On December 22, 2017, President Trump signed into law the biggest federal tax law overhaul since 1986. The new law, frequently referred to as the Tax Cuts and Jobs Act (TCJA) will significantly affect individuals, corporations, international taxpayers and estates and trusts. Many provisions of the Internal Revenue Code of 1986 have been repealed or amended, and new ones have been added.
Many of the new provisions are temporary (December 31, 2025, being the common expiration date) and are subject to phase-in and phase-out rules, while others are intended to be permanent. This summary seeks to explain and analyze the most substantive changes to existing law, giving particular attention to those changes affecting the taxation of domestic businesses.
Reducing the Corporate Tax Rate and Repeal of the Corporate AMT
Prior to the TCJA, C corporations were subject to a four-step graduated tax rate structure on income with the highest marginal rate set at 35 percent and the alternative minimum tax (AMT), which significantly changed the way C corporations were taxed — often causing them to give up many of the benefits otherwise obtained through the application of certain deductions and credits.
The TCJA significantly changes the corporate income tax. First, the graduated marginal rate structure has been replaced with a flat rate tax of 21 percent. Thus, all corporate income is taxed at a flat rate of 21 percent. Second, the corporate AMT has been repealed allowing C corporations to take advantage of certain deductions and credits once again. Third, the amounts of the dividends received deductions for dividends received by a C corporation from certain other domestic C corporations have been reduced. These three changes are effective for taxable years beginning on or after January 1, 2018, and are not subject to any phase-ins or phase-outs.
The new rate may push owners of pass-through entities such as S corporations and partnerships to consider converting such entities to C corporations as the combined 21 percent corporate rate and the 23.8 percent dividend rate will generally result in an effective tax rate of 39.8 percent on dividends paid to individuals, which is lower than the combined top federal tax rate on ordinary income of individuals of 37 percent and the 3.8 percent Medicare or Net Investment Income tax. However, other considerations, such as the accumulated earnings tax, the flexibility of limited liability companies and potential double taxation with respect to asset sales and liquidations will have to be evaluated when deciding on which entity is the most beneficial. Moreover, it is anticipated that the rates for C corporations will eventually change.
In regards to newly formed companies, the reduction in the corporate tax rate may tip the balance in favor of using a C corporation in some cases. This is especially the case when the reduction in the corporate tax rate is combined with the exemption from capital gains tax for sales of shares of qualified small business stock held for more than five years. Notably, the TCJA does not change the ability of C corporations to fully deduct state and local income and property taxes (although it does limit the ability of individual taxpayers, including owners of pass-through entities, to do so – $10,000 cap). This could increase the attractiveness of using a C corporation, especially if the business owners reside in or conduct business in high-tax states.
Limitations on the Business Interest Expense
Before passage of the TCJA, taxpayers could deduct all business interest paid or accrued during its taxable year. Under the TCJA, a taxpayer’s deduction for business interest paid or accrued is now limited to the sum of the amount of interest includible in the taxpayer’s gross income that is allocable to a trade or business, plus 30 percent of the taxpayer’s adjusted taxable income for the year. This is computed without regard to income, gain, deductions or losses that are not allocable to a trade or business; business interest or business interest income; net operating loss deductions; deductions allowed under new Code §199A; or deductions for depreciation, amortization, or depletion that are allowable for tax years before January 1, 2022.
Although limited under the TCJA, the amount of any disallowed business interest deduction can now be carried forward to the next taxable year and treated as paid or accrued in that year. Further, the limitation on the business interest expense deduction does not apply to taxpayers whose average annual gross receipts for the three-taxable-year period ending with the prior taxable year is equal to or less than $25 million. For partnerships and S corporations, the limitation applies at the entity level and provides for special rules that prevent double-counting for partners or shareholders who also pay or accrue business interest. A “trade or business” as it is used in this provision, does not include any electing real property trade or business, which includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business; any electing farming business; or certain utility companies.
The limitation on the business interest deduction will undoubtedly affect many businesses and will apply to new and existing debt arrangements. Highly leveraged businesses or those that anticipate incurring new debt should integrate these limitations into their cash flow models and may also need to consider alternative capital structures. On the other hand, small businesses and real estate ventures are unlikely to be affected by the new limitations.
Carryback and Carryforward of Net Operating Losses
Prior to the TCJA, net operating losses (NOLs) could generally be carried back two years and forward 20 years to offset taxable income in those years.
NOLs are now subject to new limitations. NOLs can no longer be carried back to prior tax years (exceptions exist for farming businesses and property and casualty insurance companies). NOLs carryforwards are still permitted but are subject to new limitations. For losses arising in taxable years after December 31, 2017, the NOL carryforward deduction is limited to 80 percent of taxable income for the taxable year. However, NOL carryforwards will no longer expire after 20 years.
The new NOLs rules are intended to be permanent and should be carefully considered and scrutinized when projecting cash flows and estimating the value of a company. The limitations may also disproportionately affect start-up businesses since these businesses often have high NOLs in their early years.
Limitations on Carried Interests
Under prior law, if certain requirements were met, taxpayers who received a “profits” interest in a partnership in exchange for future services generally were not taxed upon receipt of the interest and could qualify for favorable long-term capital gain treatment on gains arising from a disposition of such interest if held for more than a year and long-term capital gains passed through to that partner by the partnership.
The TCJA constraints carried interests by requiring the service provider to hold the interest for at least three years before it can obtain the preferable long-term capital gain rate. New Code §1061 is broadly worded and applies to businesses that raise or return capital and invest in “specified assets,” including stocks and other securities, commodities, derivative contracts, and real estate held for rental or investment. The new rules contained in Code §1061 are effective for taxable years beginning on or after January 1, 2018, and are not subject to phase-ins or outs.
The Internal Revenue Service is responsible for issuing regulations or other guidance as necessary or appropriate to carry out the purpose of this new provision. Although broad and somewhat ambiguous, it appears that the new rule will apply to gains passed through to a service partner from the sale of a partnership’s portfolio investments, in addition to gains related to the disposition of the partnership interest itself. Because most private equity investments are held for more than three years, the TCJA's new limitations should have minimal impact on private equity carried interests. The impact on hedge fund carried interests may be more significant because many hedge fund portfolio investments are held for less than three years. The new provision does not appear to affect the interests of hedge funds that rely heavily on the 60-40 long-term/short-term capital gain treatment of regulated futures contracts and other so-called “section 1256 contracts.”
Pass-Through Taxation and “Qualified Business Income”
Under existing law, an individual who receives business income from a partnership, S corporation, or sole proprietorship is taxed on that income at the individual's regular individual income tax rate. As a result of the TCJA, Code §199A now provides non-corporate taxpayers a deduction in the amount of up to 20 percent of "Qualified Business Income" (QBI) from partnerships (including LLCs classified as partnerships for federal income tax purposes), S corporations, and sole proprietors (the "QBI Deduction").
QBI includes the net amount of income, gain, deductions and loss from a "qualified trade or business" within the United States excluding certain types of investment income, reasonable compensation paid to the taxpayer by any qualified trade or business, any guaranteed payment under Code §707(c), or payment for services under Code §707(a). However, the QBI Deduction is limited to the greater of (i) 50 percent of the taxpayer's allocable share of W-2 Wages paid by the qualified business to employees or (ii) the sum of 25 percent of the taxpayer's allocable share of W-2 wages plus 2.5 percent of the unadjusted basis of "qualified property," which is defined as tangible, depreciable property that has not reached the end of its applicable depreciation period and is used in the qualified business, with respect to the qualified business of the taxpayer (the "Wage Limitation"). However, this limitation does not apply to taxpayers with taxable income below $157,500 ($315,000 in the case of a taxpayer filing a joint return) (the "Threshold Amount")
The term "qualified trade or business" does not include “specified service businesses” (SSBs) (the "SBB Limitation"). An SSB is defined, by reference to Code §1202(e), as any trade or businesses in the fields of law, accounting, health, athletics, performing arts, actuarial services, consulting, financial services, and brokerage, as well as businesses the principal asset of which is the “reputation or skill” of one or more of its owners or employees. However, like the Wage Limitation, the SBB Limitation does not apply to taxpayers with taxable income below the Threshold Amount, which is increased by $50,000 to $207,500 in the case of a single taxpayer and by $100,000 to $415,000 in the case of a taxpayer filing a joint return when applying the SBB Limitation.
Unfortunately, neither Congress nor the Internal Revenue Service has provided any guidance on determining whether a taxpayer is engaged in an SSB under Code §199A or the cross-referenced Code §1202(e); however, as pointed out by the Conference Committee, a similar list of service trades or business is provided in Code §448(d)(2)(A), under which the IRS has promulgated Treasury Regulations providing examples of several of the service businesses listed above. There is also uncertainty as to what qualifies as a "trade or business" given that there is no uniform definition in the Code.
Immediate Expensing for the Costs of Certain Business Assets
Prior to the TCJA, taxpayers were required to capitalize the cost of property acquired for use in a trade or business or held for the production of income. These acquisition costs could be recovered through annual depreciation deductions. Under the TCJA, taxpayers can now immediately expense 100 percent of the cost of both new and used tangible depreciable property (excluding real property). Additionally, there is no longer a requirement that the taxpayer is the original user of the property acquired (an exception exists for property purchased from related parties). Importantly, this new provision applies only to assets purchased over the next five years; to be eligible for immediate expensing, the asset must be placed in service after September 27, 2017, and before January 1, 2023. In regards to mergers and acquisitions, this new provision is likely to increase the attractiveness of asset purchases over-stock purchases and encourage large-scale capital investments.
Other Important Changes
The TCJA makes changes to various provisions that may be significant for particular taxpayers. For example, tax deferral under Code §1031 for exchanges of like-kind property will be permanently limited to exchanges of real property, companies may no longer deduct legal fees associated with certain sexual harassment lawsuits, taxpayers face new limits on deductions for amounts paid to settle certain governmental investigations regarding potential violations of law and taxpayers with “excess losses” from business activities (losses exceeding $500,000 or $250,000 for single filers) in which they “materially participate” may no longer deduct those losses against wages or portfolio income. With respect to the annual limitation on losses from business activities, the excess losses can be carried forward and treated as business losses in subsequent years, but they remain subject to the same annual cap – and, unlike passive activity losses, the losses from businesses in which the taxpayer actively participates continue to be subject to the annual limitation even after the business is disposed of.
As noted, the TCJA is the most sweeping federal tax legislation passed since 1986 and will affect commercial activities for many years to come. In light of the changes to federal tax law, businesses must carefully consider proposed transactions and business structuring. These considerations will be further complicated as a result of uncertainty regarding how the IRS and Treasury Department will interpret many of the TCJA’s complex provisions.
This news alert is created by the attorneys in the Mergers and Acquisitions Practice Group at Friday, Eldredge & Clark, LLP. The information provided is not a substitute for legal advice and should be considered for general guidance only. If you have any questions or need assistance, please contact one of our attorneys for specific legal advice regarding this matter.