The Tax Cuts and Jobs Act and its impacts on businesses and individuals

On December 22, 2017, President Trump signed into law H.R.1, also known as the Tax Cuts and Jobs Act (the “TCJA”). The TCJA makes the most significant and sweeping changes to the federal taxation of business and individuals in more than a generation.  Due to the unusual speed with which the TCJA went through the legislative process, the new law raises several technical issues and contains numerous drafting errors that are expected to be addressed in a 2018 technical corrections bill.

This blog post summarizes several of the TCJA’s most significant tax changes for businesses and individuals.  The Kean Miller Tax and Transactions Groups will post additional summaries of specific, identified provisions in the coming days.

Corporate Tax Changes

Reduced Corporate Tax Rate – The TCJA permanently reduces the corporate income tax rate from 35% to 21% for tax years starting in 2018.

Capital Expenditures – For the next five years (or, for certain property, six years) the TCJA allows corporations to fully expense the cost of “qualified property,” including tangible personal property and computer software.  This provision is phased out after five years and does not apply to property currently in use.  In addition, the TCJA alters the cost recovery period for certain real property and leasehold improvements.  The Section 179 expensing cap is increased from $500,000 to $1 million.

Dividends Received Deduction – The TCJA reduces the 80% dividends received deduction to 65% and the 70% dividends received deduction to 50% for tax years beginning after December 31, 2017.

Repeal of the Corporate AMT – The Corporate AMT is repealed for tax years beginning after 2017 and taxpayers can claim a refund for previously paid AMT amounts.

Net Operating Losses (“NOLs”) – The deduction for NOLs is limited to 80% of taxable income for losses arising in tax years after 2017.  NOLs generated in tax years ending after 2017 may be carried forward indefinitely, but the two-year carryback provisions are repealed (with certain exceptions).

Interest Expense Limitation –  For tax years beginning after December 31, 2017, the deduction for interest expense is limited to 30% of earnings before interest, taxes, depreciation and amortization through 2021 and of earnings before interest and taxes beginning in 2022.

Section 451 Revenue Recognition – Under the TCJA, and for tax years beginning after 2017, an accrual-method taxpayer is required to recognize income that is subject to the all-events test no later than the tax year in which the income is taken into account on the taxpayer’s financial statements (except for certain income).  The deferral method of accounting for advance payments for goods and services in Revenue Procedure 2004-34 is codified.

Research and Experimental Expenditures – Amounts paid or accrued for Research &Experimental expenditures after 2012 are capitalized and amortized over five years (15 years for certain foreign research expenditures).

Section 199 Domestic Production Deduction – The Section 199 deduction is repealed for tax years beginning after 2017.

Entertainment Expenses and Fringe Benefits – The 50% deduction for entertainment expenses is repealed, as are deductions for qualified transportation fringe benefits.  Deductions for other fringe benefits are also reduced or eliminated.

Like-Kind Exchanges – Under the TCJA, like-kind exchanges will be tax free, but only for real property exchanges.

Cash Accounting Limit Raised – More businesses will be able to use cash accounting as the upper limit in average annual gross receipts (measured as of the prior three years) has been raised from $5 million to $25 million.

Self-Created Property – The TCJA amends Section 1221(a)(3) and excludes patents, inventions, models or designs (whether or not patented), and secret formulas or processes that are held by the taxpayer who created the property or by a taxpayer with a substituted or transferred basis from the taxpayer who created the property, from the definition of a capital asset.  This provision is effective for dispositions after December 31, 2017.

Affordable Care Act – While the TCJA reduced the Affordable Care Act (the “ACA”) individual penalty to zero for months beginning after December 31, 2018, the ACA’s employer mandate rules have not been repealed and remain in full effect.

International Tax Changes

The TCJA’s most significant changes are to the US international tax regime.  Those changes include implementing a quasi-territorial tax system, imposing a one-time transition tax on accumulated foreign earnings, and imposing anti-deferral and anti-base erosion rules.

Pass-Through Deduction

The TCJA creates new Section 199A, which permits an individual to deduct up to 20% of their “qualified business income” earned through a partnership, S corporation or sole proprietorship, and qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income.  This deduction expires on December 31, 2025.

Qualified businesses includes partnerships; S corporations; sole proprietorships; REITs; cooperative and master limited partnerships.  However, specified service trades or businesses with income over $315,000 of taxable income for joint filers or $157,500 for other filers (with the deduction phased out over the next $50,000/$100,000 of taxable income) are excluded, including:

  • Any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services; or
  • Any business where the principal asset of the business is the reputation or skill of one or more of its employees

Qualified business income includes the net amount of qualified items of income, gain, deduction, and loss of a qualified trade or business that is effectively connected with the conduct of a US trade or business.  Certain specified investment-related income, deductions, or losses, and an S corporation shareholder’s reasonable compensation, guaranteed payments, or—to the extent provided in regulations—payments to a partner who is acting in a capacity other than his or her capacity as a partner are excluded from the definition of qualified business income.

Qualified business income deduction is limited to the greatest of 50% of wages paid by the business to its employees or 25% of wages paid plus 2.5% of the cost (unadjusted basis) of certain qualified business property.  Taxpayers with less than $315,000 of taxable income (joint return) or $157,500 (other filers) are not subject to this limitation (the wage limitation is phased in over the next $50,000/$100,000 of taxable income).

Individual Income Tax Changes

The TCJA reduces individual tax rates for taxable years beginning January 1, 2018 and ending December 31, 2025.  The top marginal tax rate is reduced from 39.6% to 37% and bracket widths are modified.  The new tax brackets are summarized below:

Single Individuals:

  • 10% – $0-$9,525
  • 12% – $9,525-$38,700
  • 22% – $38,700-$82,500
  • 24% – $82,500-$157,500
  • 32% – $157,500-$200,000
  • 35% – $200,000-$500,000
  • 37% – $500,000+

Married Filing Jointly and Surviving Spouses:

  • 10% – $0-$19,050
  • 12% – $19,050-$77,400
  • 22% – $77,400-$165,000
  • 24% – $165,000-$315,000
  • 32% – $315,000-$400,000
  • 35% – $400,000-$600,000
  • 37% – $600,000+

In addition to temporarily reducing the individual income tax rates and modifying the bracket widths, the TCJA also increased the standard deduction for married individuals filing jointly from $12,000 to $24,000 and for single filers from $6,350 to $12,700.  The TCJA also imposes significant limits on certain itemized deductions and eliminates several other deductions.  Notably, the TCJA limits the state tax deduction to $10,000, limits the mortgage interest deduction to the first $750,000 in principal value, and eliminates the home equity debt deduction and the personal exemption.  The limitation on itemized deductions, which phased out 3% of a taxpayer’s itemized deductions once income exceeded a threshold, is also suspended through 2025.  The Alternative Minimum Tax (“AMT”) is retained but the exemption is increased.

The Affordable Care Act required individuals not covered by a health plan that provided minimum essential coverage to pay a penalty with their federal tax return, unless an exception applied.  The TCJA permanently reduces that penalty to zero for months beginning after Dec. 31, 2018.

The legislation also permits distributions from retirement plans for persons who suffered losses as a result of the 2016 severe storms and flooding in Louisiana without penalty (but subject to tax, which may be spread over 3 years).  The distributions must be made before January 1, 2018.  Retirement plans may be amended to permit such distributions, and the amendment must be made by the last day of the first plan year beginning on or after January 1, 2018.  Also, distributees are permitted to repay such distributions within 3 years and treat them as rollovers.  This is an extension of the IRS guidance issued in 2016.

Implications

The TCJA is a significant and substantive, yet flawed revision to the US federal income tax regime.  The business tax consequences of the TCJA are only beginning to come into focus, but it is clear that most businesses should consider whether restructuring would make sense to maximize the tax benefits available under the TCJA.  In addition, certain provisions of the TCJA, such as the limitation on the interest expense deduction, could negatively impact certain businesses.  Those businesses should consider whether it is possible to restructure operations or financing to avoid or minimize the tax impact of the TCJA’s limitations on interest expense deductions.  For example, a highly-leveraged business could consider exploring alternative financing arrangements that do not generate interest expense.  Owners of flow-through entities that are not eligible for the 20% qualified business income deduction should also consider restructuring their operations in a manner that allows them to claim all or a portion of the deduction.

The TCJA will also have substantial state and local tax implications.  It is not clear at this time whether or to what extent states will conform to the provisions created by the TCJA.  But states like Louisiana that use federal taxable income as a starting point for computing state taxable income will certainly be impacted by the TCJA.

This article was submitted by Kean Miller LLC