As 2018 begins, US taxpayers will soon understand the full effects of the tax reform bill signed into law on December 22, 2017. This legislation is the largest overhaul of the US tax code since 1986. The new law will bring sweeping changes to all taxpayers, regardless of their tax filing complexity.
One of the most talked about effects of the legislation is its impact on corporate taxes. While the individual and pass-through (i.e., S Corporation / Partnership) provisions will be in effect for the next few years, the tax cuts for C Corporations are permanent.
In this installation of the Ultimate Account Blog, we will examine the following areas affected by the new law.
- Corporate tax rate reduction and the alternative minimum tax (AMT) repeal
- Capital contributions and dividends to corporations
- Limitations on deducting interest expense
- Corporate net operating losses (NOLs)
If you wish to learn more about these areas and the other impacts the new tax laws have on corporate taxpayers, continue to check our website for continuing coverage of this new law. Also, please consider attending our upcoming Tax Reform seminar on Tuesday, January 30. Click here for more details.
1. Corporate Tax Rate Reduction and the Alternative Minimum Tax Repeal
The top corporate tax rate has been permanently reduced by 40 percent—from 35 to a flat tax rate of 21 percent. The prior four corporate tax rates, with a top rate applicable to income over $10 million, have been reduced to a single flat rate thereby converting the corporate progressive tax system into a flat tax system. Personal service corporations (e.g., certain corporations providing health, law, and accounting services), which have historically been subject to some of the highest tax rates and could not benefit from the lower progressive rates, are now taxed at the same rate as other C corporations. The corporate tax rate of 21 percent may increase the relative use of C corporations for certain businesses based on the facts and circumstances of each situation (e.g., the applicability of the new top individual rate of 37 percent, still subject to the individual AMT, and a new deduction for certain pass-through income discussed below). Taxpayers have already begun the difficult task of modeling out specific factors that could impact choice of entity determinations (e.g., temporary vs. permanent rate differences).
The corporate AMT has generally applied to the extent a corporation’s tentative minimum tax, based on a 20 percent rate, exceeds its regular tax, by reducing certain tax incentives and deductions. While the House bill eliminated the corporate AMT, the Senate proposal did not. Ultimately, the Conferees opted to repeal it because retaining the corporate AMT could reduce research and development incentives intended to improve competitiveness and innovation. Further, the historic policy concerns underlying the corporate AMT, with its tax rate threshold of 20 percent, have been greatly diminished as a result of the top corporate tax rate reduction from 35 to 21 percent.
The corporate AMT repeal is effective for taxable years beginning after December 31, 2017. Going forward, any corporate AMT credit may offset the regular tax liability for any taxable year after 2017. The AMT credit is simply the corporation’s prior AMT liabilities. In addition, the AMT credit is refundable for any taxable year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent for taxable years beginning in 2021) of the excess credit for the taxable year.
2. Capital Contributions and Dividends to Corporations
Certain capital contributions from state and local governments will no longer be excluded from income under section 118. Section 108(e)(6), however, will not be altered for computations of cancellation of debt income on certain contributions of debt. And the meaningless gesture doctrine will continue to apply to section 351 exchanges of wholly-owned corporations in which no shares are issued. While section 108(e)(6) and section 351 concerns arose following broad statutory language found in the House proposal, the subsequent Congressional reports eliminated these concerns.
As in the Senate proposal, the 70 and 80 percent dividend received deduction percentages for corporations have been reduced to 50 and 65 percent, respectively, under the new law.
3. New Limitation on Deducting Interest Expense
The recent section 385 regulations were identified by the Administration for possible elimination. That elimination determination was put on hold after statements that new statutory provisions may eliminate or mitigate the need for the regulations. As indicated, the new law modifies section 163 with an enhanced limitation on the deduction of interest for any business. The new provision limits the deduction of business interest by any taxpayer to the sum of (1) business interest income; (2) 30 percent of the adjusted taxable income of the taxpayer; and (3) the floor plan financing interest of the taxpayer for the taxable year. The last element, floor plan financing, applies to dealers of vehicles, boats, farm machinery or construction machinery. For all other taxpayers, the limitation on net interest expense (interest expense less interest income) will be 30 percent of adjusted taxable income. Adjusted taxable income for this purpose is the taxable income of the taxpayer with the exclusion of: (1) any nonbusiness income, gain, deduction or loss, (2) business interest and business interest income, (3) any net operating loss deduction, and (4) any deduction allowable for depreciation, amortization or depletion.
Any amount disallowed under the limitation is treated as business interest paid or accrued in the following tax year. Disallowed interest will have an indefinite carryforward. In addition, the disallowed interest carryforward will be a tax attribute that carries over in certain corporate acquisitions subject to section 381 (such as tax free liquidations under section 332 and most reorganizations under section 368). The bill also modifies section 382 to expand the definition of pre-change loss to include any disallowed interest carryforward, making these carryforwards subject to the section 382 limitation in the same manner as NOL carryforwards.
Special rules apply to account for interests held by partners and S corporation shareholders. Specifically, the partnership must first calculate the limitation on business interest expense at the partnership level. Any excess interest is allocated to each partner in the partnership. The partner can then carryforward the excess, but can only deduct the carryforward to the extent the partnership allocates excess business income to that partner in a future year. Excess business income is the portion of that partnership’s taxable income which bears the same ratio to the partnership’s adjusted taxable income as the excess of 30 percent of the adjusted taxable income over the amount of net business interest bears to 30 percent of the adjusted taxable income of the partnership. In addition, if a taxpayer is a partner in a partnership, the taxpayer removes all items of income, deduction, gain or loss of the partnership when calculating adjusted taxable income. Instead, the taxpayer only includes the excess taxable income of the partnership in the taxpayer’s calculation of adjusted taxable income. S corporations will apply similar rules to that of partnerships.
The following taxpayers are excluded from the application of the new interest limitations: (1) any taxpayer that has annual gross receipts under $25 million, (2) regulated public utilities, (3) an electing real property trade or business, and (4) an electing farming business.
These new rules generally apply to taxable years beginning after December 31, 2017. The new interest limitations could lead to the repeal of the recent section 385 regulations in whole or in part.
4. Corporate Net Operating Losses
Under current law, section 172 allows businesses to offset current taxable income by any NOL carryforward or carryback, subject to several limitations. Although no limitation is placed on the use of NOLs under section 172, the AMT as it applies to businesses effectively limits utilization of NOLs to an offset of 90 percent of taxable income. The House bill took the AMT limitation and proposed to incorporate it within section 172, imposing a 90-percent limitation on the use of NOL carryforwards and carrybacks. The House bill also proposed to allow the indefinite carryforward of NOLs, eliminating the current 20-year carryforward limitation, while also eliminating all NOL carrybacks with the narrow exception of certain carrybacks for small businesses and farms in the event of casualty or disaster losses arising in a tax year beginning after 2017. The Senate bill proposed to limit NOL deductions to 90 percent of taxable income, and then 80 percent in tax years beginning after December 31, 2022. Like the House bill, the Senate bill also proposed the elimination of NOL carrybacks and an indefinite NOL carryforward period. The Conference Committee report and new law adopts the Senate bill approach, with the exception that NOL deductions be limited to 80 percent of taxable income for all years beginning after December 31, 2017.
The 80 percent limitation on NOL deductions applies to losses generated in tax years beginning after December 31, 2017, and the elimination of carrybacks and indefinite extension of carryforwards applies only to NOLs generated in taxable years ending after December 31, 2017. NOLs generated in 2017 and earlier would retain their 20-year life and be available to offset 100 percent of taxable income, subject to certain limitations. The result is that taxpayers will have to track NOLs before and after the effective date separately. While NOLs are expected to increase as a result of the expansion of allowable depreciation deductions (see below), there may be an incentive to defer deductions to a year where they can be deducted 100 percent against taxable income as opposed to generating an NOL which is limited to 80 percent. Taxpayers should also consider any carryforward of disallowed interest under revised section 163, which will be an attribute subject to the same limitations on NOLs (specifically section 382), potentially causing taxpayers in a profitable position to consider change of control impacts.