By Peter T. Beach
The Tax Cuts and Jobs Act (the “Act”) signed by the president on December 22, 2017, lowers most business and individual tax rates, makes fundamental changes to US international tax rules, and generally represents the most sweeping reform of the US tax code in over 30 years. The Act will affect how businesses are organized and capitalized, whether and to what extent businesses should operate in foreign jurisdictions, and many aspects of day-to-day business operations and transactions. While there are some exceptions, for the most part the individual changes are effective January 1, 2018, through December 31, 2025, and the business changes are effective January 1, 2018 with no sunset date.
Here is a high level summary of significant changes made by the Act affecting individuals and businesses—the list is not exhaustive. Be forewarned that this summary moves from the relatively simple individual changes through the mix of simple and complicated business changes, ending with the decidedly complex international tax changes. As 2018 unfolds, we will be sending out other communications that focus on certain aspects of the Act. If you have any questions about this Overview, please reach out to Peter Beach or any other Sheehan Phinney attorney whom you normally consult.
Individual Tax Provisions
- Tax Rates. Individual tax rates are now 10%, 12%, 22%, 24%, 32%, 35% and 37%. Whether and by how much a taxpayer benefits from these changes will depend on what their tax bracket was for 2017, what it will be for 2018 and how the other changes, including those discussed below, affect their taxable income. Capital gain tax rates generally remain the same. The top tax rates on long-term capital gains and qualified dividend income remain at 20%. The 3.8% net investment income tax imposed on investment income of individuals with income above certain thresholds is retained.
- Standard Deduction. There is now a higher standard deduction of $24,000 for married couples filing jointly, $18,000 for heads of households and $12,000 for singles and married couples filing separately. However, to simply compare this to your itemized deductions for last year can be misleading because itemized deductions allowed as of January 1, 2018 will also change.
- Personal Exemptions. Personal exemptions, the amounts taxpayers were able to exclude from income based on themselves, their spouse and their dependents, are no longer part of the tax law.
- Child Tax Credit. The child tax credit has increased to $2,000 per child and is modified in other ways to reach more taxpayers. The adjusted gross income levels at which the credit begins to phase out has increased to $400,000 for married taxpayers filing a joint return and $200,000 for all other taxpayers. The Act also provides for a $500 non-refundable credit for qualifying dependents other than qualifying children and generally retains the current Code definition of a dependent.
- Individual Mandate. Taxpayers not covered by a qualifying health plan will no longer be required to pay a penalty under the Affordable Care Act’s so-called individual mandate.
- Medical Expenses. The adjusted gross income threshold for the medical expense deduction will be 7.5% for regular and alternative minimum tax purposes for 2017 and 2018. After that, the threshold will return to its previous level of 10%.
- Deduction for State and Local Taxes. The itemized deduction for state and local property taxes and income taxes (or sales taxes in lieu of income taxes) is now limited to $10,000 ($5,000 for a married taxpayer filing a separate return).
- Mortgage Interest. The mortgage debt limit for the home mortgage interest deduction has been reduced from $1,000,000 to $750,000 ($375,000 for separate filers) with certain exceptions, and taxpayers can no longer deduct interest on home equity debt. This provision is applicable as of December 15, 2017, presumably, to prevent home buyers who obtained new mortgages between the date the Committee of Conference released its report and the January 1, 2018, effective date of the Act from skirting the reduced debt limit.
- Miscellaneous Itemized Deductions. Taxpayers can no longer deduct miscellaneous itemized deductions (such as certain investment expenses, professional fees and unreimbursed employee business expenses), which were previously allowed over a 2% floor. For example, investors in private investment funds will not be able to deduct management fees, even if such fees exceed 2% of their income.
- Reduction of Itemized Deductions. Prior law that had required the reduction of certain itemized deductions when adjusted gross income reached a certain threshold no longer applies.
- Casualty and Theft Losses. Taxpayers can no longer deduct personal casualty and theft losses, except for those arising in connection with federally declared disasters.
- Moving Expense Deduction. Taxpayers, other than members of the military in certain circumstances, can no longer deduct moving expenses.
- Section 529 Plans. Tax-free Section 529 plan distributions will now include distributions used to pay qualifying elementary and secondary school expenses up to $10,000 per student per tax year.
- Charitable Deduction. The charitable deduction is retained but the income-based percentage limit for charitable contributions of cash to public charities by individuals is increased from 50% to 60%. In addition, deductions for payments made in exchange for college athletic event seating rights are no longer allowed.
- Alimony. Under prior law, alimony and separate maintenance payments were deductible by the spouse who made the payments and were included in income by the spouse receiving the payments. Under the Act, for any divorce or separation agreement executed after December 31, 2018, alimony and separate maintenance payments are no longer deductible by the spouse who makes the payments and are not includible in income by the spouse who receives the payments.
- Individual Alternative Minimum Tax (“AMT”). The individual AMT, which imposes an alternative tax system under which individuals pay the greater of their regular tax and their AMT, still applies, but the amount of alternative minimum taxable income that is exempt has increased to $109,400 for joint filers, $70,300 for singles and heads of households, and $54,700 for separate filers. In addition, the exemption phases out at significantly higher levels of income.
- Capital Asset Treatment of Patents. Capital gain treatment no longer applies to the sale of a “self-created” patent (or invention or trade secret). Sales of such assets will now be taxed at ordinary income tax rates (similar to treatment of copyrights under current law) to the extent sold by the person who created the patent or who has a carryover basis from the person who created the patent. This provision could make sales of such assets by S corporations less attractive because gain associated with such assets would pass through to the shareholders as ordinary income rather than capital gain.
- Like-Kind Exchanges. The like-kind exchange rules, which previously generally exempted from tax the exchange of certain business or investment property for similar property is now limited to exchanges of real estate other than real estate held as inventory. However, any previously qualifying exchange that is completed after December 31, 2017, may qualify if one leg of the exchange is completed before that date.
- Estate Tax. For estates of decedents dying on or between December 31, 2017, and January 1, 2026, the gift and estate tax exemption will increase to $10 million, with indexing applied for inflation occurring after 2011, which is expected to yield an exemption level of $11.2 million per person for 2018. The Act also retains the basis step-up on death.
Corporate Tax Provisions
- Tax Rate. Corporations had previously been subject to graduated tax rates that ranged from 15% to 35%, but will now be subject to a flat rate of 21%. This new rate may affect decisions to organize a business as a corporation or a “pass-through” vehicle (e.g., a partnership, LLC or S corporation). In light of this significant reduction in the corporate tax rate, many owners of businesses that are classified as partnerships or sole proprietorships for tax purposes may consider operating the business as a C corporation, especially if the owners are ineligible to qualify for the pass-through tax deduction, discussed below. In some cases, however, these owners may be reluctant to operate as a C corporation, because, although it is generally easy to convert a partnership or a sole proprietorship to a C corporation, converting back to a partnership or a sole proprietorship in the event that the relative tax rates for C corporations and individuals reverted back to something closer to their 2017 levels, would trigger a tax based on the underlying business’s unrealized appreciation. Also, in certain cases, the tax benefits arising from C corporation status may be disallowed pursuant to judicial, statutory or regulatory anti-abuse rules, including the economic substance and assignment of income doctrines, the accumulated earnings tax; the personal holding company tax; and anti-abuse regulations promulgated pursuant to the Act.
- Corporate AMT. The corporate AMT is repealed and corporations previously subject to the AMT are eligible for a refundable credit (subject to limitations until 2022) against their regular tax liability.
- Net Operating Losses. The deduction for net operating losses (NOLs) is now limited to 80% of a corporation’s taxable income in the carryover year. In addition, while under prior law NOLs could be carried back for two years and carried forward for 20 years, now NOLs cannot be carried back at all, but they can be carried forward indefinitely. Farming businesses, however, are still allowed a two-year NOL carryback. Since a tax deduction or loss when the tax rate is 35% yields a greater savings than a deduction or loss when the tax rate is 21%, such deductions or losses will have less value going forward.
- Deductibility of Interest. The Act limits corporations’ deductions for net interest expense to 30% of adjusted taxable income (“ATI”), a proxy for EBITDA (earnings before interests, taxes, depreciation and amortization). Starting in 2022, the ATI limitation will be determined without adding back deductions for depreciation, amortization or depletion (i.e., a proxy for EBIT instead of EBITDA). Disallowed amounts can be carried forward indefinitely. Companies with average gross receipts of $25 million or less during a 3-year look-back period are exempt. The Act also repeals existing “earnings stripping” limitations on interest deductions. These rules may make debt-financed acquisitions such as leveraged buyouts less attractive; however, the reduction in the general corporate tax rate may mitigate the impact.
- Bonus Depreciation. The bonus depreciation deduction will be doubled to 100% and will apply not just to new, but also used, assets. This change is effective for assets acquired and placed in service on and between September 27, 2017, and December 31, 2022. For assets placed in service after 2023, this bonus depreciation percentage will phase down from 80% in 2023 to 0% in 2027.
- Section 179 Expenses. The Section 179 expensing limit will increase to $1 million and the expensing phase-out threshold will increase to $2.5 million. The Act also expanded the definition of Section 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. It also expanded the definition of qualified real property eligible for Section 179 expensing to include any of the following improvements to nonresidential real property: heating, ventilation, and air-conditioning property; roofs; fire protection and alarm systems; and security systems.
- Dividends Received Deduction. The Act reduces the dividends received deduction for less-than-20%-owned subsidiaries from 70% to 50% and for less-than-80%-owned subsidiaries from 80% to 65%.
- Domestic Production Activities Deduction. The Section 199 deduction, also commonly referred to as the domestic production activities deduction or manufacturers’ deduction has been repealed. For non-corporate taxpayers, this change is effective for tax years beginning after December 31, 2017 and for corporate taxpayers it is effective beginning after December 31, 2018.
- Entertainment Expenses. The Act disallows a deduction for an activity generally considered to be entertainment, amusement, or recreation, for membership dues for any club organized for business, pleasure, recreation, or other social purposes, or for a facility or portion thereof used in connection with any of the above items.
- Qualified Transportation Fringe Benefits. The Act disallows a deduction for expenses associated with providing any qualified transportation fringe benefit to employees of the taxpayer and, except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
- Meals. Under the Act, taxpayers are still generally able to deduct 50% of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). But the Act expands this 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringe benefits and for the convenience of the employer. This expansion sunsets on December 31, 2025.
- Cash Method of Accounting. The Act expanded the list of taxpayers that are eligible to use the cash method of accounting by allowing taxpayers that have average annual gross receipts of $25 million (indexed for inflation after 2018) or less in the three prior tax years to use the cash method. Under prior law, the average annual gross receipts test requirement was $5 million and was not adjusted for inflation. Under the Act, the cash method of accounting may be used by taxpayers, other than tax shelters, that satisfy the gross-receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The current-law exceptions from the use of the accrual method otherwise remain the same, so qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities continue to be allowed to use the cash method without regard to whether they meet the $25 million gross-receipts test, so long as the use of that method clearly reflects income.
- Rehabilitation Credit. The Act modifies the Section 47 rehabilitation credit to repeal the 10% credit for pre-1936 buildings and retain the 20% credit for certified historic structures. However, the credit must now be claimed over a five-year period.
- Employer Credit for Paid Family or Medical Leave. The Act allows eligible employers to claim a credit equal to 12.5% of the amount of wages paid to a qualifying employee during any period in which the employee is on family and medical leave if the rate of payment under the program is 50% of the wages normally paid to the employee. The credit is increased by 0.25 percentage points (but not above 25%) for each percentage point by which the rate of payment exceeds 50%. The maximum amount of family and medical leave that may be taken into account for any employee in any tax year is 12 weeks. This credit is only available in 2018 and 2019.
- Amortization of Research and Experimental Expenditures. Under prior law, a taxpayer could elect to take a current deduction for certain research and experimental expenses paid or incurred in connection with a trade or business. The Act mandates that taxpayers must capitalize and amortize such expenses over five years or, in the case of expenses attributable to foreign research, 15 years. This mandatory capitalization is effective for amounts paid or incurred in taxable years beginning after December 31, 2021.
Pass-through Entity Tax Provisions
- Pass-through Income. Under the Act, individuals may generally deduct up to 20% of qualified business income earned through a pass-through vehicle (including, partnerships, LLCs taxable as partnerships and S corporations). The deduction is generally subject to a complicated limitation based on the W-2 wages and capital of the pass-through business. The deduction is available to taxpayers that do not itemize their deductions. It expires in 2025. Individuals with taxable income in excess of $157,500 ($315,000 for joint returns) plus $50,000 ($100,000 for a joint return) cannot claim the deduction for income from most service partnerships (e.g., law firms, accounting firms, medical practices, etc.). The rules governing this new deduction are extremely complex and the deduction generally will not be available for high income owners of most service partnerships, but owners of operating businesses and certain real estate investments may see a significant benefit.
- Carried Interests. Under the Act, partners in partnerships or LLCs taxable as partnerships the business of which is raising or returning capital, or investing in specified assets, including securities, commodities, cash or cash equivalents, and some real estate interests must satisfy a three-year holding period to qualify to be taxed at long-term capital gains rates on “carried interests” (that is, the share of partnership profits received by such partner). Otherwise, carried interests would be taxed as short-term capital gains at a top marginal rate of 37%. Significantly, the new rules generally should not apply to “profits interests” granted to service providers of LLCs and partnerships who are employed by an entity related to the company granting the profits interest.
- Look-through Treatment of Gain on Sale of Partnership Interests. For sales on or after November 27, 2017, non-US sellers of interests in pass-through vehicles conducting business in the US must pay tax on the portion of the seller’s gain which is deemed to be connected with the vehicle’s US trade or business. Starting in 2018, the buyer is required to withhold 10% of the amount realized on the sale or exchange unless the seller certifies it is not a non-US person. The pass-through vehicle is required to withhold from distributions to the buyer to the extent the buyer fails to withhold the correct amount from a non-certifying seller.
- Partnership Technical Terminations. The Act repealed the rule providing for technical terminations of partnerships where within a 12-month period there was a sale or exchange of 50% or more of the total interest in partnership capital and profits. The provision does not change the rule that a partnership is considered to be terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.
Compensation Tax Provisions
- Deferred Compensation. Earlier House and Senate bills would have replaced Section 409A with rules that taxed deferred compensation upon service-based vesting. This would have, for example, resulted in taxes being due on non-qualified stock options at vesting rather than on exercise. Instead, Section 409A remains in place with no changes.
- Income Tax Deferral Election for Private Company Equity Awards. Certain eligible employees of qualifying private companies may now elect to delay federal income taxes normally arising on an option exercise or restricted stock unit settlement for up to 5 years, subject to early acceleration on certain triggering events. This change gives employees in pre-IPO companies extra time to pay federal income taxes on stock compensation, and is also intended to promote broad-based employee ownership. However, eligibility restrictions may limit its use.
- Deduction Limit on Executive Compensation Paid by Public Companies. Public companies will no longer be able to exclude performance-based compensation and commissions from the $1 million deduction limit under Section 162(m). The Act also expands the scope of covered employees to include the CFO (in addition to the CEO and the next three highest paid officers), and provides for continued application of the deduction limitation for as long as the individual (or any beneficiaries) receives any compensation.
International Tax Provisions
The Act makes fundamental changes in how the United States taxes US-based corporations with operations and activities outside the United States, effectively moving to a modified “territorial” tax system (rather than the “worldwide” tax system that exists under current law). The stated goals of these changes are to encourage businesses to locate operations in the United States and discourage “offshoring” and other transactions which seek to move profit-making operations to a low-tax jurisdiction. These changes are highly technical for the most part and the brief explanations below are intended to provide no more than a high level introduction. That said, this can still be though going for the uninitiated. Taxpayers planning their way through these changes will need professional guidance.
- Foreign Dividends. A 100% dividends received deduction (DRD) will now apply to the foreign-source portion of dividends paid by certain foreign corporations to US corporate shareholders owning at least 10% of the foreign corporation. This provision moves the US corporate tax system away from a “worldwide” tax system and towards a “territorial” system (by excluding from the US tax base certain income earned through foreign subsidiaries). No foreign tax credit or deduction will be allowed for any taxes paid or accrued with respect to a dividend that qualifies for the deduction.
- Deemed Repatriation of Foreign Earnings and Profits. A transitional rule imposes a one-time tax on US shareholders of certain foreign corporations. The tax is assessed on the US shareholder’s share of the foreign corporation’s accumulated foreign earnings that have not previously been taxed. Earnings in the form of cash and cash equivalents will be taxed at a rate of 15.5%; all other earnings will be taxed at 8%. The tax can be paid in installments over 8 years. The Treasury is authorized to issue regulations to adjust the amount of accumulated earnings subject to this tax in response to strategies designed to avoid the impact of the tax.
- Passive/Mobile Undistributed Income of CFCs. Under the Act, US shareholders of a controlled foreign corporation (a CFC) will be taxed currently on their shares of what the Act refers to as “global intangible low-taxed income” (GILTI). These rules are intended to discourage US corporations from holding or moving low-basis business assets in low-tax jurisdictions. However, they do not appear to take away the incentive for a US company to move high-basis assets to such a jurisdiction (e.g., factories, equipment, etc.).
- Foreign-derived Intangible Income Rule. This new provision in the Act is similar to a “patent box,” and applies a reduced tax rate to export income from U.S. held intangibles. There is essentially a lower tax rate of 13.125%, as opposed to 21%, imposed on a taxpayer’s income from exports of property or services. As a result, U.S. corporations will be taxed on their foreign-derived intangible income (FDII), which is the portion of a domestic corporation’s income derived from serving foreign markets using a statutory formula. Beginning in 2026, only 21.875% of a domestic corporation’s FDII will be deductible, increasing the effective U.S. tax rate on FDII to 16.40625%.
- Base Erosion Minimum Tax. Applicable corporations will be subject to a new tax equal to their “base erosion minimum tax amount.” The formula for determining this tax is complex, but at a high level, is equal to 10% of the US corporation’s modified taxable income (modified by adding back deductible payments to related foreign persons) minus the US corporation’s regular tax liability (where the income base is reduced by deductible payments to related foreign persons, and the tax liability itself is reduced by certain credits). A 5% rate applies for one year for base erosion payments paid or accrued in taxable years beginning after December 31, 2017. Starting in 2026, the 10% rate will increase to 12.5%. This provision is intended to apply to US corporations that reduce their US tax liability by making deductible payments to related foreign persons (e.g., interest on intercompany loans; royalties to affiliated entities) but generally applies only to C corporations with average annual gross receipts of at least $500 million (based on a 3-year look-back period) and a “base erosion percentage” of at least 3%.
- Modification of US Shareholder Rules for Controlled Foreign Corporations. Under the Act, the definition of “US Shareholder” for purposes of the CFC rules is expanded to include any US person who owns 10% or more of the total value (instead of only voting power) of shares of all classes of stock of a foreign corporation.