On Dec. 22, President Donald Trump signed into law the tax reform bill, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (H.R. 1). This legislation is considered the most significant overhaul of the U.S. tax code since 1986. Generally applying to taxable years beginning on and after Jan. 1, 2018, the changes will have a profound impact on individuals and businesses in a variety of ways.
Generally, the new tax law alters individual income taxation, reduces corporate income taxes and introduces a new form of taxing the earnings from certain pass-through entities. In addition, the law moves the United States toward a modified territorial system that alters the current tax landscape for multinational entities. This alert addresses provisions of the new law that are most relevant to businesses and their owners.
Individual Income Tax Rates
For tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the new law modifies the tax brackets for individual income tax, with the highest bracket being a marginal rate of 37 percent (prior to the new law, the highest bracket was 39.6 percent). The reduced tax rates may not produce a lower tax liability, as the new law also eliminates personal exemptions, suspends or limits many itemized deductions and increases the standard deduction.
Taxation on U.S. Businesses
Corporate Income Tax and Corporate AMT: The new law provides for a permanent 21 percent flat corporate income tax rate and repeals corporate alternative minimum tax (AMT) for taxable years beginning after Dec. 31, 2017. The new law also reduces the 80 percent dividends-received deduction to 65 percent and the 70 percent dividends-received deduction to 50 percent. The new lower corporate income tax rate may cause more businesses to utilize the corporate structure, especially in scenarios where there will be limited distributions to shareholders and earnings will be used to pay down debt or finance acquisitions or growth.
Corporate Net Operating Losses: The new tax law limits the deduction for net operating loss carryovers to 80 percent of taxable income, eliminates the carryback of such losses for most companies and provides for an indefinite carryforward. This provision is generally effective for losses arising in tax years beginning after 2017.
Deduction for Qualified Business Income of Pass-Through Entities: A new deduction will be available to individuals, trusts and estates for qualified business income from pass-through and disregarded entities. Importantly, the deduction against qualifying income would expire for tax years beginning after Dec. 31, 2025.
During the covered years, individuals, estates and trusts may deduct from their taxable income 20 percent of qualified business income from a partnership, S corporation or sole proprietorship, including a disregarded entity treated as a sole proprietorship, subject to certain limitations.
Generally, a taxpayer’s qualified business income is derived from an active trade or business. It excludes any amounts paid by an S corporation treated as reasonable compensation, guaranteed payments to a partner in a partnership, and amounts paid to a partner acting in a capacity other than as a partner. The new law excludes income generated from certain specified service businesses (such as law, health, accounting and financial services) from qualified business income status if the taxpayer’s taxable income exceeds certain thresholds.
The pass-through deduction is limited to the greater of: 50 percent of the W-2 wages paid by the qualified business, or 25 percent of the W-2 wages plus 2.5 percent of the depreciable property in service in the qualified business.
Private equity funds and real estate companies whose employees are “housed” in separate related party entities may be limited in taking advantage of this deduction due to the wage limitation. However, this new deduction could mean significant income tax savings for many business owners.
Carried Interest: The new law institutes a three-year holding requirement for carried interests (defined as “applicable partnership interests”) to be eligible for long-term capital gain treatment. If such holding requirement is not satisfied, any capital gain recognized by the holder of “applicable partnership interests” will receive short-term capital gain treatment. An “applicable partnership interest” is a partnership interest transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer or certain related persons in an “applicable trade or business.” Covered trades or business are activities that are conducted on a regular, continuous, and substantial basis and that consist, in whole or in part, of:
- raising or returning capital; and
- either developing, or investing in or disposing of (or identifying for investing or disposition) “specified assets,” such as securities, commodities, real estate held for rental or investment, or cash or cash equivalent.
There are two notable carve-outs from the definition of applicable partnership interests. First, a partnership interest held by a corporation is excluded. Second, applicable partnership interests do not include capital partnership interests that provide the partner with the right to share in partnership capital commensurate with the amount of capital contributed or the value of such interest included in income under Section 83 of the Internal Revenue Code upon the receipt or vesting of the interest.
The new provision applies notwithstanding the application of Section 83 to the interest or whether the holder made a Section 83(b) election with respect to the interest. Interestingly, the new law does not include rules “grandfathering” applicable partnership interests held as of the effective date of the new law.
There will likely be future guidance in this area as the new tax law authorizes the U.S. Department of Treasury to promulgate regulations necessary to carry out the purposes of the provision. Also, portions of the technical language of the provision are ambiguous, so clarifying authority will be necessary.
Business Interest Expenses: Business interest expenses once deductible under Section 163 of the Internal Revenue Code now may be limited to 30 percent of the taxpayer’s earnings before interest, tax, depreciation and amortization (EBITDA) for taxable years beginning after 2017 and before 2022, and limited to 30 percent of a taxpayer’s earnings before interest and tax (EBIT) for taxable years beginning after 2021. At the taxpayer’s election, the limitation does not apply to interest incurred by the taxpayer in any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. It also does not apply to regulated public utilities, certain electric cooperatives and taxpayers with average annual gross receipts for the current and prior two taxable years that do not exceed $25 million.
Disallowed interest expenses can be carried forward indefinitely. Also, the business expense limitation is applied at the partnership level for businesses operated in a partnership. Any interest that cannot be deducted by the partnership because of the limit would be allocated to the partners in the same ratio as net income and loss, and could be used in future years to offset any excess income allocations. The exclusion of interest deductions will impact businesses with business interest expenses, particularly taxpayers with large annual revenues beginning in 2021 when the 30 percent limit is applied to a much smaller earnings base.
Bonus Depreciation: The new law modifies bonus depreciation under Section 168(k) of the Internal Revenue Code to allow 100 percent expensing for property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, and then phases out bonus depreciation with 20 percent reductions each year. Property “acquired” before Sept. 28, 2017, including under a binding written contract, will be subject to the old bonus depreciation rules, which is 50 percent through 2017, 40 percent in 2018, and 30 percent in 2019 with no bonus depreciation thereafter. The new law removed the “original use” requirement for bonus depreciation. This means property previously placed in service will qualify for 100 percent bonus depreciation when acquired by another party before Jan. 1, 2023.
Like-Kind Exchanges of Real Property: The new law limits the like-kind exchange rules to exchanges of real property that is not held primarily for sale. Thus, personal property (tangible or intangible) is no longer eligible for like-kind exchange treatment. This new provision applies to exchanges completed after Dec. 31, 2017.
Partnership Technical Terminations: The new tax law eliminates the current rules regarding partnership technical terminations under Section 708(b)(1)(B). Technical terminations occur when 50 percent or more of interests in both profits and capital are transferred in any rolling 12-month period. This results in the technical termination of the current partnership and the formation of a new partnership for federal tax purposes, with depreciation schedules restarted in the new partnership. Many partnership agreements have prohibitions on transfers that could result in a technical termination, including upstream transfers. The removal of the partnership technical termination rules will allow partners to more easily make transfers of their partnership interests, and even avoid indemnification if the partnership documents required indemnification by the transferring partner for technical terminations.
Section 199 Deductions: The new law eliminates the deduction for income attributable to domestic production. Section 199 of the Internal Revenue Code allowed for a 9 percent deduction from income for qualifying production activities income, including the domestic manufacture of tangible personal property or computer software and energy generation from renewable energy projects. The elimination of this deduction will impact owners of qualifying production property since the deduction is no longer available.
New Participation Tax Exemption: The new law adopts a “territorial” tax regime and exempts from U.S. tax the foreign-source portion of dividends received from certain foreign corporations. In concept, the exemption is similar to the “participation exemption” available under the laws of many foreign countries and used by foreign corporations resident in that country to avoid tax on dividends received from foreign subsidiaries. Newly enacted Section 245A of the U.S. Internal Revenue Code provides a 100 percent dividends-received deduction for certain eligible U.S. shareholders. To be eligible, the recipient must be a U.S. C corporation that owns at least 10 percent of the stock of the paying foreign corporation — and has retained that stock ownership for a specified period of time. The exemption is not available to S corporations or individuals.
Tax on Deemed Repatriation of Accumulated Foreign Earnings: To prevent U.S. corporations from using the new U.S. tax exemption to repatriate, on a tax-free basis, cash accumulated by foreign subsidiaries in prior years, the new law requires certain U.S. taxpayers to include in taxable income the taxpayer’s allocable share of a foreign corporation’s pre-2018 accumulated foreign earnings, as adjusted for foreign deficits and other items. These earnings will be subject to U.S. tax at an effective tax rate of 15.5 percent, to the extent attributable to cash or certain other liquid assets, or an effective tax rate of 8 percent if the earnings have been reinvested by the foreign corporation in illiquid assets. These effective rates are derived via a new deduction that has the effect of reducing the U.S. taxpayer’s higher statutory tax rate to the reduced 15.5 percent or 8 percent effective rate.
Notably, shareholders in certain S corporations will be required to include in taxable income their allocable shares of the foreign corporation’s unremitted earnings. To minimize the tax impact to S corporation shareholders, however, the new law defers or postpones the time at which this additional U.S. tax must be paid. More specifically, a United States C corporation must pay U.S. tax on its allocable share of unremitted foreign earnings over an eight-year period (with an acceleration in the event of certain triggering events). Shareholders of an S corporation, however, may elect to defer payment of this U.S. tax until there is a triggering event. Notably, the definition of a “triggering event” includes the termination of S corporation status and the sale of S corporation stock. Further, the S corporation is liable in the event the shareholder fails to pay such tax. Thus, shareholders of an S corporation that are subject to this new U.S. tax on unrepatriated foreign earnings must carefully consider any actions that would accelerate the payment of this tax.
Rules to Minimize Base Erosion: The new law creates a new base erosion and anti-abuse tax (the BEAT). The BEAT is intended to apply to companies that significantly reduce their U.S. tax liability by making cross-border payments to affiliates. The BEAT applies if 10 percent of the cross-border payment amounts exceed the company’s regular U.S. tax liability.
The new law adopts a number of base erosion provisions, including the following:
- Denial of new participation tax exemption (discussed above) for passive foreign investment company (PFIC) dividends and purging distributions
- Recapture of accumulated losses upon incorporation of a foreign branch
- Repeal of Section 367(a)(3), which currently permits U.S. taxpayers to transfer active trade or business assets to a foreign corporation on a tax-deferred basis
- Expansion of the pool of items of intangible property (including goodwill) that, if transferred by a U.S. taxpayer to a foreign corporation, would be subject to tax
- New Code Section 951A, by which some U.S. taxpayers will pay tax on certain income earned by controlled foreign corporations in excess of a specified return on tangible business assets
- New Section 250, by which U.S. corporations that derive certain income from unrelated foreign persons will benefit from a new tax deduction
- Adoption of an anti-inversion rule that denies the participation exemption and imposes a 35 percent tax rate (and applies certain other rules) in respect of “expatriated entities” during the 10-year period following enactment of the new law
Other Tax Rules : The new law also amends, repeals or enacts a number of other U.S. tax rules. For example, among other changes, it expands the definition of “U.S. shareholder” for purposes of the Subpart F rules, repeals the foreign tax credit available under Section 902 in respect of future foreign dividends and creates a new foreign tax credit limitation, and revises source rules for sales of inventory and certain partnership interests.
The tax law’s changes to domestic, international and cross-border transactions will have a significant impact on the structure and operation of transactions. In addition to creating additional complexity, these changes raise new issues for U.S. taxpayers that own, acquire or sell U.S. or foreign business ventures. Businesses and business owners need to carefully re-evaluate their transaction and operational structures in light of the new law.