The Tax Cuts and Jobs Act: Observations and Strategies After One Tax Season
The Tax Cuts and Jobs Act of 2017 (TCJA) made sweeping changes to individual and business income taxation, estate and gift taxation, and international taxation. In the year since enactment, the Internal Revenue Service and Treasury have provided guidance in many areas, some of which require further clarification. However, there are still many sections of the law on which they have been silent. This has created many challenges for individuals, businesses and tax professionals in addressing particular tax return issues.
The key question everyone wants to discuss is who won and lost under the new law. Unfortunately there is no easy answer to this, since it depends on each particular fact and circumstance. But now that we have completed the first tax season under the new law, we can offer the following observations and strategies for individuals and businesses to consider for 2019 and beyond (based on current guidance).
The TCJA reduced the income tax rates applying to individuals, trusts and estates. The IRS has issued the following changes to the income tax brackets for 2019, including the new levels at which the preferential rates on long-term capital gains and qualified dividends apply. Also shown is the effective rate of tax where the section 199A (Qualified Business Income) deduction applies, discussed later in this Year-End Guide. This will take on greater significance in the discussion of entity selection. It must be noted that all of the individual tax changes expire after 2025 and revert to pre-TCJA rates.
INDIVIDUAL TAX RATES — 7 BRACKETS FOR 2019 TAX YEARS
|SINGLE||JOINT||EFFECTIVE 199A RATE|
|% 2018 2019||2018 2019|
|10% $9,525 $9,700||$19,050 $19,400||8%|
|12% $38,700 $39,475||$77,400 $78,950||9.6%|
|22% $82,500 $84,200||$165,000 $168,400||17.6%|
|24% $157,500 $160,725||$315,000 $321,450||19.2%|
|32% $200,000 $204,100||$400,000 $408,200||25.6%|
|35% $500,000 $510,300||$600,000 $612,350||28.0%|
|37% $500,001 $510,301+||$600,001 $612,351+||29.6%|
HEAD OF HOUSEHOLD
|EFFECTIVE 199A RATE|
PREFERENTIAL CAPITAL GAIN INCOME TAX RATES – 2019
|SINGLE||JOINT||HEAD OF HOUSEHOLD||MARRIED SEPARATE|
The standard deduction has undergone a slight modification from 2018 to 2019 due to the inflation adjustment. (The additional standard deduction for the elderly or disabled is retained in the law.)
|HEAD OF HOUSEHOLD|
Due to the elimination of, or limitation on, many popular itemized deductions, many more taxpayers used the standard deduction in 2018. This produced some of the “simplification” promised by lawmakers on enactment of the TCJA.
CHARITABLE CONTRIBUTION DEDUCTIONS
60% Adjusted Gross Income Glitch
For individuals, cash charitable contributions were previously limited to 50% of Adjusted Gross Income (AGI). The TCJA increased this limit to 60% of AGI. One might expect that in circumstances where contributions of cash and property equal to 50% of AGI have already been made, an additional cash contribution equal to 10% of AGI would be permitted. Unfortunately, due to a glitch in the law, this is not the case. Where there is a combined contribution of appreciated property and cash, the total contribution can be limited to 50% of AGI.
For example, assume that taxpayer X (individual) has $10 million AGI and makes a donation of appreciated stock which has been held for more than one year. This contribution is normally limited to 30% of AGI (or $3 million). X would expect to be able to contribute an additional $3 million in cash to maximize the 60% of AGI limit. However, under the new law, the cash deduction reduces the contribution limit on the stock contribution to 20%, so that only $2 million of the stock contribution is immediately deductible. The excess contribution becomes a carryover to the following year.
Charitable contributions produce no tax benefit until the standard deduction is reached. This scenario is exacerbated by the limitation on the state and local tax (SALT) deduction and the elimination of miscellaneous itemized deductions. It is possible that a taxpayer could realize no tax benefit for his or her annual contributions. One solution is to “bunch” or “stack” several years’ worth of contributions into a single year. If the itemized deductions then exceed the standard deduction, a tax benefit is provided for such excess amount.
Example: Husband H and Wife W ($24,400 standard deduction combined for 2019) have a $10,000 SALT deduction and a $5,000 mortgage interest deduction in each of the next five years. The first $9,000 of contributions will produce no tax benefit for them. If two years of contributions are bunched into a single year ($18,000), a $9,000 itemized deduction benefit is generated in the year of bunching.
The use of qualified appreciated capital gain property produces an additional benefit to the normal bunching strategy, since the gain inherent in the contributed property may be leveraged to escape taxation. The donor can then use the cash which would have been contributed to acquire a similar asset (e.g., other marketable stock) which will establish a new stock basis (though a new holding period will begin for the asset).
Some individuals may prefer to transfer equal amounts to their favorite charities on an annual basis. In this case, the bunching strategy can be used along with a donor advised fund, which will provide the funds to the charity in the years desired.
Qualified Contribution of IRA Required Minimum Distribution to Charity
The law permits a taxpayer who is 70.5 or older to direct a transfer of up to $100,000 of deductible contributions and earnings from an IRA to a qualified charitable organization. This amount is not taxable and offsets the required minimum distribution (RMD) the retirement account owner must withdraw for the tax year. This effectively gives the taxpayer a 100% deduction without AGI limits and for which a benefit is provided as a reduction of adjusted gross income – even if the taxpayer utilizes the standard deduction.
As we approach year-end and required minimum distributions are being made, this is a strategy which must be considered.
STATE AND LOCAL TAX (SALT) DEDUCTION LIMITATION
The TCJA limits the SALT deduction for individuals, trusts and estates for non-trade or business activities to $10,000 each year as an itemized deduction. In addition to the direct impact on taxable income, the SALT deduction limitation produces an indirect impact on Net Investment Income Tax (NII). The deductions which are “attributable to investment income” and which would reduce net investment income are decreased.
Segregate Personal, Business and Investment Related Activities
The statutory language specifically provides that the SALT limitation does not apply to a trade or business or to investment (i.e., Internal Revenue Code section 212) activities. It is important to determine the nature of the property on which property taxes are paid to determine deductibility.
Potential Deduction for Allocated Coop Taxes
There is a reasonable textual argument that real property taxes allocated to a “tenant-stockholder” should not be subject to the SALT limitation. The owner is permitted a deduction for the allocable share of coop taxes paid for real estate taxes allowable to the corporation. Since corporations are not subject to this limitation, arguably the individual owner should not be subject to the SALT limit. The problem is that Congressional reports suggest the intention to include these payments within the limitation; however, this may require a legislative fix.
Since it may produce an unusually large tax deduction, taxpayers should consider disclosing this position on their filed tax returns.
Incomplete Non-Grantor (ING) Trust
Historically, non-grantor trusts have been used to avoid state income tax, with trusts having residence in states such as Nevada and Delaware, where trust income is state tax-exempt. This strategy does not work to exempt income from state income tax in states where the residence of a trust is based on the residence of the grantor. Additionally, the trust must avoid “grantor trust,” status whereby income is taxed to the grantor.
The TCJA SALT limitation has created new interest in INGs as a mechanism to create multiple taxpayers with separate $10,000 SALT limitation buckets (depending on number of trusts). To be effective, the trust must generate sufficient income to utilize the deductions. Additionally, care must be taken in drafting to avoid the consolidation of multiple trusts by the IRS into a single trust and to avoid grantor trust status.
“BLUE STATE” WORKAROUNDS
Several states have sued the federal government over the constitutionality of the SALT limitation. However, in State of New York, Connecticut, Maryland & New Jersey v Steven Mnuchin, Treasury Secretary, a New York Court granted the U.S. government’s motion to dismiss a lawsuit claiming harm resulting from the SALT limitation. While other lawsuits remain, it seems most likely that a Congressional fix in the law will be needed to overturn this rule.
SALT Cap Workaround
Several states developed a workaround to the federal $10,000 limitation on SALT deductions, whereby state residents can receive property or income tax credits as the result of making a contribution to a certain state or municipal charitable organization created for this purpose.
In response, the IRS issued regulations requiring a reduction in the charitable deduction if the credit provided exceeds 15% of the amount donated. Under the rules, a credit equivalent to 15% or less of the contribution will not reduce the charitable deduction.
An Internal Revenue Service-issued notice indicates that the regulations requiring a reduction of the contribution for the credit do not apply to contributions which would be fully deductible as a business expense, i.e., where the transfer to the charitable or municipal organization bears a relationship to the trade or business and there is a reasonable expectation of a financial reward commensurate with the transfer.
Revenue Procedure 2019-12 establishes safe harbors for C corporations and “specified pass-through entities” making such contributions The portion of the donation equal to the credit can be deducted as a business expense (with the treatment of any excess amount being based on facts and circumstances). This is apparently based on the theory that the amount of the credit received is a reasonable expectation of a financial reward commensurate with that portion of the transfer. For a pass-through entity, the safe harbor rule applies only to the extent that the tax credit offsets taxes owed by the business itself (e.g., local property taxes, state excise taxes) other than income taxes. The Revenue Procedure states that if the tax credit applies to state or local taxes owed by individual owners, the safe harbor does not apply and is governed by the TCJA limits, as interpreted by the IRS in regulations.
Pass-Through Entity Tax
Several states have created a Pass-Through Entity (PTE) tax which is deductible against the entity’s business income. IRS has not yet ruled on the federal deductibility of such a PTE tax. Each version of the PTE suffers from certain flaws. The Wisconsin and Rhode Island versions are elective. The Connecticut version, while mandatory, provides a credit for the tax paid, allocable to the PTE owners, who include their share of the entity income (net of the taxes taken as a deduction) in their personal incomes.
ACA Health Coverage
The TCJA repealed the Affordable Care Act (ACA) individual shared responsibility payment (the “individual mandate” penalty) for health coverage, effective as of 2019. In 2018, the law required minimal essential coverage health insurance for each month (unless the individual fell under certain exemptions). Failure to have coverage carried a potential penalty of $695 per adult and $347.50 per child, or 2.5% of Adjusted Gross Income, whichever was higher, up to a maximum penalty of $2,085.Beginning in 2019, required minimal essential coverage and the associated penalties are no longer in effect.
However, the law did not eliminate the obligation of an Applicable Large Employer or “ALE” (those with 50 or more full-time or full-time equivalent employees) to provide affordable health coverage. For determining ALE status, related groups of employers must aggregate their employee counts.
The suspension of miscellaneous itemized deductions until 2025 has impacted typical investment expenses previously required to be reflected on Schedule A. This inability to deduct investment expenses effectively reduces taxpayers’ overall investment returns.
IRA/SEP Plan Expenses
The IRS allows certain IRA and Simplified Employee Plan (SEP) expenses to be paid either from the plan or by the owner. In the past, the rule of thumb was that it was better to pay the fees personally and allow the fund to grow tax- deferred. However, the elimination of the deduction for plan expenses warrants a reconsideration of this strategy. An analysis should be made comparing the expected rate of tax to be paid on future distributions from the IRA/SEP vehicle, the potential growth of assets inside the fund and the value of investments outside of the fund.
For a traditional IRA or SEP, where growth in the plan will ultimately be taxed as ordinary income, consideration should be given to paying the fees out of the plan. This effectively generates a deduction by reducing the amounts ultimately subject to tax in the future. The potential harm is the loss of the tax-deferred growth (versus growth on the retained funds). Roth IRAs require a different analysis since future payments will generally be nontaxable. It may still makes sense for the individual to pay the fees; consult your tax advisor.
MORTGAGE INTEREST LIMITATION
The TCJA reduced the amount of home mortgage acquisition debt (an amount to purchase, construct, improve or reconstruct the property) — from $1 million to $750,000 – on which interest can be deducted, for tax years 2018 through 2025. The TCJA also eliminated the ability to deduct as home mortgage interest amounts paid on up to $100,000 of non- acquisition debt. While this latter amount is commonly referred to as “home equity debt,” it does not refer to the mortgage product but to the use of the funds. If funds are borrowed through a home equity loan and are used for acquisition debt purposes, they are subject to the $750,000 deduction limit. If the loan is secured by the residence, it falls under these mortgage interest rules. Under a grandfather rule, for acquisition debt in place before December 15, 2017, the $1 million limit continues to apply.
Payoff All or Portion of the Mortgage: For taxpayers who will not get the benefit of the deduction (due to taking the standard deduction), consideration should be given to paying off or paying down the home mortgage debt.
EMPLOYEE BUSINESS EXPENSES
The suspension of miscellaneous itemized deductions has caused the loss of tax benefit for those employees who are responsible for paying expenses related to their employment.
Accountable Plans: This change in the law has caused increased interest in accountable plans instituted by employers to cover employee business expenses. This is a nontaxable benefit to the employee, and the employer will generally reduce the employee’s income to account for this additional nontaxable benefit.
This type of plan must comply with three rules:
(i)advances made must be designated for expense incurred in the course of normal business; (ii) expenses must be accounted for within a reasonable amount of time; and (iii) excess reimbursements or allowances must be returned within a reasonable period of time.
One additional benefit is that since this amount is a nontaxable benefit, the employer is relieved of withholding responsibility on these amounts as well as for the employer’s share of FICA taxes. Existing plans should be reviewed to insure compliance.
Conversion to Self-Employed Status: There is a major difference between how business expenses are treated for a taxpayer who is self-employed (deductible) and for an employee (nondeductible under the suspension rule). Self- employed status has become more popular due to the new section 199A deduction on qualified business income.
This status conversion is not free from potential IRS attack to recharacterize the taxpayer’s activities as those of an employee. This creates risks for both the taxpayer (as a service provider) and the service recipient (who would be treated as an employer).
There are several potential negatives involved in this plan. The self-employed person must now pay what was previously the employer’s share of payroll taxes (through self-employment tax). This can be compensated for through a gross-up of payments. More significantly, there are a number of non-tax issues to consider, including (a) the inability to participate in other employee benefits, including possibly health insurance and pension plans; and (b) unemployment compensation.
The law treats taxation of net unearned income of certain children differently than other income. Pre-2018, the child paid tax on net unearned income over a specified level ($2,100) at the parent’s marginal rate (potentially as high as 39.6%). However, in many situations, the rate was much lower. This law is intended to avoid shifting of investment income from high-rate parents to their low-tax rate children. The law required the child to wait until the parents’ tax return was completed to make this calculation.
The TCJA adjusted the Kiddie Tax so that it is no longer based on the parents’ marginal tax rate, but is based on trust rates. Note that the 37% rate applied to trusts in 2018, starting at income of $12,501, whereas married joint filing parents reached this rate at $600,000. This produced a substantial tax increase for some low and middle-income families. This has been particularly problematic for dependent children of service members who died on active duty and for those with scholarships used for expenses other than tuition and books, which are taxable.
Congress recognizes the political nightmare and has indicated an intention to fix the problem, possibly by returning to the old law. One proposal would permit families to amend 2018 tax returns to elect to use new Kiddie Tax rules, which produce the better result. No action has been taken as of this writing.
C corporations are now subject to a flat 21% rate. While considerably lower than the maximum 35% which applied under prior law, many small corporations saw a tax increase since the lower brackets no longer apply.
The new law did not eliminate the potential second tax on distribution of corporate funds through a dividend or on a sale of stock. The structure of the law is such that if the corporation is subject to a 21% rate on its income, and the remaining 79% net after-tax income is distributed and taxed at a federal 20% rate (producing a 15.8% tax), the combination equates to an effective 36.8% rate – which is essentially equal to the maximum individual rate. However, this is considerably higher than the 29.6% maximum rate that applies to flow-through entity trades or businesses where the section 199A deduction can be fully utilized. Furthermore, the combined corporate rate excludes the 3.8% net investment income tax, which may apply to the dividend.
However, if the company can justify maintaining assets in the corporation to avoid accumulated earnings tax issues and enough active income to avoid personal holding company tax issues, this second personal level tax can be deferred. In evaluating the selection of C corporation status, a number of factors should be considered, including: (i) exit strategy for the owners (stock sale or asset sale); (ii) timing of the exit; (iii) ages of the owners; (iv) potential impact on stock value through annual use of the increased after-tax cash flow of the corporation; and (v) potential application of the new GILTI tax for multinational entities (where C corporations get a tax deduction not available to flow-through entities). Additionally, not all owners will be in the top tax bracket, and their tax rates (adjusted for any section 199A deduction) may equal or be lower than the 21% corporate rate.
- Section 1202 Stock: The C corporation benefits have attracted increased interest in the qualified small business stock rules of IRC section 1202 (see detailed article in this guide.) For certain corporations satisfying an active trade or business requirement, original issuance stock held for five years can be eligible to have gain excluded from tax, to the extent of the greater of $10 million or 10 times tax basis.
- Alternative Minimum Tax (AMT) Repeal: The TCJA repealed the AMT for corporations for 2018 and later. In addition, C corporations with an AMT credit in 2017 can recover the credit via refund over a four-year period starting in 2018 through 2021.
Section 199A Qualified Business Income Deduction
Since most business in the United States is not conducted through C corporations, Congress recognized that it needed to provide relief to businesses that operate as sole proprietors (including single member limited liability companies), partnerships, and S corporations – commonly referred to as “flow-through entities.” The result is a rather complicated set of rules under new section 199A of the Code, under which a 20% deduction is allowed on qualified business income (QBI). A taxpayer in the top 37% tax bracket, after this deduction, pays an effective 29.6% tax on qualified business income. Part of the reason for the complexity under this section is that while Congress wanted to provide a tax benefit to these businesses, it believed that reduced tax should not
extend to amounts received for services.
- For those with taxable income under $315,000 in 2018 and $321,400 in 2019 for joint filers, and $157,500 in 2018 and $160,700 in 2019 for other filers, the 20% deduction applies to all qualified trade or business income.
- For those with taxable income over $415,000 in 2018 and $421,400 in 2019 for joint filers, and $207,500 in 2018 and $210,700 in 2019 for other filers, the 20% deduction applies to qualified trade or business income. However, two separate limitations apply: (i) the deduction is limited to the greater of (a) 50% of W-2 wages or (b) 25% of W-2 wages and 2.5% of the unadjusted basis of investment assets (UBIA) used in the business; and (ii) certain “specified service trades or businesses” do not qualify for the 20% deduction.
- For those with taxable income between the amounts above, a complex set of phase-out rules apply, so that a portion of specified service trade or business income qualifies for the deduction, and the W-2 or W-2/UBIA limits apply in part.
For the Section 199A deduction, “specified services trades and businesses” (SSTBs) includes the fields of law, accounting, consulting, financial services, and performing arts; performance of services that consist of investing and investment management trading, dealing in securities, partnership interests, or commodities; and a catch-all provision that includes any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
REIT dividends and publicly traded partnership distributive income are eligible for the new 20% deduction, but are not subject to any of the limitations discussed above.
The IRS and Treasury recently issued regulations which provide significant guidance on the operation of the new section 199A deduction, including:
- Determining if the activity constitutes a trade or business.
- Whether businesses can be aggregated for purposes of calculating the limitations on the deduction.
- Defining the meaning of “specified trades and services,” including providing an extremely limited interpretation of businesses falling within the catch-all.
- Banning the “crack-and-pack” strategy. This is where operations or property is pulled from a specified service business (e.g., personnel, IT services, real or personal property rental) and placed into a separate business which then provides the services or leased the property to the related SSTB. The intention is to convert a portion of the SSTB income into income qualifying for the deduction. The proposed regulations treat the related entity as part of the SSTB in whole or in part.
Rental Real Estate
Particular issues are raised under general tax law principles as to whether rental real estate constitutes a trade or business. Treasury regulations provide some relief, stating that real property rental to a commonly controlled (based on a 50% or greater common ownership) individual and pass-through entity is deemed to be a trade or business. If the rental of the real property is made to a specified service trade or business (SSTB), then the rental (while a trade or business) will also be treated as a SSTB. Note that this automatic trade or business rule does not apply where the property is leased to a C corporation.
The IRS has issued procedures which provide a safe harbor for establishing trade or business status for rental real estate activities. This requires that 250 hours be spent on the rental real estate enterprise (RREE) by the taxpayer, its employees or agents. Commercial properties can be combined with other commercial properties, and residential properties can be combined with other residential properties, but commercial and residential properties cannot be aggregated. Certain conditions must be satisfied for this safe harbor rule to apply, including that there be contemporaneous records maintained. However, the contemporaneous records requirement is waived for tax years beginning prior to January 1, 2020. Despite this waiver, IRS reminded taxpayers that they bear of burden of establishing the right to any claimed deductions. Generally, net lease properties are not included under the safe harbor rules.
Unadjusted Basis of Investment Assets (UBIA)
Tax depreciation schedules must be reviewed to determine if the appropriate amounts are being included. Many software companies are not calculating UBIA correctly. In addition, certain transactions may cause depreciable basis to be different from UBIA (for example, where property is acquired under a like-kind exchange where the UBIA is based on the cost of the transferred property).
Where UBIA is significant for obtaining the benefit of a continued section 199A deduction, the structure of a merger and acquisition (M&A) transaction can be impacted. For example, the regulations provide that a purchase of a partnership interest outside of the partnership (a cross- purchase) may produce a basis addition to the property which increased UBIA for the purchasing partner. However, a redemption of the interest, which may produce a comparable tax basis increase, is not treated as a new asset and does not increase UBIA.
Since the asset must be owned at year-end to be included in UBIA, year-end disposition should be deferred until the following year where UBIA is used to qualify the section 199A deduction.
Where the limitations apply, maximizing W-2 wages becomes a significant issue. If there is a third-party payer, it is necessary to determine if the taxpayer is the common law employer. Related party management and common employee arrangements should be reviewed.
Entity restructuring may produce different section 199A results. Where the 50% W-2 limit applies, the goal is to have W-2 wages (for both owners and non-owners) equal 28.75% of pre-salary taxable income.
- If third party salaries are not sufficient, consider a conversion to S corporation status and pay salaries to owners to reach appropriate levels. However, non-section 199A implications must be considered. In addition, IRS could attack W-2 wages to owners as being too low and as not being reasonable.
- If third party salaries are sufficient, consider use of partnerships.
Guaranteed payments and proprietorship draws are not salaries.
- Since guaranteed payments from a partnership do not qualify as QBI, many partnerships have reviewed their agreements to determine:
- Whether payments treated as guaranteed payments meet the statutory and IRS definitions. In many cases, these payments are being mischaracterized.
- Other partnerships have amended their operating agreements to convert guaranteed payments to non- guaranteed payments. Note that any change to a partnership agreement for calendar year 2019 allocations must be done by March 15, 2020.
Increased Penalty: The tax law generally provides for a substantial understatement of income tax where an underpayment of tax exceeds the greater of (a) 10% of tax o be shown on the return, or (b) $5,000. Under the TCJA, where a section 199A deduction is taken, the threshold is reduced to 5% of the tax to be shown on the return – even if the underpayment is due to a reason other than a section 199A deduction error.
BUSINESS INTEREST LIMITATION
Under new IRC section 163(j), every business, regardless of form, is subject to a disallowance of the deduction for net interest expenses (i.e., business interest expense in excess of business interest income) which exceeds 30% of adjusted taxable income. For years beginning before January 1, 2022, adjusted taxable income is business taxable income without considering the deductions for depreciation, amortization, or depletion.
The law contains several exceptions:
- A small business exception excludes from this limitation a business whose average gross receipts do not exceed $25 million. However, as with the accounting simplification rules discussed below, certain commonly controlled businesses will need to be aggregated to determine if this income requirement is satisfied.
- Certain businesses can elect out of this interest limitation such as an electing real property trade or business or an electing farming business. The cost of this election is that the business is required to use the Alternate Depreciation System (ADS) instead of the normal cost recovery rules. ADS requires the use of longer lives and the use of a straight-line method. Of greater significance, those required to use ADS cannot take bonus depreciation on the acquired assets.
- Certain floor plan interest is excluded from this rule.
- Certain regulated public utilities and electric cooperatives are not subject to this rule.
There was a problem with IRS regulations used to determine whether businesses need to be aggregated for determining whether average gross receipts exceed $25 million. The intention was to use attributions that would provide for constructive ownership between family members, from entities to their owners, from owners to their entities, and to treat stock subject to an option to purchase as being owned by the option holder. However, the published regulations referred only to the option attribution rule. IRS republished the regulations including the full constructive ownership rules. However, the IRS also noted that it would not upset conclusions reached using the previous regulation for 2018 and 2019 filings. This may provide an opportunity for these two years for taxpayers to fall under the $25 million threshold.
The TCJA contains a number of accounting method simplification rules which should be considered by all taxpayers who may be affected.
- Cash Basis:
- C corporations and partnerships with C corporation partners, and certain farming entities, will be permitted to use the cash basis where average gross receipts for the prior three years is $25 million or less. Previously, the gross receipts level was set at $5 million.
- Businesses where sales are an income-producing factor are normally required to use the accrual basis with inventories. Prior IRS authority permitted those with average annual gross receipts of $1 million, or $10 million for certain taxpayers, to elect to use the cash
basis of accounting. The TCJA increases the threshold to $25 million.
- Uniform Cost Capitalization: Businesses, including manufacturers and other producers of property, are exempt from using the uniform cost capitalization rule if they have average gross receipts of $25 million or less.
- Percentage-of-Completion: The law’s exception from the use of the percentage-of-completion method for certain long-term contracts to be completed within a two-year period applies to taxpayers with average gross receipts of $25 million or less. This exception permits the use of cash basis or even the completed contract method.
If an election is made to take advantage of an accounting simplification rule, a Form 3115 (Change of Accounting Method) must be filed. The Service has issued guidance indicating that these method changes will be permitted under the automatic change rules. This means that IRS consent is not required.
The same aggregation rules apply (as for the Business Interest Expense Limitation) in determining if the taxpayer meets the $25 million gross receipts test. This includes the same exception to the constructive ownership rules for 2018 and 2019.
BONUS DEPRECIATION AND SECTION 179 EXPENSE
All businesses will benefit from the rules increasing the amount of capital costs that can be expensed.
- For assets acquired after September 27, 2017, and before January 1, 2023, bonus depreciation of 100% is allowed. The percentage of bonus depreciation is scheduled to be reduced in 2023 and later years. Property qualified for the bonus depreciation includes qualified film, television, and live theatrical productions. Additionally, used property is now eligible for bonus depreciation.
- Section 179 expensing is increased to $1 million for tax years 2018 to 2022. The allowed deduction is reduced when acquisitions of section 179 property exceed $2.5 million for the tax year. These dollar amounts are indexed for inflation after 2018. Property eligible as section 179 property includes property used to furnish lodging and qualified real property improvements including roofs, heating, ventilation, air conditioning, fire, and security systems.
The rushed legislative process behind the TCJA produced a drafting error that impacts real estate. It was the clear intention of the law (as expressed in the Conference Committee reports) that commercial real estate qualified improvement property would be eligible for 15-year depreciation and 100% bonus depreciation. However, due to the drafting error, the language including this type of real estate improvement as 15-year property was never written into the statute. This inclusion would have made the property automatically eligible for bonus depreciation. As a consequence, for property placed in service after 2017, the law does not permit bonus depreciation, and 39-year depreciation applies.
IRS has confirmed in regulations that qualified improvement property (QIP) acquired and placed in service between September 27, 2017, and before January 1, 2018, was eligible for bonus depreciation. The Congressional tax writers have attempted to convince IRS and Treasury that they could permit bonus depreciation and a 15-year write-off through regulations (by stating they will delay application of the statutory language, as they did with the delayed effective date of the Affordable Care Act rules). Treasury has stated that legislative action is needed to correct the error for QIP acquired after December 31, 2017.
Capitalization v. Expensing
If a cost could be deducted as an expense under the capitalization regulations under IRC section 263a or capitalized, it might be preferable to capitalize the asset and take bonus deprecation. For the business interest expense limitation, the expense will reduce Adjusted Taxable Income and potentially reduce the limitation on one’s allowable interest deduction. However, bonus depreciation is scheduled to be added back for years beginning before January 1, 2022 making this strategy ineffective at that time.
NET OPERATING LOSS DEDUCTIONS (NOL)
The new law repeals net operating loss carrybacks (with a few exceptions) and limits the use of an NOL carryforward to 80% of taxable income of the year to which the loss is carried. However, the carryforward is for an unlimited period. This means that NOLs created in 2018 and later cannot zero the income for a year to which they are carried. Prior NOL carryforwards are not subject to this limit.
Taxpayers may look to defer deductions into future years where the current deduction would produce a net operating loss that would be limited in effect in later years.
NON-CORPORATE TAXPAYER BUSINESS LOSS LIMITATION
Net business losses which are allowed against non-business income will be limited to $500,000 for joint filers and $250,000 for other filers. The unused business losses are treated as a net operating loss carryforward to future years. This means that current business losses may not be able offset other current-year income. These taxpayers may have taxable income and an income tax obligation, despite incurring real cash losses.
The Service has not issued guidance (beyond the related tax form and its instructions) with respect to this Code section.
MEALS AND ENTERTAINMENT
For amounts paid or incurred after December 31, 2018, business-related entertainment expenses are no longer deductible. Meals while traveling away from home on business remain 50% deductible. A significant change applies to the 50% limit for meals provided on the employer’s premises for the convenience of the employer or in an on-premises cafeteria through 2025. In 2026, these amounts will become nondeductible.
Under IRC section 274, the cost of employee parking which is nontaxable to employees (up to $260 per month for 2019) is nondeductible to the employer. To create parity between for-profit and exempt organizations, the TCJA requires an exempt organization to increase its Unrelated Business Taxable Income by an equal amount for its employees.
The Notice contains a four-step process (as a reasonable method) for determining the nondeductible portion of the costs related to employee parking.
- If the taxpayer owns the parking property, it must accumulate all costs related to the parking area.
- If the taxpayer leases the parking area, it must base the adjustment on the costs under the lease.
The Notice refers to a lease that covers both office space and parking for a single amount. The employer-lessee must carve out the portion of the rent allocable to the parking. No guidance is provided as to an appropriate method. The takeaway is that if you are providing free parking to employees, you must consider this as a potential taxable income adjustment. It will probably be low-hanging fruit for the IRS on examination. respect to these topics. And, they represent only a portion of the many aspects of the new law. Hopefully this article and others contained in this Marcum Tax Guide will inspire you to consider how the new law has affected you and will impact you in the future.