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 and their industries in the years to come. If you have any questions regarding the Act, please contact a Schwabe attorney.
SUMMARY OF THE TAX CUTS AND JOBS ACT
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.
Certain self-created property no longer qualifies as capital assets. Effective for dipositions after December 31, 2017, patents, inventions, models or designs (whether or not patented), secret formulae or processes are no longer considered capital assets if held by the taxpayer who created the property or by a taxpayer with a substituted basis from the taxpayer who created the property. This can result in less-favorable tax treatment on the disposition of the property.
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.
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.
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.
“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.
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.
Look-through rule applied to gain on sale of partnership interest. For sales and exchanges on or after November 27, 2017, gain or loss from the sale or exchange of a partnership interest is “effectively connected” with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. Any gain or loss from the hypothetical asset sale by the partnership must be allocated to interests in the partnership in the same manner as non-separately stated income and loss.
For sales, exchanges and dispositions after December 31, 2017, the transferee of a partnership interest must withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation.
Treatment of S corporation converted to C corporation. The Act provides that any IRC § 481(a) adjustment of an “eligible terminated S corporation” attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during a six-tax-year period beginning with the year of change. An eligible terminated S corporation is any C corporation that (1) is an S corporation the day before the date of enactment; (2) during the two-year period beginning on the date of enactment revokes its S corporation election; and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of enactment.
In the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account shall be allocated to such distribution, and the distribution shall be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount of the accumulated earnings and profits.
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.
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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