The most sweeping tax legislation enacted in three decades, the Tax Cuts and Jobs Act, was signed into law by President Trump on December 22. The legislation, which has been widely praised and assailed along party lines, permanently reduces the top corporate tax rate to 21%, revamps the taxation of international operations and for eight years provides a “pass-through deduction” for the owners of qualified partnerships, S corporations and limited liability company and sole proprietorship business income and cuts rates for individual taxpayers.
The Joint Committee of Taxation’s traditional revenue estimate modeling indicated that the Act would have a cost of $1.5 trillion to the federal government over the next ten years. On December 22, 2017, the Joint Committee on Taxation produced a macroeconomic analysis with the conclusion that, as a result of the Act, the economy should grow at an additional seven tenths of a percent (0.7%) resulting in a positive effect to the federal government of approximately $385 billion and reducing the estimated cost of the Act to $1.1 trillion over the ten-year period.
Following is a high-level summary of key changes made by the Act to the Internal Revenue Code with respect to:
- Corporate Tax Provisions
- International Provisions
- 100% Expensing of Business Investment
- Limitation on Net Interest Expense Deduction
- Pass-through Deduction of up to 20% of Qualified Business Income for Partners and S Corporation Shareholders
- Limitation on Like-Kind Exchanges
- Estate and Gift Taxes
- Individual Taxpayers
- State and Local Tax Deductions
- Individual Healthcare Mandate Effectively Repealed
- Employee Benefits
- Tax-Exempt Bonds
- Tax-Exempt Organizations
Corporate Tax Provisions
For companies with audited financial statements the Act’s changes will require adjustments for deferred tax assets and liabilities. The data and calculation of the needed changes is such that the SEC in SAB 118 released December 22, 2017, announced public companies filing fourth-quarter 2017 financial statements may take a reasonable period to determine the effects of the Act. The SEC will accept a reasonable estimate in the financial statements reported as a provisional amount during the measurement period and subject to adjustment until the accounting under ASC 740 is complete.
Corporate rate reduction and AMT repeal
The Act adopts a flat corporate tax rate of 21% and repeals the corporate alternative minimum tax for tax years beginning after December 31, 2017.
Reduction in Dividends Received Deduction
The Act reduces the dividend received deductions for dividends received by corporations after December 31, 2018 from 70% to 50% for general, non-qualifying dividends and from 80% to 65% for dividends received from 20%-owned corporations.
Expansion of Cash Basis Method of Accounting
Under current law, corporations (and certain partnerships with corporate partners) with average gross receipts of more than $5 million dollars over a three year period, with limited exceptions, are prohibited from using the cash method of accounting. Beginning in 2018, the Act increases the gross receipts limit for purposes of this test to $25 million.
For multinational corporations, beginning in 2018, there is a 100% deduction for the foreign-sourced portion of dividends paid to a U.S. corporation owning at least 10% of the distributing foreign corporation. The Act does not extend this deduction to “hybrid dividends,” which are defined as amounts that would otherwise fall under the 100% deduction, but for which the distributing foreign corporation already realized a tax benefit from taxes imposed by a foreign country. No foreign tax credit or deduction is allowed for taxes paid or accrued with respect to distributions treated as dividends that qualify for the dividends received deduction.
Under the provisions of the Act, beginning in 2018, corporate shareholders of controlled foreign corporations (CFCs) are subject to current U.S. taxation on 50% of the corporation’s global intangible low-taxed income, which is income from its foreign subsidiaries exceeding an amount connected to tangible, depreciable assets held by its foreign subsidiaries and excluding certain income, such as subpart F income and effectively connected income. U.S. corporate shareholders are permitted to use foreign tax credits related to the global intangible low-taxed income to reduce their tax liability. The Act also provides a 37.5% deduction for foreign-derived intangible income of a U.S. corporation.
One-Time Tax on Tax-Deferred Foreign Income
The Act includes a deemed repatriation provision, which subjects accumulated, post-1986 deferred foreign income to current year taxation under Subpart F. Deferred earnings and profits held in cash or cash equivalents are subject to a 15.5% tax rate, and other profits would be subject to a 8% tax rate. A U.S. shareholder of a deferred foreign income corporation can elect to pay its net tax liability in eight separate installments of 8% of the tax the first five years, 15% in year six, 20% in year seven and 25% in year eight. The deemed repatriation provision is effective for the last taxable year of a deferred foreign income corporation which begins before January 1, 2018. The first installment payment is due on the due date, without extensions, of the tax return for the tax year beginning in 2017.
Pass-Through Qualified Business Income Deduction.
For tax years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer may deduct 20% of the domestic qualified business income of a pass-through entity or a sole proprietorship subject to various restrictions and limitations. For single individuals with $157,000 or less of adjusted gross income ($314,000 if married filing jointly) the limitation of such taxpayer’s proportionate share of (i) 50% of W-2 income wages paid to employees or (ii) 25% of the W-2 wages paid to others plus 2.5% of the unadjusted basis of business assets does not apply nor does the prohibition on the business constituting specified services (generally professional, banking and investment services) apply to such individuals. In a rather complex paradigm shift, many businesses are likely to be restructured in a manner to take advantage of this special deduction. A more thorough summary discussion is available at this link.
100% Expensing of Business Investment
The Act allows a temporary 100% bonus depreciation for certain business assets placed into service after September 27, 2017 but before January 1, 2023; 80% bonus depreciation in the case of property that is acquired and placed in service after December 31, 2022 and before January 1, 2024; 60% in the case of property acquired and placed in service after December 31, 2023 and before January 1, 2025; 40% in the case of property placed in service after December 31, 2024 and before January 1, 2026; and 20% in the case of property acquired and placed in service after December 31, 2026 and before January 1, 2027. The 100% expensing timeframe is extended to January 1, 2024 for certain property with longer production periods. The Act also removes the requirement for bonus depreciation under pre-existing law that the original use of qualified property must commence with the taxpayer so that first-year depreciation will be allowed for used property as well as new property. This should have the effect of increasing the value of used equipment.
Additionally, for tax years beginning after December 31, 2017, the §179 dollar limitation on expensing depreciable business assets is increased from $500,000 to $1 million and the phase-out threshold is increased to $2.5 million. Certain qualified real property, roofs, heating, ventilation and air-conditioning property, fire protection and fire and security alarm systems are included as eligible property.
Limitation on Net Interest Expense Deduction
Beginning in 2018, the Act limits the deduction amount that taxpayers may take for business interest in a taxable year to an amount that does not exceed the sum of the taxpayer’s business interest income for the taxable year, 30% of the taxpayer’s adjusted taxable income for the taxable year and the corporation’s floor plan financing interest for the taxable year. The Act allows any disallowed business interest to carryforward to succeeding years. With respect to partnerships, the interest expense limitation is determined at the partnership level with allowed business interest expense flowing through to the partners as non-separately stated partnership income or loss. Any business interest expense in excess of the limitation is allocated to the partners and carried forward by the partners to be offset only against the partner’s share of future taxable income of the partnership that is unused to offset business interest expense, i.e., if the 30% of the partnership’s adjusted taxable income exceeds the partnership’s business interest expense over its business interest income. The Act contains complex provisions related to partnerships designed to prevent taxpayers from double counting the same income in computing their business interest income limitation for business interest from other sources.
This deduction limitation does not apply to taxpayers having $25 million or less in average, annual gross receipts. The Act defines business interest as interest paid or accrued on indebtedness that is allocable to a “trade or business” and is not to include investment interest. Certain types of businesses may be excluded from the term “trade or business” for purposes of calculating business interest, including real property trade or businesses that make an irrevocable election.
Net Operating Loss Deductions
For tax years beginning after December 31, 2017, non-farm net operating business losses can generally be carried forward indefinitely but there is no carryback. With respect to a pass-through entity, the net operating loss is determined at the partner level. The net operating loss can only offset up to 80% of the taxable income of the taxpayer. Neither the pass-through business income deduction nor the deduction for foreign-derived intangible income can create or increase a net operating loss deduction.
Limitation on Like-Kind Exchanges
For exchanges completed after December 31, 2017, only real estate will qualify for like-kind exchange treatment deferring gain. The trade-in or exchange of used equipment for new equipment will generally trigger taxable gain. This may lead to an unpleasant surprise when a business automobile or truck, for example, is traded in on a new vehicle. The trade-in value of equipment may go down while the sale price may also go down as a result.
Estate and Gift Taxes
Beginning January 1, 2018, the basic exclusion amount (i.e., the aggregate amount an individual may transfer tax free either during his or her lifetime or at death) is doubled to approximately $11.2 million and remains subject to an annual inflation adjustment. Similarly, since the GST Tax exemption is equal to the basic exclusion amount, the Act also doubles the GST Tax exemption amount. Also noteworthy, is that the Act does not affect portability, which allows a deceased spouse’s unused exclusion amount to be utilized by the surviving spouse, either during the surviving spouse’s lifetime or at his or her subsequent death.
The doubling of the exclusion amount could have a significant impact on existing estate plans. For example, a typical testamentary plan provides for a transfer of the decedent’s assets equal to the exclusion amount to a bypass or exemption trust(s) and the balance of such assets to a marital trust for the surviving spouse. When dealing with blended families where there are children from a prior marriage, it is not uncommon for the surviving spouse not to be a beneficiary of the bypass or exemption trust(s). Given the doubling of the exclusion amount, a testamentary plan containing such a formula would result, potentially, in doubling the amount passing to the bypass or exemption trust(s), potentially to the exclusion of the surviving spouse. For example, assuming a decedent’s estate was $9 million, if the decedent died in 2018 under existing law, approximately $5.6 million of assets would pass to the bypass or exemption trust and $3.4 million would pass to a marital trust. Under the Act, however, the entire $9 million would pass to the bypass or exemption trust and nothing to the marital trust, meaning that no assets are set aside for the surviving spouse if he/she is not a beneficiary of the bypass or exemption trust. Other testamentary plans containing similar formula-based distributions would run into a similar issue. Examples of this situation would include a distribution of the exclusion amount to descendants and the balance to charities or, similarly, a plan that provides for distribution of the GST Tax exemption amount to grandchildren first, and the balance to other family members.
As written, the law will expire on January 1, 2026, at which time, absent further congressional action, the basic exclusion amount will, effectively, be slashed in half. Consequently, prudent estate planning dictates a continued focus, when appropriate, of shifting appreciation of assets out of an individual’s estate in a tax-efficient manner given the potential for the return of a harsher estate tax beginning in January 2026. Currently, it is unclear what effect the expiration of the law on January 1, 2026 will have on an individual who took advantage of the increased basic exemption amount by making lifetime gifts where, at such individual’s death, the basic exclusion amount has been reduced cut in half (and potentially equal to an amount less than the lifetime gifts). However, the Act directs the Treasury Secretary to promulgate regulations to address this situation and account for the difference between the amounts during life and at death.
For tax years 2018 through 2025, the Act retains the current tax-bracket structure for individual income tax, but adjusts the taxable income thresholds of each bracket and lowers the tax rate applied to each bracket, with the highest tax rate decreasing from 39.6 percent to 37 percent and applying to (i) married individuals filing jointly with taxable income over $600,000, (ii) married individuals separately filing with taxable income over $300,000 and (iii) heads of households and single individuals with taxable income over $500,000. The tax-brackets can be found at this link.
For tax years 2018 through 2025, the Act increases the standard deduction for single filers to $12,000 and for joint filers to $24,000. The amount of the standard deduction is to be adjusted for inflation using the Chained Consumer Price Index for All Urban Consumers, as published by the Department of Labor.
For tax years 2018 through 2025, the Act eliminates the personal exemptions. In essence, they are rolled up into the standard deduction and the child tax credit increase. This makes the standard deduction more valuable to higher income individuals whose personal exemptions were phased out and less valuable to those who received the benefit of the personal exemptions.
Limitation on Excess Business Losses
For tax years beginning in 2018 through 2025, net non-corporate business losses of a taxpayer in excess of a threshold amount cannot be deducted but are carried over and treated as part of the taxpayer’s net operating loss to the next succeeding years to be applied against business income. In the case of entities taxable as partnerships or S corporations, the calculation is applied at the partner or shareholder level. The threshold amount is $500,000 for married filing jointly or $250,000 for all others. The threshold amount is adjusted for inflation.
Child Tax Credit
For tax years 2018 through 2025, the Act doubles the child tax credit to $2,000 per child and increases the limitation threshold for availability of the full amount of the child tax credit to $400,000 for joint filers and $200,000 for others. The Act provides that the maximum amount of refundable child tax credit will increase to $1,400 and will be adjusted for inflation. The Act adds a $500 nonrefundable credit for filers with a dependent who would not qualify for the child tax credit. This increased and additional credit was also a part of the rationale for eliminating personal exemptions.
Charitable Contribution Deduction Limit Increased
The Act increases the existing limitation on an individual’s charitable contribution deductions for charitable contributions of cash to public charities and certain other organizations from 50 percent of a taxpayer’s modified adjusted gross income to 60 percent. The increase limitation will be effective for contributions made in taxable years beginning after December 31, 2017.
Repeal of Substantiation Exception for Certain Charitable Contribution Deductions
A donor is required to obtain a contemporaneous written acknowledgement from a donee charity with respect to contributions of $250 or more to substantiate a charitable deduction. Under current law, there is an exception to this requirement when the donee charity files a return reporting the donor’s information and contribution amounts to the IRS. The Act repeals this exception effective for contributions made in taxable years beginning after December 31, 2016.
Denial of Charitable Contribution Deduction for College Athletic Event Seating Rights
The Act provides that no charitable deduction is allowed for any amount paid to an institution of higher education in exchange for the right to purchase tickets or seating at an athletic event. This modification is effective for contributions made in taxable years beginning after December 31, 2017.
The ABLE account concept was created in 2014, under Internal Revenue Code Section 529A, as a means for individuals who became disabled before age 26 to hold and manage assets in a manner that is both tax efficient (income from the ABLE account is generally tax free) and provides some protection for benefits that would otherwise be receivable through Medicaid or Social Security (e.g., the SSI program). Under current law, a maximum of $14,000 (indexed for inflation, $15,000 for 2018) per year can be deposited in a disabled person’s ABLE account (from all sources, including gifts from family members).
The Act makes three significant changes to ABLE accounts:
- the contribution limit is increased by the disabled person’s compensation income (up to the federal poverty line for a one person household, and provided that the disabled person does not participate in a qualified retirement plan);
- an educational 529 account where the disabled person or one of their family members is the beneficiary can be “rolled over” into the ABLE account of the disabled person (subject to the same overall contribution limits); and
- contributions by the disabled person could be eligible for the “saver’s credit” that is available to lower and middle income individuals who save for retirement.
Like most of the other individual tax relief in the Act, these changes would only be effective through 2025. The Act does not change the fact that if a disabled person’s ABLE account balance exceeds $100,000, then their benefits under SSI programs are suspended until the balance is below $100,000.
529 Accounts for Elementary and Secondary Education
The Act permits expenses for elementary and secondary education (up to $10,000 per year) to be eligible to be paid out of a 529 account. Under current law, 529 accounts can only be used for post-secondary education.
State and Local Tax Deductions
The Act generally repeals state and local tax deductions for individuals except for real property taxes and either state income or sales, but not both, all of which are capped at $10,000 ($5,000 for married taxpayers filing separately). This provision limits the deduction individuals may take for state tax liabilities arising from business activities of pass-through entities (such as partnerships, limited liability companies, and subchapter S corporations) that are not imposed directly on the pass-through or the business assets thereof. Furthermore, in order to thwart attempts to claim deductions in 2017 for prepayments of 2018 state and local income taxes, the Act provides that any such prepayments made prior to January 1, 2018 “shall be treated as paid on the last day of the taxable year for which such tax is so imposed.” This does not prohibit the payment in 2017 of 2017 taxes to avoid the limitation in 2018. However, because uncapped deductions continue to be permitted for taxes imposed on and paid by pass-through entities to the extent related to business property, pass-through entity owners in states, such as Tennessee, which impose an income and net worth tax directly upon pass-through entities would continue to be entitled to a deduction therefore.
Individual Healthcare Mandate Effectively Repealed
Under the Affordable Care Act, an individual must enroll in health insurance coverage or pay a penalty equal to the greater of (i) $695 per person ($347.50 for children aged 18 or younger) or (ii) 2.5% of the household’s income above a certain threshold, subject to certain caps. This is known as the individual mandate. The Act effectively eliminates the individual mandate by reducing the penalty to zero, effective January 1, 2019. While this will not affect employers directly, some indirect effects are likely. For instance, healthier workers who only elected coverage to satisfy the individual mandate may be less likely to enroll in employer-sponsored coverage going forward.
Retirement Plan Loans
The Act allows employees whose retirement plans terminate or who have a separation from service while they have a plan loan outstanding to roll over the plan loan to an IRA at any time until the due date for filing their tax return. Under present law, the rollover period is 60 days from distribution.
Moving and Bicycle Commuting Expenses
Employer reimbursements of qualified bicycle commuting expenses and moving expenses would be taxable income to the employee during tax years 2018 through 2025. Under current law those reimbursements are nontaxable fringe benefits.
Temporary Employer Credit for Paid Family and Medical Leave
The Act adds an employer credit for paid family and medical leave, effective for years between December 31, 2017 and December 31, 2019. This credit is based on a percentage of the wages paid to “qualifying” employees who are on family and medical leave for up to 12 weeks. “Qualifying” employees are defined as employees who have been employed for at least one year, and who have compensation under $72,000. In order to qualify for this credit, employers must have a policy of providing at least two weeks of paid leave to qualifying full-time employees, and a pro rata amount for part-time employees. This policy must provide at least 50% of employees’ normal wages. The credit ranges from 12.5% to 25% of applicable wages, and does not apply to leave paid by state or local governments, or required by state or local law.
Deduction Limitation on Compensation above $1 Million
Section 162(m) of the Internal Revenue Code limits the deductibility of compensation paid to certain executive officers that exceeds $1 million but includes an exception for payment of commissions or “performance-based compensation.” Nearly all publicly traded companies have relied on this exception by designing cash bonus programs and stock incentive programs to fit within the term “performance-based compensation.”
The Act eliminates the exemption for performance-based compensation and commissions. In addition, the deduction limit will apply to many more companies and many more payments than before.
Currently, only companies that have publicly traded stock are affected by Section 162(m). Going forward, the deduction limit will apply to:
(i) companies that have any type of publicly traded securities (stock or bonds) and
(ii) any company that is required to file reports with the Securities & Exchange Commission, even if the company’s securities are not publicly traded.
The deduction limit generally applies to compensation paid to anyone who would be a “named executive officer” under the proxy disclosure rules of the Securities & Exchange Commission. This includes the CEO or CFO and the three highest compensated officers, other than the CEO and CFO. This change closed an unintended loophole that exempted the CFO from the deduction limit. Also, starting in 2017, once includible as a named executive officer, the $1 million deduction limit will always apply to compensation paid to that individual, even to payments following retirement or death.
The new law will be effective for years beginning after December 31, 2017. There is a carve-out for any “binding contract” that was in effect on November 2, 2017, unless it has been materially modified.
Excise Tax on Parachutes and Compensation above $1 Million Paid By Tax-Exempts
The Act adds new section 4960 to the Internal Revenue Code that imposes a 20% excise tax on tax-exempt organizations (not the employee) that pay excess compensation, effective for years beginning after December 31, 2017. Excess compensation is defined as:
(i) Amounts over $1 million in a year, similar to 162(m) discussed above; or
(ii) Excess parachute payments paid on a separation from employment.
An excess parachute payment is an amount that equals or exceeds 300% of the employees average yearly compensation calculated over five years. The tax incorporates definitions from the golden parachute tax rules in Section 280G of the Code.
Compensation paid to an employee of the exempt organization is subject to the tax if the employee is one of five highest compensated employees for the year. This does not include, however, licensed medical professionals (including veterinarians). For excess parachute payments, the tax does not apply for employees who earned less than $120,000 (same as the highly compensated employee definition for 401(k) plans). As with 162(m), once an employee is in the top five, beginning in 2017, payments made to that individual will always be subject to the excise tax, even after retirement or death.
Advanced Refunding Bonds Repealed
A refunding bond is any bond used to pay principal, interest, or the redemption price on a prior bond issue. A current refunding bond occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as an advance refunding bond if it is issued more than 90 days before the redemption of the refunded bond. The Act repeals current law under which the interest paid on advanced refunding bonds is excluded from gross income and is not subject to federal income taxation.
Tax-Credit Bonds and Direct-Pay Bonds Repealed
The Act repeals the authority to issue tax-credit bonds and direct-pay bonds after 2017.
Separate Computation of Unrelated Business Taxable Income for Each Trade or Business
The Act will require an exempt organization with more than one unrelated trade or business to compute its unrelated business taxable income separately with respect to each trade or business and without regard to the specific deduction generally allowed under Section 512(b)(12) of the Code. The result of this provision is that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year.
New Excise Tax on Investment Income of Certain Private Colleges and Universities
For tax years beginning after December 31, 2017, the Act imposes an excise tax on an applicable educational institution for each taxable year equal to 1.4 percent of the net investment income of the institution for the taxable year. An applicable educational institution is one with over 500 students and assets which are not used directly in carrying out the institution’s exempt purpose with a fair market value of over $500,000 per student. The provision will be effective for taxable years beginning after December 31, 2017.
Waller will closely monitor developments related to the implementation of the Tax Cut and Jobs Act. For additional information, please contact any member of the Waller Tax practice.
The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.