those interests for that tax year over
The taxpayer’s net long-term capita gain with respect to those interests for that tax year computed by applying Code section 1222(3) and Code Section 1222(4) by substituting “3 years” for “1 year.”
This amount will be treated as short term capital gain and will apply notwithstanding Code Section 83 or any election in effect under Code section 83(b). Observe also that this calculation applies to an “applicable partnership interest.” This is defined as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. An interest held by an individual employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to that other entity is not an applicable partnership interest. Code Section 1061(c)(1). Also, expressly excluded from the definition of “applicable partnership interest” is any interest in a partnership held by a corporation. Code Section 1061(c)(4)(A). This language does not limit the exclusion to any type of corporation, so it arguably could be interpreted to allow for an S-corporation to serve as a carried interest partner and thereby avoid the 3-year holding period. While Treasury has stated it will narrow this apparent loophole by regulation, it is not at all clear that it has the authority to do so.
Deduction for Foreign-Source Portion of Dividends. The tax law now provides a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned foreign corporations by domestic corporations that are 10% shareholders of those foreign corporations. No foreign tax credit is allowed for any taxes paid and accrued as to any dividend for which the deduction is allowed, and those amounts are not treated as foreign source income for purposes of the foreign tax limitation. In addition, if there is a loss on any disposition of stock of the specified 10%-owned foreign corporation, the basis of the domestic corporation in that stock is reduced (but not below zero) by the amount of the allowable deduction.
Sales or Exchanges of Stock in Foreign Corporations. Now, if a domestic corporation sells or exchanges stock in a foreign corporation held for over a year, any amount it receives which is treated as a dividend for Code Section 1248 purposes, will be treated as a dividend for purposes of the deduction for dividends received, discussed above. In the same way, any gain received by a CFC from the sale or exchange of stock in a foreign corporation that is treated as a dividend under Code Section 964 to the same extent that it would have been so treated had the CFC been a U.S. person is also treated as a dividend for purposes of the deduction for dividends received.
Incorporation of Foreign Branches. The new tax law now provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign subsidiary, the transferred loss amount must be recognized in the U.S. corporation’s gross income.
Deemed Repatriation. The tax law now requires U.S. shareholders owning at least 10% of a foreign subsidiary to include in income, for the subsidiary’s last tax year before beginning before 2018, the shareholder’s pro-rata share of the undistributed, non-previously taxed post-1986 foreign earnings of the corporation. The inclusion amount is reduced by any aggregate foreign earning and profits deficits, and a partial deduction is allowed such that a shareholder’s effective tax rate is 15.5% on his aggregate foreign cash positions and 8% otherwise. The net tax liability can be spread over a period of up to 8 years, Special rules apply for S corporation shareholders and for RICs and REITs.
Global Intangible Low-Taxed Income. GILTI must now be included in gross income by taxpayers who are shareholders of controlled foreign corporations (CFCs). This is the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return (10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder). The GILTI is treated as an inclusion of Subpart F income for the shareholder. Only an 80% foreign tax credit is available for amounts included in income as GILTI.
Deduction for Foreign-Derived Intangible Income and GILTI. Under the new law, in the case of a domestic corporation, a deduction is allowed equal to the sum of (a) 37.5% of its foreign-derived intangible income (FDII) for the year, plus (b) 50% of the GILTI amount include in gross income (see above for this calculation). Generally, FDII is the amount of a corporation’s deemed intangible income that is attributable to sales of property to foreign persons for use outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S. Coupled with the 21% tax rate, for domestic corporations, these deductions result in effective tax rates of 13.125% on FDII and of 10% on GILTI. The deductions are reduced for tax years after 2025.
Subpart F Changes. The new tax law made several changes to the taxation of Subpart F income of U.S. shareholders of CFCs. Among other things, the new law expands the definition of U.S. shareholders to include U.S. persons who own 10% or more of the total value, and not merely the total vote, of shares of all classes of stock of the foreign corporation. In addition, the requirement that a corporation must be controlled for 30 days before Subpart F inclusions apply has been eliminated.
Base Erosion Prevention. To prevent companies from stripping earnings out of the U.S. through payments to foreign affiliates that are deductible for U.S. tax purposes, a base erosion minimum tax applies to corporations other than RICs, REITs, and S corporations, with average annual gross receipts of $500 million or more that made deductible payments to foreign affiliates that are at least 3% (2% in the case of banks and certain securities dealers) of the corporation’s total deductions for the year. The tax is structured as an alternative minimum tax and applies to domestic corporations, as well as to foreign corporations engaged in a U.S. trade or business in computing the tax on their effectively connected income.
Tax exempt organizations are also affected by the new tax law. Here is a summary of some of the new provisions.
Excise Tax on Exempt Organizations’ Excessive Compensation. Under prior law, executive compensation paid by tax-exempt entities was subject to reasonableness requirements and a prohibition against private inurement. The new tax law adds an excise tax that is imposed on compensation in excess of $1 million paid by an exempt organization to a “covered” employee. The tax rate is set at 21%, equal to the new corporate tax rate. For these purposes, compensation is the sum of: (a) remuneration (other than an excess parachute payment) over $1 million paid to a covered employee by a tax-exempt organization for a tax year; plus (b) any excess parachute payment paid by the organization to a covered employee. A covered employee is an employee or former employee of the organization who is one of its five highest compensated employees for the tax year, or its predecessor for any preceding tax year beginning after 2016. Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to the remuneration.
Excise Tax on Private College Investment Income. Previously, the law allowed private colleges and university to be treated as public charities, rather than private foundations, and were therefor not subject to the private foundation excise tax on the net investment income of colleges and universities meeting specified size and asset requirements. The excise tax rate is 1.4% of the institution’s net investment income and applies only to private colleges and universities with at least 500 students, more than half of whom are in the U.S., and with assets of at least $500,000 per student. For this purpose, assets used directly in carrying out the institution’s exempt purposes are not counted. The number of student is based on a daily average of “full time equivalent” students. So, for example, two students carrying half-loads of credits would count as a single, full-time equivalent student. For purposes of the excise tax, net investment income is the institution’s gross investment income minus expenses incurred to produce it, but without the use of accelerated depreciation or percentage depletion.
Exempt Organization’s UBTI Computed Separately for Specific Businesses. Previously, a tax-exempt organization computed its unrelated business taxable income (UBTI) by subtracting deductions directly connected with the unrelated trade or business. If the organization had more than one unrelated trade or business, the organization combined its income and deduction from all of the trades of businesses. Under that approach, a loss from one trade or business could offset income from another unrelated trade or business, thereby reducing overall UBTI. Now, the law provides that an exempt organization cannot use losses from one unrelated trade or business to offset income from another such business. Gains and losses are calculated and applied to each unrelated trade or business separately. This differs from the consolidated treatment available to for-profit corporations which are members of affiliated groups. The new tax law provides an exception to this separate allocation rule for net operating losses from pre-2018 tax years that are carried forward.
Exempt Organization’s UBTI to Include Disallowed Fringe Benefits Costs. The new tax law provides that an exempt organization’s unrelated business taxable income (UBTI) must include any nondeductible entertainment expenses and costs incurred for any qualified transportation fringe benefit, parking facility used in qualified parking, or any on-premises athletic facility. However, UBTI does not include any such amount to the extent it is directly connected with an unrelated trade or business regularly carried on by the organization.
This new tax law includes many other changes which can affect you and your business in substantial ways. We are happy to discuss with you how you might plan for the effects of these changes. Please do not hesitate to contact us.
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[1] This note illustrates general principles only and is not intended as tax or legal advice. You should discuss your circumstances with a qualified professional before taking any action. In some jurisdictions, this may be interpreted as attorney advertising.
