The Tax Cuts and Jobs Act (TCJA), which was signed into law on December 22, will broadly impact businesses of all sizes.
The bill significantly reduces the income tax rate for corporations and eliminates the corporate alternative minimum tax (AMT). It also provides a large new tax deduction for most owners of pass-through entities and significantly increases individual AMT and estate tax exemptions. And it makes major changes related to the taxation of foreign income.
You may even be able to utilize some enhancements on your 2017 tax return.
It’s not all good news for taxpayers, however. The TCJA also eliminates or limits many tax breaks, and much of the tax relief is only temporary.
Here are the most important changes in the new law that will affect businesses and their owners.
New Corporate Tax Rate
Beginning in 2018, the TCJA establishes a flat 21% corporate rate, and that rate applies to personal service corporations as well. Fiscal-year corporations will need to compute tax using a pro rata allocation based on days for the tax year that includes January 1, 2018.
Under pre-TCJA law, C corporations paid graduated federal income tax rates with a maximum rate of 35%.
Reduced Corporate Dividends Deduction
Under pre-TCJA law, C corporations that received dividends from other corporations were entitled to partially deduct those dividends. If the corporation owned at least 20% of the stock of another corporation, an 80% deduction applied. Otherwise, the deduction was 70% of dividends received.
For tax years beginning in 2018, the TCJA reduces the 80% deduction to 65% and the 70% deduction to 50%. These reductions are part of the price businesses have to pay for the new 21% corporate rate.
Repealed Corporate Alternative Minimum Tax
For tax years beginning in 2018, the new law repeals the corporate alternative minimum tax (AMT). For corporations that paid the corporate AMT in earlier years, an AMT credit was allowed under prior law.
The new law allows corporations to use their AMT credit carryovers in their 2018–2021 tax years to offset regular tax liability with 50% of any remaining unused credits being refundable through 2020. In 2021, 100% of any remaining credits is refundable.
Prior to the TCJA, the corporate AMT was imposed at a 20% rate. However, corporations with average annual gross receipts of less than $7.5 million for the preceding three tax years were exempt.
New Deduction for Pass-Through Businesses
Under prior law, net taxable income from pass-through business entities (such as sole proprietorships, partnerships, S corporations, and LLCs that are treated as sole proprietorships or as partnerships for tax purposes) was simply passed through to owners. It was then taxed at the owners’ standard rates. In other words, no special treatment applied to pass-through income recognized by business owners.
For tax years beginning in 2018, the TCJA establishes a new deduction based on a noncorporate owner’s qualified business income (QBI). This new tax break is available to individuals, estates, and trusts that own interests in pass-through business entities. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
QBI is generally defined as the net amount of qualified items of income, gain, deduction, and loss from any qualified business of the noncorporate owner. For this purpose, qualified items are income, gain, deduction, and loss that are effectively connected with the conduct of a US business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business, or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.
The QBI deduction isn’t allowed in calculating the noncorporate owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction.
W-2 Wage Limitation
For pass-through entities other than sole proprietorships, the QBI deduction generally can’t exceed the greater of the noncorporate owner’s share of either:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year
- The sum of 25% of W-2 wages paid plus 2.5% of the cost of qualified property
Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year-end and used by the business at any point during the tax year for the production of qualified business income.
Under an exception, the W-2 wage limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Above those income levels, the W-2 wage limitation is phased in over a $50,000 range ($100,000 range for joint filers).
Service Business Limitation
Finally, the QBI deduction generally isn’t available for income from specified service businesses (such as most professional practices other than engineering and architecture and businesses that involve investment-type services such as brokerage and investment advisory services).
Under an exception, the service business limitation doesn’t apply until an individual owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Above those income levels, the service business limitation is phased in over a $50,000 phase-in range ($100,000 range for joint filers).
The W-2 wage limitation and the service business limitation don’t apply as long as your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.
Bonus depreciation improves significantly under the TCJA.
Qualified new assets that your business placed in service in 2017 were entitled to a 50% first-year bonus depreciation deduction. Used assets didn’t qualify. This tax break could be claimed for the cost of new computer systems, purchased software, vehicles, machinery, equipment, and office furniture, among other items.
In addition, 50% bonus depreciation could be claimed for qualified improvement property (QIP), which is any qualified improvement to the interior portion of a nonresidential building if the improvement is placed in service after the date the building is placed in service. But qualified improvement costs don’t include expenditures for the enlargement of a building, an elevator or escalator, or the internal structural framework of a building.
100% Bonus Depreciation Under TCJA
For qualified property placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain property with longer production periods), the first-year bonus depreciation percentage is increased to 100%. In addition, the 100% deduction is allowed for both new and used qualifying property.
The new law also allows 100% bonus depreciation for qualified film, television, and live theatrical productions placed in service on or after September 28, 2017. Productions are considered placed in service at the time of the initial release, broadcast, or live commercial performance.
In later years, bonus depreciation is scheduled to be reduced as follows:
- 80% for property placed in service in 2023
- 60% for property placed in service in 2024
- 40% for property placed in service in 2025
- 20% for property placed in service in 2026
It’s important to note that for certain property with longer production periods, the preceding reductions are delayed by one year. For example, 80% bonus depreciation will apply to long-production-period property placed in service in 2024.
Section 179 Deduction
When 100% first-year bonus depreciation isn’t available, the Section 179 tax break can provide similar benefits. Section 179 allows eligible taxpayers to deduct the entire cost of qualifying new or used depreciable property and most software in year one, subject to various limitations.
Under pre-TCJA law, for tax years that began in 2017, the maximum Section 179 depreciation deduction is $510,000. The maximum deduction is phased out dollar for dollar to the extent the cost of eligible property placed in service during the tax year exceeds the phaseout threshold of $2.03 million.
The TCJA permanently enhances the Section 179 deduction. Under the new law, for qualifying property placed in service in tax years beginning in 2018, the maximum Section 179 deduction is increased to $1 million, and the phaseout threshold amount is increased to $2.5 million.
For later tax years, these amounts will be indexed for inflation. For purposes of determining eligibility for these higher limits, property is treated as acquired on the date a written binding contract for the acquisition is signed.
The new law also expands the definition of eligible property to include certain depreciable tangible personal property used predominantly to furnish lodging. The definition of qualified real property eligible for the Section 179 deduction is also expanded to include the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.
Business Passenger Vehicles Deductions
For new or used passenger vehicles that are placed in service in 2018 and used over 50% for business, the maximum annual depreciation deductions under the TCJA are as follows:
- $10,000 for year one
- $16,000 for year two
- $9,600 for year three
- $5,760 for year four and thereafter until the vehicle is fully depreciated
For years after 2018, these amounts will be increased for inflation.
While the year one amount is a little lower than the year one amount under pre-TCJA law, the TCJA allows much faster depreciation overall. For example, the 2017 limits for passenger cars are $11,160 for year one for a new car ($3,160 for a used car). For subsequent years for new and used cars, the limits are as follows:
- $5,100 for year two
- $3,050 for year three
- $1,875 for year four and thereafter
Slightly higher limits apply to light trucks and light vans.
Other Changes for Depreciable Property
The new law makes a few other changes impacting depreciation. For instance, it shortens the recovery period for farming business machinery and equipment from seven years to five years.
It also eliminates separate definitions for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, but retains qualified improvement property (QIP). The conference agreement indicates the intention was to reduce the recovery period for QIP from 39 years to 15 years (the eliminated definitions all had a 15-year recovery period), but the change wasn’t reflected in the final statute. Changes made within the statute also removed QIP’s eligibility for bonus depreciation; however, that doesn’t appear to have been the intent. Because of this, QIP remains 39-year property and doesn’t qualify for bonus depreciation.
New Limits on Business Interest Deductions
Subject to some restrictions and exceptions, prior law stated that interest paid or accrued by a business generally is fully deductible. Under the TCJA, affected corporate and noncorporate businesses generally can’t deduct interest expenses in excess of 30% of adjusted taxable income, starting with tax years in 2018. For S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes, this limit is applied at the entity level rather than at the owner level.
Adjusted taxable income means taxable income computed without regard to nonbusiness items, any net operating loss deduction, and the pass-through deduction. For tax years beginning in 2018 through 2021, adjusted taxable income also requires adding back allowable deductions for depreciation, amortization, and depletion. After that, these amounts aren’t added back in calculating adjusted taxable income.
Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that can’t be deducted in the current year can generally be carried forward indefinitely.
Taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three previous tax years are exempt from the interest deduction limitation. Some other taxpayers are also exempt. For example, real property businesses that elect to use a slower depreciation method for their real property with a normal depreciation period of 10 years or more are exempt. Another exemption applies to interest expense from dealer floor plan financing (for example, financing by dealers to acquire motor vehicles, boats, or farm machinery that will be sold or leased to customers).
Reduced or Eliminated Employer Deductions for Business-Related Meals and Entertainment
Prior to the TCJA, taxpayers generally could deduct 50% of expenses for business-related meals and entertainment. Meals provided to an employee for the convenience of the employer on the employer’s business premises were generally 100% deductible by the employer and tax-free to the recipient employee. Various other employer-provided fringe benefits were also deductible by the employer and tax-free to the recipient employee.
Under the new law, for amounts paid or incurred after December 31, 2017, deductions for business-related entertainment expenses are disallowed. Meal expenses incurred while traveling on business are still 50% deductible, but the 50% disallowance rule will now also apply to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises will be nondeductible.
Changes to Some Employee Fringe Benefits
The new law disallows employer deductions for the cost of providing commuting transportation to an employee, such as hiring a car service, unless the transportation is necessary for the employee’s safety.
It also eliminates employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking allowances, mass transit passes, and van pooling), but those benefits are still tax-free to recipient employees.
Foreign Tax Provisions
The TCJA includes a bevy of changes that will affect taxpayers who conduct foreign operations. In conjunction with the reduced corporate tax rate, the changes are intended to encourage multinational companies to conduct more operations in the United States, with the resulting increased investments and job creation in this country. An Alert covering the international provisions will be issued separately.
Here are some of the other business-related changes in the TCJA:
- For business net operating losses (NOLs) that arise in tax years after December 31, 2017, the maximum amount of taxable income that can be offset with NOL deductions is generally reduced from 100% to 80%. In addition, NOLs incurred in tax years ending after December 31, 2017, can no longer be carried back to an earlier tax year (except for certain farming losses). Affected NOLs can be carried forward indefinitely.
- The Section 199 deduction, also commonly referred to as the domestic production activities deduction or manufacturers’ deduction, is eliminated for tax years beginning after December 31, 2017.
- A new limitation applies to deductions for “excess business losses” incurred by noncorporate taxpayers. Losses that are disallowed under this rule are carried forward to later tax years and can then be deducted under the rules that apply to NOLs. This new limit kicks in after applying the passive activity loss rules. However, it applies to an individual taxpayer only if the excess business loss exceeds the applicable threshold.
- The eligibility rules to use the more-flexible cash method of accounting are liberalized to make them available to businesses with average gross receipts of less than $25 million. Also, eligible businesses are excused from the chore of doing inventory accounting for tax purposes.
- The Section 1031 rules that allow tax-deferred exchanges of appreciated like-kind property is allowed only for real estate for exchanges completed after December 31, 2017. Beginning in 2018, there are no more like-kind exchanges for personal property assets. However, the prior-law rules still apply if one leg of an exchange has been completed as of December 31, 2017, but one leg remains open on that date.
- Compensation deductions for amounts paid to principal executive officers generally can’t exceed $1 million per year, subject to a transition rule for amounts paid under binding contracts that were in effect as of November 2, 2017.
- Specified R&D expenses must be capitalized and amortized over five years, or 15 years if the R&D is conducted outside of the United States instead of being deducted currently. This is effective for tax years beginning after December 31, 2021.
We’re Here to Help
If you’d like to learn more about how the new tax laws will impact your business, contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.