The sweeping changes of recent tax reform may impact the choice of how business taxpayers maintain their financials, specifically regarding the cash vs accrual methods of accounting. In tax years beginning after December 31, 2017, taxpayers may select their accounting method according to the new limits and conditions, as applicable:

Tax reform permits taxpayers in certain circumstances to recognize income for tax purposes no later than the year in which it is recognized for financial reporting purposes:

Tax law changes may impact on a businesses’ accounting method choice, and warrant a company to review and, possibly, revise those choices.

In a like-kind exchange, a taxpayer doesn’t recognize gain or loss on an exchange of like-kind properties if both the relinquished property and the replacement property are held for productive use in a trade or business or for investment purposes. For exchanges completed after Dec. 31, 2017, the TCJA limits tax-free exchanges to exchanges of real property that is not held primarily for sale (real property limitation). Thus, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges.

Although the real property limitation applies to exchanges completed after Dec. 31, 2017, transition rules provide relief for certain exchanges. Specifically, the real property limitation doesn’t apply to an exchange if the relinquished property is disposed before Jan. 1, 2018, or the replacement property is received by the taxpayer before Jan. 1, 2018. If the transition rules apply and all other requirements for a tax-free exchange are satisfied, an exchange of personal property or intangible property that is completed after Dec. 31, 2017 can qualify as a tax-free like-kind exchange.

The Tax Cuts and Jobs Act (TCJA) imposes a limit on deductions for business interest for taxable years beginning in 2018. The limit, like other aspects of the law, has raised some questions for taxpayers. In response, the IRS has issued temporary guidance that taxpayers can rely on until it releases regulations. While the guidance provides some valuable information, it also leaves some questions unanswered.

The prior-law limit rules

Prior to the TCJA, corporations could not deduct “disqualified interest” expense if the borrower’s debt equaled more than one and a half times its equity and net interest expense exceeded 50% of its adjusted taxable income. Disqualified interest included interest paid or accrued to:

Previously, taxpayers could carry forward excess interest indefinitely. And any excess limit could be carried forward three years.

These rules were for the so-called “earnings stripping” rules. They were intended to prevent corporations from wiping out their taxable income by deducting interest payments on debt owed to certain parties.

The new-law limit

For tax years beginning after 2017, the deduction for business interest incurred by both corporate and noncorporate taxpayers is limited to the sum of:

The limit applies to all taxpayers, except those with average annual gross receipts of $25 million or less, real estate or farming businesses that elect to exempt themselves and certain regulated utilities.

The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limit. Excess limit, however, cannot be carried forward.

C-corporation business interest income and expense

The IRS announced it will issue regulations clarifying that, for purposes of Section 163(j) only, all interest paid or accrued on a C corporation’s debt is business interest. All interest on debt held by a C corporation and includable in its gross income is business interest income.

In addition, the regulations will address the proper treatment of interest paid, accrued or includable in gross income by a noncorporate entity (e.g., a partnership) in which the C corporation holds an interest. And the regulations will clarify that the disallowance and carryforward of a deduction for a C corporation’s business interest expense will not affect whether and when such an expense reduces the corporation’s earnings and profits.

Treatment of consolidated groups

For groups of affiliated corporations that file a consolidated tax return, forthcoming regulations will clarify that the business interest deduction limit applies at the group level. For example, a consolidated group’s taxable income for purposes of calculating its adjusted taxable income will be its consolidated taxable income. Intercompany obligations (e.g. debt between affiliated corporations) will not count when determining the amount of the limitation.

The regulations also will address several other issues related to the application of the limit to consolidated groups. These include the allocation of the limit among group members, the treatment of disallowed interest deduction carryforwards when a member leaves the group and the treatment of a new group member’s carryforwards. The regulations are not expected to treat an affiliated group that doesn’t file a consolidated tax return as a single taxpayer for purposes of the interest expense deduction limit.

Electing to be exempt from the interest expense deduction limit

Real estate and farm businesses can elect to exempt themselves from the Section 163(j) interest expense deduction limit. At first glance, making the election may seem like a no-brainer — but the election, which is irrevocable, can backfire.

Businesses that make the election must use the alternative depreciation system (ADS) for certain property (generally, real or farm property with a recovery period of 10 years or more) used in the business, regardless of when the property was placed in service. ADS depreciation is over longer periods, so an electing taxpayer’s annual depreciation deductions are reduced if the election is made. Electing businesses also can’t claim first-year bonus depreciation. Businesses should weigh the advantage of avoiding the interest expense deduction limit by making the election against the detriment of slower depreciation deductions if the election is made.

Treatment of pre-2018 interest carryforwards

According to the temporary guidance, the IRS will issue regulations clarifying that taxpayers with interest carryforwards from the last taxable year beginning before 2018 can carry them forward as business interest to their first taxable year beginning after 2017. The regulations will clarify that this business interest that is carried forward will be subject to potential disallowance under amended Section 163(j) in the same manner as any other business interest otherwise paid or accrued in a tax year beginning after 2017.

The regulations also will address the treatment of pre-2018 business interest under the TCJA-created IRC Section 59A, the base erosion and anti-abuse tax. The base erosion tax applies only to businesses with average annual gross receipts of at least $500 million.

Next steps

The IRS has requested comments on the rules outlined in its interim guidance. It also expects to issue regulations providing additional guidance on issues not yet covered and requested comments on which issues those regulations should address. Comments are due by May 31, 2018.

Before the Tax Cuts and Jobs Act, a second tax system called the alternative minimum tax (AMT) applied to both corporate and noncorporate taxpayers. The AMT was designed to reduce a taxpayer’s ability to avoid taxes by using certain deductions and other tax benefit items. The taxpayer’s tax liability for the year was equal to the sum of (i) the regular tax liability, plus (ii) the AMT liability for the year.

A corporation’s tentative minimum tax equalled 20% of the corporation’s “alternative minimum taxable income” (AMTI) in excess of a $40,000 exemption amount, minus the corporation’s AMT foreign tax credit. AMTI was figured by subtracting various AMT adjustments and adding back AMT preferences. The $40,000 exemption amount gradually phased out at a rate of 25% of AMTI above $150,000. “Small” corporations-those whose average annual gross receipts for the prior three years didn’t exceed $7.5 million ($5 million for startups)-were exempt from the AMT. A taxpayer’s net operating loss (NOL) deduction, generally, couldn’t reduce a taxpayer’s AMTI by more than 90% of the AMTI (determined without regard to the NOL deduction). Very complex rules applied to the deductibility of minimum tax credits (MTCs). All-in-all, the AMT was a very complicated system that added greatly to corporate tax compliance chores.

Corporate AMT repeal

The Tax Cuts and Jobs Act repealed the AMT on corporations. Conforming changes also simplified dozens of other tax code sections that were related to the corporate AMT. The TCJA also allows corporations to offset regular tax liability by any minimum tax credit they may have for any tax year. And, a corporation’s MTC is refundable for any tax year beginning after 2017 and before 2022 in an amount equal to 50% (100% for tax years beginning in 2021) of the excess MTC for the tax year, over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the corporation’s MTC will be allowed in tax years beginning before 2022.

The Tax Cuts and Jobs Act (TCJA) should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC or sole proprietorship. This income is sometimes referred to as “pass-through” income. The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business.

The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.

The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. It is available regardless of whether you itemize deductions or take the standard deduction. The deduction cannot exceed 20% of the excess of your taxable income over net capital gain. Current QBI losses will be carried forward to offset future QBI income years.

For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, or $415,000.)

Additionally, for taxpayers with taxable income more than the thresholds ($157,000/$315,000), the deduction is limited by either wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000.

Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.

The complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the threshold discussed above.

The Tax Cuts and Jobs Act makes changes to the general business credit by adding a new component credit for paid family and medical leave, and changing two current component credits, i.e., the rehabilitation credit and the orphan drug credit.

First, the Act introduces a new component credit for paid family and medical leave, i.e. the paid family and medical leave credit, which is available to eligible employers for wages paid to qualifying employees on family and medical leave. The credit is available as long as the amount paid to employees on leave is at least 50% of their normal wages and the leave payments are made in employer tax years beginning in 2018 and 2019. That is, under the Act, the new credit is temporary and won’t be available for employer tax years beginning in 2020 or later unless Congress extends it further.

For leave payments of 50% of normal wage payments, the credit amount is 12.5% of wages paid on leave. If the leave payment is more than 50% of normal wages, then the credit is raised by .25% for each 1% by which the rate is more than 50% of normal wages. So, if the leave payment rate is 100% of the normal rate, i.e. is equal to the normal rate, then the credit is raised to 25% of the on leave payment rate. The maximum leave allowed for any employee for any tax year is 12 weeks.

Eligible employers are those with a written policy in place allowing (1) qualifying full-time employees at least two weeks of paid family and medical leave a year, and (2) less than full-time employees a pro-rated amount of leave. On that note, qualifying employees are those who have (1) been employed by the employer for one year or more, and (2) who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.

Second, the Act changes the rehabilitation credit for qualified rehabilitation expenditures paid or incurred starting in 2018, by eliminating the 10% credit for expenditures for qualified rehabilitation buildings placed in service before 1936, and retaining the 20% credit for expenditures for certified historic structures, but reducing its value by requiring taxpayers to take the credit ratably over five years starting with the date the structure is placed in service. Formerly, a taxpayer could take the entire credit in the year the structure was placed in service. The Act also provides for a transition rule for buildings owned or leased at all times on and after Jan. 1, 2018.

Third, the Act also makes significant changes to another component credit of the general business credit, i.e., the orphan drug credit for clinical testing expenses for certain drugs for rare diseases or conditions. For clinical testing expense amounts paid or incurred in tax years beginning in 2018, the former 50% credit is cut in half to 25%. Taxpayers that claim the full credit have to reduce the amount of any otherwise allowable deduction for the expenses regardless of limitations under the general business credit. Similarly, taxpayers that capitalize, rather than deduct, their expenses have to reduce the amount charged to a capital account. The credit has been reduced and now equals 25 percent of qualifying clinical testing expenses. However, the Act gives taxpayers the option of taking a reduced orphan drug credit that if elected allows taxpayers to avoid reducing otherwise allowable deductions or charges to their capital account. The election for the reduced credit for any tax year must be made on a tax return no later than the time for filing the return for that year (including extensions) and in a manner prescribed by IRS. Once the reduced credit election is made, it is irrevocable.

Net Operating Losses

Under pre-Tax Cuts and Jobs Act law, a net operating loss (NOL) for any tax year was generally carried back two years, and then carried forward 20 years. Taxpayers could elect to forego the carryback. The entire amount of the NOL for a tax year was carried to the earliest of the tax years to which it may be carried, then carried to the next earliest of those tax years, etc.

New Law: Tax Reform repeals the general two-year NOL carryback and the special carryback provisions, but provides a two-year carryback for certain losses incurred in a farming trade or business. The Act also provides that NOLs may be carried forward indefinitely. There is also a provision that limits the NOL deduction to 80% of taxable income.

Disallowance of Excess Business Losses

Under pre-Tax Cuts and Jobs Act law, if a non-corporate taxpayer received any applicable subsidy for any tax year, the taxpayer’s excess farm loss for the tax year wasn’t allowed. Thus, the amount of losses that could be claimed by an individual, estate, trust, or partnership were limited to a threshold amount if the taxpayer had received an applicable subsidy. For this purpose, an excess farm loss was the excess of the taxpayer’s aggregate deductions that were attributable to farming businesses over the sum of the taxpayer’s aggregate gross income or gain attributable to farming businesses plus a threshold amount. Any excess farm loss was carried over to the next tax year.

New Law: The Tax Cuts and Jobs Act provides that, for a tax year of a taxpayer other than a corporation beginning after Dec. 31, 2017 the limitation on excess farm loss for non-corporate taxpayers under Code Sec. 461(j) doesn’t apply. Thus, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, excess business loss of a taxpayer other than a corporation are not allowed for the tax year. In other words, the Tax Cuts and Jobs Act expands the limitation on excess farming loss to other non-corporate taxpayers engaged in any business. This can apply to the excess business loss of sole proprietorships, partnerships, S corporations, limited liability companies (LLCs), estates, and trusts.

An “excess business loss” is the excess (if any) of  the taxpayer’s aggregate deductions for the tax year that are attributable to trades or businesses of the taxpayer, over the sum of:  (i)  the taxpayer’s aggregate gross income or gain for the tax year which is attributable to those trades or businesses, plus (ii)  $250,000 (200% of that amount for a joint return (i.e., $500,000)).

Any loss that is disallowed as an excess business loss is treated as a net operating loss (NOL) carryover to the following tax year. Under the Tax Cuts and Jobs Act, NOL carryovers are generally allowed for a tax year up to the lesser of the carryover amount or 90% (80% for tax years beginning after 2022) of taxable income determined without regard to the deduction for NOLs.

As you can see from this overview, the new law affects many areas of taxation. If you wish to discuss the impact of the law on your particular situation, please give us a call.

Shopping, anyone? If your business is in need of office equipment, computer software or perhaps an HVAC system, the purchase you make today could provide you with a tax break tomorrow — or, more specifically, when you’re ready to file your 2016 taxes. The Section 179 expensing deduction remains a solid potential tax-saving value for today’s companies.

Expensing your buys

Sec. 179 of the Internal Revenue Code allows businesses to elect to immediately deduct — or “expense” — the cost of certain tangible personal property acquired and placed in service during the tax year. This is instead of claiming the costs more slowly through depreciation deductions. The election can only offset net income, however. It can’t reduce it below $0 to create a net operating loss.

The election is also subject to annual dollar limits. For 2016, businesses can expense up to $500,000 in qualified new or used assets, subject to a dollar-for-dollar phaseout once the cost of all qualifying property placed in service during the tax year exceeds $2 million.

Improving real property, too

The expensing limit and phaseout amounts would have been far lower had Congress not passed the Protecting Americans from Tax Hikes Act in late 2015. The new law made the limits permanent, indexing them for inflation beginning this year. It also makes permanent the ability to apply Sec. 179 expensing to qualified real property, such as eligible leasehold-improvement, restaurant and retail-improvement property.

Finally, the new law permanently includes off-the-shelf computer software on the list of qualified property. And, beginning in 2016, it adds air conditioning and heating units to the list.

Considering all options

You can use Sec. 179 expensing for both new and used property. A related tax break, bonus depreciation, applies only to new property. Be sure to consider all options when purchasing assets. Questions? Please call us — we can help you identify the right depreciation tax breaks for your business.