The Tax Cuts and Jobs Act (TCJA), signed into law on December 22, 2017, is arguably the most comprehensive reform of U.S. tax code since 1986. In particular, the TCJA makes fundamental changes to the way corporations and pass-through entities are taxed. This alert briefly explains some of the changes under the TCJA that may be relevant to technology companies.
- Corporate Rate. The TCJA permanently lowers the corporate tax rate to a flat rate of 21% beginning in 2018. The flat corporate rate will replace the progressive corporate income tax rates ranging from 15% to 35%. The lower flat corporate rate of 21%, the possibility of shareholders qualifying for the current 100% exclusion of gain from the sale of “qualified small business stock,” and certain other considerations under the TCJA now warrant consideration of whether a C corporation is a better choice of entity from a tax perspective.
- Effective Pass-Through Rate. Partnership, limited liability company and S corporation (i.e., pass-through entities) owners may deduct 20% of certain types of U.S. qualifying business income (“QBI”). This new deduction (along with the reduction in the maximum individual tax rate from 39.6% to 37%) potentially brings the top marginal tax rate on pass-through QBI down from a maximum rate of 39.6% to a maximum rate of 29.6%. The new 20% deduction is, however, subject to certain limitations, including limitations on application to service businesses.
- Cash Method of Accounting. Under pre-TCJA law, a taxpayer generally could only use the cash method of accounting if the taxpayer’s average annual gross receipts for the testing period did not exceed $5 million. Under the TCJA, the $5 million cap is increased to $25 million for tax years beginning after December 31, 2017. Corporations, S corporations and partnerships with a corporate partner can use the cash method of accounting if annual average gross receipts do not exceed $25 million for the three prior tax years.
- Expensing. The TCJA allows businesses to immediately deduct 100% of the cost of certain new depreciable assets (not structures or land) instead of having to recover such costs through depreciation deductions if the asset is placed into service after September 27, 2017, but before January 1, 2023. In addition, the maximum amount that can be expensed under Section 179 is increased from $500,000 to $1 million and the phase-out threshold amount is increased to $2.5 million.
- Repeal of Corporate Alternative Minimum Tax. The Alternative Minimum Tax (“AMT”) has been repealed for corporations. A corporation’s AMT credit may continue to offset its regular tax liability for any year. Also, the AMT credit is refundable for any taxable year beginning after 2017 and before in an amount equal to 50% (and 100% for tax years beginning in 2021) of the excess of the minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability.
- Certain Self-Created Property Not Treated as a Capital Asset. Under the TCJA, a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) from the definition of a “capital asset.” Thus, gains or losses from the sale or exchange of a patent, invention, model or design (whether or not patented), or a secret formula or process which is held as provided above will not receive capital gain treatment, and also would be excluded from the definition of property used in the trade or business under Section 1231.
- Net Operating Loss Limitation. A corporation’s deduction of its net operating losses (“NOLs”) arising in tax years ending after 2017 will be limited to 80% of taxable income. Under pre-TCJA law, NOLs (100%) could be carried back two years and forward 20 years. Under the TCJA, NOLs (80%) generally may not be carried back and may be carried forward indefinitely.
- Interest Deduction Limitation. Under the TCJA, every business, regardless of its form, is generally subject to a disallowance of a deduction for “net interest expense” in excess of 30% of the business's “adjusted taxable income.” Interest amounts exceeding the cap can be carried forward into future tax years. Businesses with average annual gross receipts over a three-year period below $25 million are exempted from this limitation.
- Dividends Received Deduction Limitation. Under pre-TCJA law, a corporation was entitled to an 80% deduction of dividends received if the corporation owned at least 20% of the stock of the corporation and a 70% deduction if the corporation owned less than 20% of the stock. Beginning in 2018, the 80% dividend received deduction is reduced to 65% and the 70% deduction is reduced to 50%.
- Entertainment Deduction Repeal. Under pre-TCJA law, 50% of business related entertainment expenses are deductible. Under the TCJA, no portion of entertainment expenses paid or incurred after December 31, 2017 are deductible.
- Research and Development Credits. Beginning in 2022, any research and development expenditures incurred will have to be capitalized and amortized over five years if incurred in the U.S. and fifteen years if incurred outside of the U.S, beginning with the midpoint of the tax year in which the expenses were paid or incurred. Specified research and development expenses subject to capitalization include expenses for software development. In addition, upon disposition, retirement or abandonment, no deduction is allowed and the amortization would have to continue for the remainder of the amortization period.
- Territorial Tax System. The TCJA implements a territorial tax system for corporations (i.e., generally corporations pay U.S. tax only on income earned in the U.S., not on income earned outside the U.S.), which provides a 100% deduction to U.S. corporations for dividends received from foreign subsidiaries in which the corporation owns at least a 10% interest.
- Repatriation of Foreign Profits. The TCJA imposes a new one-time transition tax on businesses with accumulated overseas profits. The tax rate for this one-time tax is 15.5% for liquid assets and 8% for physical assets. This repatriation tax can be paid in installments over an eight year period. A special rule applying to S corporations allows a S corporation shareholder to elect to defer its deemed repatriation liabilities until the shareholder transfers its stock, the S corporation no longer exists, or the S corporation sells off substantially all of its assets.
- Foreign Derived Intangible Income. A deduction for corporations with foreign derived intangible income is now available, which is intended to reduce the effective tax rate on foreign passive income.
- Employee Stock Options and Restricted Stock Units. Eligible employees who receive stock options and restricted stock units (“RSUs”) settled in employer stock may be eligible to defer the inclusion of income attributable to the exercise or settlement of such awards by making an election within 30 days after the first time the employee’s right to the stock vests. Income may be deferred for up to five years or until the occurrence of certain events, if sooner (e.g., the date the stock received pursuant to the award becomes transferable). The rule generally applies with respect to privately-held companies that provide at least 80% of their employees with such awards during the tax year. Any such election by the employee also results in the deferral of the associated deduction of the company.
Each taxpayer must consider his, her or its individual tax and financial circumstances in order to determine whether any of the foregoing information is applicable. Consultation with a competent tax professional is strongly urged when considering and/or implementing any tax planning strategy. Nothing contained in this bulletin is intended as tax, accounting, legal or investment advice.
If you have questions or would like additional information, please contact your MMM attorney, or any of the following members of our Tax Practice:
Anthony R. Boggs