Business Tax Planning

PLEASE KEEP IN MIND THAT THESE ARE INITIAL PROPOSALS FOR TAX REFORM

2017 Tax Reform: Proposed business tax changes in the "Tax Cuts & Jobs Act"

H.R. 1, the Tax Cuts and Jobs Act

Ways and Means' Section-by-Section Summary of the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act, released on Nov. 2 and scheduled to be marked up by House Ways and Means on Nov. 6, would make major changes to taxation of individuals, corporations and other businesses, foreign income taxpayers, and exempt organizations. It also would repeal the AMT and double the estate tax exclusion before eliminating the estate tax after 2023. This article describes the major business tax provisions of this Act, including a reduction to 20% in the corporate tax rate (25% for PSCs), expansion of expensing of business property, small business accounting reforms and interest deduction liberalizations, interest deduction limits on thinly capitalized large businesses, limitation on NOL deductions, limiting like-kind exchanges to real property transactions, taxation of some contributions to capital, repeal of the domestic production activities deduction, elimination of deductions for entertainment or recreation activities. Also, many special capital gains breaks and business tax credits would be repealed. This article also describes provisions related to the taxation of exempt organizations, including the expansion of UBIT to all Code Sec. 501(a) exempt entities, simplification of the excise tax on private foundation income, subjecting wealthier private colleges and universities to an excise tax on net investment income, new reporting requirements for donor advised funds, and a liberalization of the "Johnson amendment", which currently bans certain political activity by exempt religious and educational institutions.

For Tax Cuts and Jobs Act provisions related to individuals, see ¶ 2.

For Tax Cuts and Jobs Act provisions related to foreign income and persons, see ¶ 32.

Changes to Corporate Tax Rates

Under the Act, the corporate tax rate would generally be a flat 20% rate beginning in 2018, eliminating the current graduated rates of 15% (for taxable income of $0-$50,000), 25% (for taxable income of $50,001-$75,000), 34% (for taxable income of $75,001-$10,000,000), and 35% (for taxable income over $10,000,000). (Act Sec. 3001)

The Act would provide that personal services corporations would be subject to a flat 25% corporate tax rate, rather than the current 35% rate, effective for tax years beginning after 2017. A personal service corporation is a corporation the principal activity of which is the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and such services are substantially performed by the employee-owners. (Act Sec. 3001)

100% Cost Recovery Deduction

Under the Act, instead of bonus depreciation for qualified property, taxpayers would be able to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023 (with an additional year for certain qualified property with a longer production period). (Act Sec. 3101(a), Act Sec. 3101(b))

Property would be eligible for this immediate expensing if it is the taxpayer's first use, repealing the current requirement that the original use of the property begin with the taxpayer. (Act Sec. 3101(c)) The Act would provide that qualified property would not include any property used by a regulated public utility company or any property used in a real property trade or business. (Act Sec. 3101(d))

Under the Act, the taxpayer's election to use the minimum tax credit in lieu of the additional depreciation would be repealed, effective for tax years beginning after 2017.

Increased Code 179 Expensing

Under the Act, for purposes of Code Sec. 179 small business expensing, the limitation on the amount that could be expensed would be increased to $5 million (from the current $500,000), and the phase-out amount would be increased to $20 million (from the current $2 million), effective for tax years beginning after 2017 through tax years beginning before 2023. Both amounts would be indexed for inflation. The definition of section 179 property would also include qualified energy efficient heating and air-conditioning property permanently, effective for property acquired and placed in service after Nov. 2, 2017. (Act Sec. 3102)

Small Business Accounting Method Reforms

The Act provides several provisions reforming and simplifying accounting methods for small businesses:

Cash method of accounting. Under current law, a corporation or partnership with a corporate partner may only use the cash method of accounting if its average gross receipts do not exceed $5 million for all prior years (including the prior tax years of any predecessor of the entity). Under the Act, the $5 million threshold for corporations and partnerships with a corporate partner would be increased to $25 million and the requirement that such businesses satisfy the requirement for all prior years would be repealed. (Act Sec. 3202(a))

Under current law, farm corporations and farm partnerships with a corporate partner may only use the cash method of accounting if their gross receipts do not exceed $1 million in any year. An exception allows certain family farm corporations to qualify if its gross receipts do not exceed $25 million. Under the Act, the increased $25 million threshold (above) would be extended to farm corporations and farm partnerships with a corporate partner, as well as family farm corporations (the average gross receipts test would be indexed for inflation).

Accounting for inventories. Under the Act, businesses with average gross receipts of $25 million or less would be permitted to use the cash method of accounting even if the business has inventories. (Act Sec. 3202(c)) In contrast, under current law, the cash method can be used for certain small businesses with average gross receipts of not more than $1 million (for businesses in certain industries whose annual gross receipts do not exceed $10 million). Under the cash method, the business could account for inventory as non-incidental materials and supplies. Under the Act, a business with inventories that qualifies for and uses the cash method would be able to account for its inventories using its method of accounting reflected on its financial statements or its books and records.

Capitalization and inclusion of certain expenses in inventory costs. Under the Act, businesses with average gross receipts of $25 million or less would be fully exempt from the uniform capitalization (UNICAP) rules. (Act Sec. 3202(b)) The UNICAP rules generally require certain direct and indirect costs associated with real or tangible personal property manufactured by a business to be included in either inventory or capitalized into the basis of such property. The Act's exemption would apply to real and personal property acquired or manufactured by such business.

Accounting for long-term contracts. Under current law, an exception from the requirement to use the percentage-of-completion method is provided for certain businesses with average annual gross receipts of $10 million or less in the preceding three years. Under the Act, the $10 million average gross receipts exception to the percentage-of-completion method would be increased to $25 million, effective for tax years beginning after 2017. (Act Sec. 3202(d)). Businesses that meet the increased average gross receipts test would be allowed to use the completed-contract method (or any other permissible exempt contract method).

Effective date. The above provisions would be effective for tax years beginning after 2017.

Limits on Deduction of Business Interest.

Under the Act, every business, regardless of its form, would be subject to a disallowance of a deduction for net interest expense in excess of 30% of the business's adjusted taxable income. The net interest expense disallowance would be determined at the tax filer level. For example, it would be determined at the partnership level rather than the partner level. Adjusted taxable income is a business's taxable income computed without regard to business interest expense, business interest income, net operating losses (NOLs), and depreciation, amortization, and depletion. (Act Sec. 3301(a)) Any interest amounts so disallowed would be carried forward to the succeeding five tax years and would be an attribute of the business (as opposed to its owners). (Act Sec. 3301(b))

Special rules would apply to allow a pass-through entity's unused interest limitation for the tax year to be used by the pass-through entity's owners and to ensure that net income from pass-through entities would not be double counted at the partner level. These provisions would not apply to certain regulated public utilities and real property trades or businesses, which would be ineligible for full expensing under Act Sec. 3101 (see above). (Act Sec. 3301(a))

Under the Act, businesses with average gross receipts of $25 million or less would be exempt from the above interest limitation rules in Act Sec. 3301. (Act Sec. 3203)

Under the Act, the current earning stripping rules under Code Sec. 163(j) would be repealed.

Effective date. The above provisions would be effective for tax years beginning after 2017.

NOL Deduction Limited

Under the Act, taxpayers would be able to deduct a net operating loss (NOL) carryover or carryback only to the extent of 90% of the taxpayer's taxable income (determined without regard to the NOL deduction). This would conform to the current AMT rule. The Act would also generally repeal all carrybacks but provide a special one-year carryback for small businesses and farms in the case of certain casualty and disaster losses. This provision generally would be effective for losses arising in tax years beginning after 2017.

In the case of any net operating loss, specified liability loss, excess interest loss or eligible loss, carrybacks would be permitted in a tax year beginning in 2017, as long as the NOL is not attributable to the increased expensing that would be allowed under Sec. 3101. In addition, the Act would allow NOLs arising in tax years beginning after 2017 and that are carried forward to be increased by an interest factor to preserve its value. (Act Sec. 3302)

Business-related Exclusions, Deductions, etc.

Like-kind exchanges. Under the Act, the rule allowing the deferral of gain on like-kind exchanges would be modified to allow for like-kind exchanges only with respect to real property. (Act Sec. 3303) Under current law, a special rule provides that no gain or loss is recognized to the extent that property—which includes a wide range of property from real estate to tangible personal property—held for productive use in the taxpayer's trade or business, or property held for investment purposes, is exchanged for property of a like-kind that also is held for productive use in a trade or business or for investment.

Effective date. The provisions would generally be effective for transfers after 2017. A transition rule would allow like-kind exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before Dec. 31, 2017.

Contributions to capital. Under the Act, the gross income of a corporation would include contributions to its capital, to the extent the amount of money and fair market value of property contributed to the corporation exceeds the fair market value of any stock that is issued in exchange for such money or property. Similar rules would apply to contributions to the capital of any non-corporate entity, such as a partnership. Under current law, the gross income of a corporation generally does not include contributions to its capital (i.e., transfers of money or property to the corporation by a non-shareholder such as a government entity). (Act Sec. 3304)

Effective date. The provision would be effective for contributions made, and transactions entered into, after the date of enactment.

Entertainment and other expenses. Under the Act, no deduction would be allowed for entertainment, amusement or recreation activities, facilities, or membership dues relating to such activities or other social purposes. In addition, no deduction would be allowed for transportation fringe benefits, benefits in the form of on-premises gyms and other athletic facilities, or for amenities provided to an employee that are primarily personal in nature and that involve property or services not directly related to the employer's trade or business, except to the extent that such benefits are treated as taxable compensation to an employee (or includible in gross income of a recipient who is not an employee).

The 50% limitation under current law also would apply only to expenses for food or beverages and to qualifying business meals under the Act provision, with no deduction allowed for other entertainment expenses. Further, no deduction would be allowed for reimbursed entertainment expenses paid as part of a reimbursement arrangement that involves a tax-indifferent party such as a foreign person or an entity exempt from tax. (Act Sec. 3307)

Effective date. The provision would be effective for amounts paid or incurred after 2017.

Unrelated business taxable income. Under the Act, tax-exempt entities would be taxed on the values of providing their employees with transportation fringe benefits, and on-premises gyms and other athletic facilities, by treating the funds used to pay for such benefits as unrelated business taxable income (UBTI), and so subjecting the values of those employee benefits to a tax equal to the corporate tax rate. (Act Sec. 3308)

Effective date. The provision would be effective for amounts paid or incurred after 2017.

Limitation on deduction for FDIC premiums. Under current law, amounts paid by insured depository institutions pursuant to an assessment by the Federal Deposit Insurance Corporation (FDIC) to support the Deposit Insurance Fund (DIF) are currently deductible as a trade or business expense. Under the Act, a percentage of such assessments would be non-deductible for institutions with total consolidated assets in excess of $10 billion. The percentage of nondeductible assessments would be equal to the ratio that total consolidated assets in excess of $10 billion bears to $40 billion, so that assessments would be completely non-deductible for institutions with total consolidated assets in excess of $50 billion. (Act Sec. 3309)

Effective date. The provision would be effective for tax years beginning after 2017.

Self-created property not treated as a capital asset. Under the Act, gain or loss from the disposition of a self-created patent, invention, model or design (whether or not patented), or secret formula or process would be ordinary in character. The election to treat musical compositions and copyrights in musical works as a capital asset would be repealed. (Act Sec. 3311)

Effective date. The provision would be effective for dispositions of such property after 2017

Repeal of numerous provisions. The Act would also repeal a variety of business provisions. It would repeal:

  • The deduction for local lobbying expenses, effective for amounts paid or incurred after 2017; (Act Sec. 3305)
  • The deduction for income attributable to domestic production activities, for tax years beginning after 2017; (Act Sec. 3306)
  • The rollover of publicly traded securities gain into specialized small business investment companies, effective for sales after 2017; (Act Sec. 3310)
  • The special rule treating the transfer of a patent prior to its commercial exploitation as long-term capital gain, effective for dispositions after 2017; (Act Sec. 3312)
  • The rule on the technical termination of partnerships; (Act Sec. 3313) and
  • The deduction for certain unused business credits, effective for tax years beginning after 2017. (Act Sec. 3405)

Business Credits

Credit for portion of employer social security taxes. Under the Act, the credit for a portion of the employer social security taxes paid with respect to employee tip would be modified to reflect the current minimum wage so that it is available with regard to tips reported only above the current minimum wage rather than tips above $5.15 per hour. In addition, all restaurants claiming the credit would be required to report to IRS tip allocations among tipped employees (allocations at no less than 10% of gross receipts per tipped employee rather than 8%), which is a reporting requirement now required only of restaurants with at least ten employees. (Act Sec. 3408)

Effective date. The provision would be effective for tips received for services performed after 2017.

Repeal of numerous credits. The Act would also repeal a variety of business credits. It would repeal:

  • The credit for clinical testing expenses for certain drugs for rare diseases or conditions, effective for tax years beginning after 2017; (Act Sec. 3401)
  • The employer-provided child care credit, effective for tax years beginning after 2017; (Act Sec. 3402)
  • The rehabilitation credit, generally for amounts paid or incurred after 2017. Under a transition rule, the credit would continue to apply to expenditures incurred through the end of a 24-month period of qualified expenditures, which would have to begin within 180 days after Jan 1, 2018; (Act Sec. 3403)
  • The work opportunity tax credit, effective for wages paid or incurred to individuals who begin work after 2017; (Act Sec. 3404)
  • The new markets tax credit—i.e., no additional new markets tax credits would be allocated after 2017, but credits that would have already been allocated may be used over the course of up to seven years as contemplated by the credit's multi-year timeline; (Act Sec. 3406) and
  • The credit for expenditures to provide access to disabled individuals, effective for tax years beginning after 2017. (Act Sec. 3407) and

Tax Changes for Energy Credits

  • Production tax credit (PTC) modified. Currently a production tax credit (PTC) for the production of electricity from qualified energy resources (e.g., wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy) at a qualified facility during the 10-year period beginning on the date the facility was originally placed in service. The base amount of the PTC is 1.5 cents (indexed annually for inflation) per kilowatt-hour of electricity produced. The PTC generally is available for wind facilities the construction of which begins before 2020 and for other facilities the construction of which began before 2017. Under the Act, the inflation adjustment in the base amount of the PTC would be repealed, effective for electricity and refined coal produced at a facility the construction of which begins after Nov. 2, 2017. Additionally, for tax years beginning before, on, or after Nov. 2, 2017, the Act would clarify that the construction of any facility, modification, improvement, addition, or other property isn't treated as beginning before any date unless there is a continuous program of construction which begins before such date and ends on the date that such property is placed in service.
  • Energy investment tax credit (ITC) modified. Under the Act, the 30% ITC for solar energy, fiber-optic solar energy, qualified fuel cell, and qualified small wind energy property is available for property the construction of which begins before 2020 and is then phased out for property the construction of which begins before 2022, with no ITC available for property the construction of which begins after 2021. Additionally, the 10% ITC for qualified microturbine, combined heat and power system, and thermal energy property is made available for property the construction of which begins before 2022. And the permanent 10% ITC available for solar energy and geothermal energy property is eliminated for property the construction of which begins after 2027. Additionally, for tax years beginning before, on, or after Nov. 2, 2017, the Act would clarify that the construction of any facility, modification, improvement, addition, or other property may not be treated as beginning before any date unless there is a continuous program of construction which begins before such date and ends on the date that such property is placed in service.
  • Extension and phaseout of residential energy efficient property credit. Currently, a taxpayer may claim a 30% credit for: the purchase of qualified solar electric property and qualified solar water heating property that is used exclusively for purposes other than heating swimming pools and hot tubs; and the purchase of qualified geothermal heat pump property, qualified small wind energy property, and qualified fuel cell power plants. The credit applies to property placed in service prior to 2017, but for qualified solar electric property and qualified solar water heating property, it applies for property placed in service before 2022 (subject to a reduced rate of 26% for property placed in service during 2020 and 22% for property placed in service during 2021). Effective for property placed in service after 2016, the Act would retroactively extend the credit for residential energy efficient property for all qualified property placed in service before 2022, subject to a reduced rate of 26% for property placed in service during 2020 and 22% for property placed in service during 2021.
  • Enhanced oil recovery (EOR) credit repealed. Currently, there's an EOR credit equal to 15% of the taxpayer's qualified EOR costs for the tax year. The credit is phased out as the average per barrel wellhead price of domestic crude oil (reference price) for the last calendar year that ended before the tax year in question exceeds an inflation-adjusted figure by at least $6. The Act would repeal the EOR credit.
  • Credit for marginal well production repealed. The marginal well production credit, a general business credit, provides a $3 per barrel credit for qualified crude oil production and 50¢ per 1,000 cubic feet credit for qualified natural gas production. The credit is reduced proportionately when the reference price of oil is between $15 and $18 ($1.67 and $2.00 for natural gas). The Act would repeal the credit for marginal well production.

Compensation

Nonqualified deferred compensation. Under the Act, an employee would be taxed on compensation as soon as there is no substantial risk of forfeiture with regard to that compensation (i.e., receipt of the compensation is not subject to future performance of substantial services). A condition would not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates (nominally or otherwise) to a purpose of the compensation other than the future performance of services, regardless of whether such condition is intended to advance a purpose of the compensation or is solely intended to defer taxation of the compensation. (Act Sec. 3801)

Effective date. The provision would be effective for amounts attributable to services performed after 2017. The current-law rules would continue to apply to existing non-qualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the Act's provision.

Limitation on excessive employee remuneration. Under current law, the deduction for compensation paid or accrued with respect to a covered employee of a publicly traded corporation is limited to no more than $1 million per year. However, exceptions apply for:

  1. Commissions;
  2. Performance-based remuneration, including stock options;
  3. Payments to a tax-qualified retirement plan; and
  4. Amounts that are excludable from the executive's gross income.

Under the Act, the exceptions to the $1 million deduction limitation for commissions and performance-based compensation would be repealed. The Act would also revise the definition of "covered employee" to include the CEO, the chief financial officer, and the three other highest paid employees. Under the modified definition, once an employee qualifies as a covered person, the deduction limitation would apply for Federal tax purposes to that person so long as the corporation pays remuneration to such person (or to any beneficiaries). (Act Sec. 3802)

Effective date. The provision would be effective for tax years beginning after 2017.

Excise tax on excess tax-exempt organization executive compensation. Under the Act, a tax-exempt organization would be subject to a 20% excise tax on compensation in excess of $1 million paid to any of its five highest paid employees for the tax year. The excise tax would apply to all remuneration paid to a covered person for services, including cash and the cash value of all remuneration (including benefits) paid in a medium other than cash, except for payments to a tax-qualified retirement plan, and amounts that are excludable from the executive's gross income. Once an employee qualifies as a covered person, the excise tax would apply to compensation in excess of $1 million paid to that person so long as the organization pays him remuneration. The excise tax also would apply to excess parachute payments —i.e., a payment contingent on the employee's separation from employment with an aggregate present value of three times the employee's base compensation or more. (Act Sec. 3803)

Effective date. The provision would be effective for tax years beginning after 2017.

Changes for Exempt Organizations

  • UBIT of entities exempt under Code Sec. 501(a). The Act would clarify that all entities exempt from tax under Code Sec. 501(a), notwithstanding the entity's exemption under any other Code provision, are subject to the UBIT rules. The change would end the uncertainty over whether certain State and local entities (such as public pension plans) that are exempt under Code Sec. 115(1) as government-sponsored entities as well as Code Sec. 501(a) are subject to the UBIT rules.
  • Exclusion of research income from UBIT. Currently, where an organization operated primarily to carry on fundamental (as opposed to applied) research the results of which are freely available to the general public, it may exclude from UBIT all income derived from research performed for any person and all deductions connected with such income. The Act would clarify that under Code Sec. 512(b)(9), an eligible organization may exclude from UBIT only income from such fundamental research the results of which are freely made available to the public.
  • Streamlined excise tax on private foundation income. Private foundations currently are subject to a 2% excise tax on their net investment incomes, but they may reduce this excise tax rate to 1% by making distributions equal to the averages of their distributions from the previous five years plus 1% of the net investment income for the tax year. Under the Act, the excise tax rate on net investment income would be streamlined to a single rate of 1.4% and the rules providing for a reduction in the excise tax rate from 2% to 1% would be repealed.
  • Excise tax on private colleges and universities. The excise tax on net investment income currently does not apply to public charities, including colleges and universities, even though some have substantial investment income similar to private foundations. Under the Act, a 1.4% excise tax on net investment income would apply to private colleges and universities that have at least 500 students and assets (other than those used directly in carrying out the institution's educational purposes) valued at the close of the preceding tax year of at least $100,000 per full-time student. State colleges and universities would not be subject to the change.
  • Changes for art museums. Under the Act, an art museum claiming the status of a private operating foundation would not be recognized as such unless it is open to the public for at least 1,000 hours per year.
  • Certain philanthropic business holdings exempt from excess business holding tax. Under current law, a private foundation that has any excess business holdings generally is subject to an initial tax equal to 10% of those excess holdings. Under the Act, private foundations would be exempt from this Code Sec. 4943(a) excess-business-holdings tax if they own a for-profit business and:
    1. The foundation owns all of the for-profit business' voting stock,
    2. The foundation acquired all of its interests in the for-profit business other than by purchasing it,
    3. The for-profit business distributes all of its net operating income for any given tax year to the private foundation within 120 days of the close of that tax year, and
    4. The for-profit business' directors and executives are not substantial contributors to the private foundation nor make up a majority of the private foundation's board of directors.
  • Johnson amendment restricted. Under current law, the so-called "Johnson Amendment", a provision in Code Sec. 501(c)(3), bars tax-exempt organizations, including religious and educational institutions, from engaging in certain types of political activity if they want to retain exempt status. Effective for tax years ending after the date of enactment, the Act would provide that a church won't fail to be treated as organized and operated exclusively for a religious purpose, nor will it be deemed to have participated in, or intervened in any political campaign on behalf of (or in opposition to) any candidate for public office, solely because of the content of any homily, sermon, etc., made during religious services or gatherings. The change would apply only if the preparation and presentation of such content is in the ordinary course of the organization's regular and customary activities in carrying out its exempt purpose, and results in the organization incurring not more than de minimis incremental expenses.

RIA observation: On May 4, President Trump signed an Executive Order (EO) "promoting free speech and religious liberty". Among other provisions, the EO directs IRS not to enforce the so-called "Johnson Amendment".

  • New reporting for donor advised funds. Effective for returns filed for tax years beginning after Dec. 31, 2017, the Act would require donor advised funds to disclose the average amount of grants made during the tax year (expressed as a percentage of the value of assets held in the funds at the beginning of the tax year), and to indicate whether the organization has a policy with respect to donor advised funds for frequency and minimum level of distributions (and if so, to include with its return a copy of the policy).



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