2018 Tax Alert - Corporate/Business Taxation
The following is the Corporate Taxation section of the 2018 client advisory "Tax Alert: How the New Tax Laws Will Affect You Now and in the Future."
The full version of this client advisory is available here.
Tax Rates – The Act provides significant benefits to corporate taxpayers. It drastically cuts the corporate income tax rate from 35% to a flat 21% rate effective January 1, 2018. Professional service corporations receive the same tax break by being subject to the general corporate tax rate. A professional service corporation is a C corporation of which (i) substantially all of the activities consist of the performance of services in fields such as accounting, health, law, etc., and (ii) of which employees performing services for the corporation in the identified fields own, directly or indirectly, substantially all of its stock. Of course, for all corporate income, there is still the second tax that must be paid on distributions from the corporation to its shareholders. In most cases this will make the effective tax rate 39.5%.
Corporate AMT – The Act completely eliminates the alternative minimum tax for corporations. For tax years beginning in 2018, 2019, and 2020, to the extent that AMT credit carryovers exceed regular tax liability (as reduced by certain other credits), 50% of the excess AMT credit carryovers are refundable (a proration rule with respect to short tax years). Any remaining AMT credits will be fully refundable in 2021.
Deductions/Credits – The new law changes the 80% dividends received deduction (for dividends from 20% owned corporations) to 65% and the 70% dividends received deduction (for dividends from less than 20% owned corporations) to 50%, effective for tax years beginning after 2017.
In addition, the Act increases first-year "bonus" depreciation deductions to 100%, which allows for an immediate write off for the cost of acquisitions of plant and equipment for property acquired and placed in service after September 27, 2017, and before 2023. This expensing allowance provides for bonus depreciation to both new and used acquired property. The 100% bonus depreciation rule applies through 2022, and then ratably phases down over the succeeding five years. Bonus depreciation is not available for businesses providing electrical energy, water or sewage disposal serves, gas or steam through a local distribution system or transportation of gas or steam by pipeline.
The Act changes the use of net operating losses ("NOLs") by limiting the NOL deduction to 80% of taxable income for losses arising in tax years beginning after December 31, 2017. The Act eliminates carrybacks (except for farming NOLs, which would be permitted a two-year carryback) and allows unused NOLs to be carried forward indefinitely.
The Act makes changes to the section 179 expensing election by increasing the maximum amount that may be deducted to $1 million (up from $500,000 under present law) (the "dollar limit"). The dollar limit is then reduced dollar-for-dollar to the extent the total cost of section 179 property placed in service during the tax year exceeds $2.5 million (up from $2 million). These limits will be adjusted annually for inflation. The changes are effective for property placed in service in tax years beginning after 2017.
The Act limits the deduction for net interest expenses incurred by a business to (i) the sum of business interest income, (ii) 30% of the business's adjusted taxable income, and (iii) floor plan financing interest. Businesses with average annual gross receipts of $25 million or less are exempt from this limit. In addition, businesses engaged in a "real property trade or business (as defined in IRC Section 469(c)(7)) can avoid this limitation but only if they agree to depreciate their residential and non-residential real estate and qualified improvement property under the less favorable ADS depreciation method. However, if the real estate business is heavily leveraged electing to avoid the interest expense limitation may be worth giving up the accelerated depreciation benefits.
The Act eliminates the deductions for entertainment, amusement, and recreation when directly related to the conduct of a taxpayer's trade or business. The new law generally retains the 50% deduction for food and beverage expenses associated with a trade or business, effective for amounts paid or incurred after December 31, 2017. The new law also applies the 50% limitation to certain meals provided by an employer that are currently 100% deductible.
In addition to the disallowance of deductions for entertainment expenses, businesses can no longer claim a deduction for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payment is subject to a nondisclosure agreement. The provision is effective for amounts paid or incurred on or after December 22, 2017. Further businesses cannot deduct payments of fines or other penalties to the government or governmental entity. This means for example that fines paid to the SEC to settle securities law claims would not be deductible. Certain restitution payments identified in a court order or settlement would be deductible, as would remediation of property payments. Restitution for failure to pay taxes assessed under the IRC would be deductible only to the extent that their payment would have been allowable if it had been timely paid.
The Act adds a credit for paid family leave credit. The provision allows employers 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 if the rate of payment under the program 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%. The provision is effective for wages paid in taxable years beginning after December 31, 2017, and would not apply to wages paid in taxable years beginning after December 31, 2019.
Research Credits – Currently, companies can claim a 50% tax credit for qualified clinical testing expenses incurred in testing certain drugs for rare diseases or conditions for disease populations with fewer than 200,000 individuals nationally, generally referred to as "orphan drugs." The tax bill reduces the credit rate to 25% of qualified clinical testing expenses effective in 2018. The new law retained the deduction for research and development expenses but now requires that such costs are amortized over a period of five years rather than being deducted in full in one year.
Accounting Method Changes – Under the new law, accrual method taxpayers must recognize income no later than the tax year in which the item is recognized as revenue on an applicable financial statement. The new law codifies the current deferral method of accounting for advance payment for goods and services provided under Revenue Procedure 2004-34, which allows taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes. The special rules for tax year of inclusion may cause an acceleration in the recognition of income for many taxpayers. For example, under the new law, any unbilled receivables for partially performed services must be recognized to the extent the amounts are taken into income for financial statement purposes, as opposed to when the services are actually completed or at the time that the taxpayer has the right to bill. Additionally, advance payments for goods and revenue from the sale of gift cards can only be deferred for one tax year; and income from credit card fees (such as late-payment, cash advance, and interchange fees) would generally be accelerated.
Under current law, with certain exceptions, a C corporation or partnership with a C corporation partner may use the cash method of accounting only if, for each prior tax year, its average annual gross receipts (based on the prior three tax years) do not exceed $5 million. Pursuant to the Act, the threshold under the three-year average annual gross receipts test is increased to $25 million. The three-year average test is applied annually.
Businesses that are required to use an inventory method must also use the accrual method of accounting for tax purposes under current law. An exception from the accrual method of accounting is provided for certain small businesses if for each prior tax year its average annual gross receipts (based on the prior three tax years) do not exceed $1 million, and a second exception is provided for businesses in certain industries if for each prior tax year their average annual gross receipts (based on the prior three tax years) do not exceed $10 million. The Act permits additional businesses with inventories to use the cash method by increasing this threshold to $25 million. Under the provision, businesses with average annual gross receipts of $25 million or less (based on the prior three tax years) are permitted to use the cash method of accounting even if the business has inventories. Under the provision, a business with inventories that otherwise qualifies for and uses the cash method of accounting is able to treat inventory as non-incidental materials and supplies or conform to its financial accounting treatment.
Another relaxation of the accounting rules in the Act allows businesses with less than $25 million average annual gross receipts (up from $10 million) to use the completed-contract method (or any other permissible exempt contract method) rather than the percentage-of-completion accounting method for long-term contracts to be completed within two years.
The Act has made substantial changes to the tax laws. There are many "glitches" in the Act that will need to be addressed in technical correction legislation. Since technical correction legislation requires a 60% vote in the Senate (it cannot come under reconciliation rules), there will need to be bi-partisan cooperation to fix the problems that such fast paced passage of the Act produced. Second, technical corrections require unanimous consent by both the majority and minority staffs of the House Committee on Ways and Means and the Senate Finance Committee. If anyone disagrees about the legislative intent of a provision and whether the statute reflects that intent, then the provision is not a technical correction but, rather, a change in policy. Thus it may take quite a while for any technical correction legislation to be passed.
Effective tax planning including choice of entity structures will be made based on the new laws that are now in effect. Only time will tell how these changes will impact individuals, businesses, and the economy.
This communication is intended for general information purposes and as a service to clients and friends of Verrill Dana, LLP. This publication, which may be considered advertising under the ethical rules of certain jurisdictions, should not be construed as legal advice or a legal opinion on any specific facts or circumstances, nor does it create attorney-client privilege.