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Tax Cuts and Jobs Act - New Income Tax Provisions

Client Advisory

January 2, 2018

The Tax Cuts and Jobs Act (Act), which was enacted on December 22, 2017, amends certain income, estate and gift and employment tax provisions of the Internal Revenue Code. Below is a summary of some of the changes to the income tax provisions and our initial observations. [1]

I.  BUSINESS TAX PROVISIONS

A.  Non-Corporate Taxpayers – Individuals and Pass-Through Entities

1.  20% deduction against “qualified business income”

Effective for taxable years beginning after December 31, 2017 and before January 1, 2026, non-corporate taxpayers conducting a trade or business, including through a pass-through entity (e.g., a partnership; a limited liability company treated as a partnership or disregarded entity for tax purposes; an S corporation), may deduct 20% of their “qualified business income” from a “qualified trade or business”. Assuming that the full deduction may be claimed, this means that “qualified business income” would be subject to an effective federal income tax rate of no more than 29.6%, which is 80 percent of the new highest non-corporate marginal tax rate of 37%.

A “qualified trade or business” (QTB) is any domestic trade or business, except a trade or business involving the performance of services: (a) in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners [2] ; (b) in investing and investment management, trading, or dealing in securities, partnership interests or commodities; or (c) as an employee. However, an owner of a service business referred to in (a) or (b) above will be potentially eligible for a 20% deduction if the owner’s total taxable income is less than $157,500 (if a single filer) or $315,000 (if a joint filer), with the deduction phased-out for taxable incomes between $157,500 and $207,500 (if single filer) or $315,000 and $415,000 (if joint filer) (Specified Service Business Taxable Income Limitation). These thresholds are indexed for inflation.

“Qualified business income” (QBI) is the net amount of domestic qualified items of income, gain, deduction and loss from a taxpayer's QTB. QBI does not include amounts paid as reasonable compensation for services rendered, amounts paid to partners as Section 707(c) [3] guaranteed payments for services rendered to or on behalf of a partnership and, to the extent provided in regulations, amounts paid to partners as Section 707(a) payments for services rendered by such partner acting in a non-partner capacity. QBI also doesn’t include certain investment income, gain, deduction, or loss.

 

It should be noted that even if an owner of a non-QTB services firm has taxable income low enough to meet the Specified Service Business Taxable Income Limitation, the owner will still need to derive income from the business that constitutes QBI in order to be able to claim the 20% deduction.

There is also an overall limitation on the 20% deduction for owners of a QTB whose taxable income exceeds the Specified Business Taxable Income Limitations. For each QTB, the amount of the deduction may not exceed the greater of: (a) 50% of the W-2 wages paid by such QTB or (b) 25% of the W-2 wages paid by such QTB plus 2.5% of the unadjusted basis of the “qualified property” with respect to such QTB (Overall Limitation). [4] Having this Overall Limitation also tied to “qualified property” will allow owners of businesses with few employees but a lot of capital qualify for the deduction. Real estate businesses are especially likely to benefit from this provision. Taxpayers might also be incentivized to “load up” on qualified property, including through debt-financed purchases [5] and by purchasing, rather than leasing, qualified property.

Taxpayers may also claim the 20% deduction against real estate investment trust (REIT) dividends, qualified cooperative dividends and qualified publicly traded partnership income without being subject to the Overall Limitation.

Our Initial Observations:

  • Feasibility of law, accounting and other service firms restructuring themselves (and their compensation arrangements)

Law, accounting and other service firms have already started inquiring about whether and how these firms and their service providers can take advantage of the 20% deduction. At least for law and accounting firms and medical practices, only those lawyers, accountants, doctors and other professionals of these firms and practices whose taxable income is low enough to meet the Specified Service Business Taxable Income Limitation would be eligible. As for architecture and engineering firms, these would seem to qualify as QTBs, [6] in which case its architects, engineers and other professionals would not be subject to the Specified Service Business Taxable Income Limitation, although the amount their deductions under this provision would still be subject to the Overall Limitation.

Even in the case of a QTB or a non-QTB service business that has owners and/or other service providers whose taxable incomes are low enough to meet the Specified Service Business Taxable Income Limitation [7] , the 20% deduction may only be claimed against income/gain that constitutes QBI. For an owner or other service provider (including an employee) who receives reasonable compensation, Section 707(c) guaranteed payments or Section 707(a) payments in a non-partner capacity, consider whether both the firm and the service provider are willing to re-structure these payments to distributions that are contingent (or at least partially contingent) on the firm’s income/profitability (essentially, turning such service provider into a type of equity owner in the firm).

  • Determining whether a non-corporate taxpayer should (or should continue to) conduct business or hold an investment in a pass-through entity (and, in particular, in a partnership or limited liability company).

The Act has greatly reduced the corporate tax rate from 35% to 21% (while retaining the 20% rate for dividends and the additional 3.8% net investment tax), which is substantially lower than the 29.6% tax rate on QBI (assuming the 20% deduction is able to be fully utilized) and the 37% tax rate on non-QBI and non-long term capital gain income.

Among the tax considerations that would be relevant in making this determination are [8] : (a) the type of business or investment; (b) the type of income or gain that such business or investment would generate; (c) the state and local income tax implications – e.g., currently, a corporation is subject to a combined New York State and New York City income tax of 15.35% on its New York City-source taxable income, whereas a partnership or limited liability company is generally not subject to New York State income tax and to only a 4% New York City unincorporated business tax [9] ; (d) whether losses are anticipated, which would be especially common for a real estate or start-up business, and whether the taxpayer wants those losses to flow-through to shelter other income [10] ; (e) whether and how frequently distributions will be made; and (f) the federal, state and local income and other tax implications of moving a business or investment into a C corporation or converting an S corporation, partnership or limited liability company into a C corporation, e.g., under Section 357(c) if the business or investment is leveraged and liabilities exceed tax basis or real estate transfer tax, if the business or investment constitutes an interest in real property (and, particularly, leveraged real property).

2.  Non-corporate taxpayers limited in amount of trade or business losses available to shelter non-trade or business income

For taxable years beginning after December 31, 2017 and before January 1, 2026, non-corporate taxpayers may shelter no more than $250,000 ($500,000 for joint filers), indexed for inflation, of their non-trade or business income with their non-passive trade or business losses. Any unused losses are treated as net operating losses carried to succeeding tax years and would be subject to the provision limiting such loss carryovers to 90% (80% for post-2022 tax years) of taxable income.

Our Initial Observations:

This provision has attracted far less attention than the new 20% deduction discussed above and perhaps because there are probably fewer taxpayers who might be impacted by it. But this limitation would adversely impact taxpayers who both have more than $250,000 ($500,000 if a joint filer) of non-trade or business income and who are engaged in one or more trades or businesses that generate an overall net loss of more than $250,000 ($500,000 if a joint filer). Such loss-generating trades or businesses could include, for example, a real property business under Section 469(c)(7), an oil and gas investment or a start-up business in which the taxpayer materially participates. A taxpayer who completely disposes of a passive activity resulting in the freeing up of suspended passive losses could also be affected.

3.  Increased holding period (from 1 to 3 years) for long-term capital gain treatment with respect to partnership profits interests

In general, a partnership’s issuance to a partner, employee or other non-employee service provider (Service Provider Partner) of a partnership interest that constitutes a “profits interests” is generally tax-free to the Service Provider Partner. See Revenue Procedures 93-27 and 2001-43. Absent unusual circumstances, for income tax purposes, a profits interest becomes a capital asset in the hands of the Service Provider Partner with the Service Provider Partner (if not already a partner) becoming a partner of the partnership. Like any partner of the partnership, the Service Provider Partner would be allocated the amount of the partnership’s income, gain, loss and deductions allocable to such profits interest, with such allocated income, gain, loss and deductions retaining the character for income tax purposes that they had when recognized by the partnership. For example, any gain recognized by the partnership from the sale of a capital asset held by the partnership for more than one year would constitute long-term capital gain, with a partner’s allocable share of such gain also being long-term capital gain in the hands of the partner.

Effective for tax years beginning after December 31, 2017, a taxpayer that is transferred or holds a partnership interest (referred to as an “applicable partnership interest” [11] ) in connection with the performance of services by the taxpayer or related person(s) in an “applicable trade or business” [12] will need to hold the interest for at least three years in order to realize long-term capital gain with respect to such interest. This extended holding period requirement applies notwithstanding Section 83 or any Section 83(b) election in effect. If a partner sells an applicable partnership interest that has been held for less than three years, the partner’s capital gain in respect of such interest would be treated as short-term capital gain and, thus, ineligible for the preferential 20% long-term capital gain rate.

Our Initial Observations:

A partnership’s (or limited liability company’s) issuance of equity in the form of a “profits interest” serves as an important tool for incentivizing service providers by being able to provide them with equity in the business tax-free. It also potentially enables service providers to recognize their share of any appreciation in the value of the business as long-term capital gain, rather than ordinary compensation income or wages. [13] Moreover, it is a tool that the Internal Revenue Service (IRS) has expressly recognized and blessed by its issuance of Revenue Procedures 93-27 and 2001-43 (Revenue Procedures) providing a safe harbor for these interests and their tax treatment. While the Revenue Procedures impose a two-year holding period in order for taxpayers to be able to rely on the Revenue Procedures, the Revenue Procedures do not change or override the generally applicable rule defining long-term capital gain as the gain from the sale or exchange of a capital asset held for more than one year.

This new provision will do just that for profits interests and other compensatory partnership interests held for less than three years. Although the provision contains a number of ambiguities that will hopefully be addressed by future legislative, regulatory or administrative action, in that most profits interests are already held for at least two years to satisfy the Revenue Procedures’ two-year holding requirement, the impact of this new three-year holding period requirement may be less consequential than might appear on its face.

4.  Foreign partner’s sale, exchange or other disposition of interest in partnership engaged in U.S. trade or business results in U.S. effectively connected income; transferee subject to 10% withholding obligation

Effective for sales, exchanges and dispositions on or after November 27, 2017, the Act clarifies the law to provide that gain or loss from the sale, exchange or disposition of a partnership interest is gain or loss that is effectively connected with a U.S. trade or business (ECI) to the extent that the transferor would be allocated ECI if the partnership were to sell all of its assets at fair market value as of the date of the sale, exchange or disposition and the resulting gain or loss allocated to the partner would be ECI. For this purpose, such ECI would have to be treated as being allocated in the same manner as the partnership’s non-separately stated income and loss would be allocated.

Effective for sales, exchanges and dispositions after December 31, 2017, a transferee of a partnership interest is required to withhold 10% of the amount realized in such sale, exchange or disposition unless the transferor certifies to the transferee that the transferor is not a foreign person. [14] If the transferee fails to withhold the correct amount, the partnership would be required to withhold from distributions to the transferee partner the amount that the transferee failed to withhold.

The Act essentially codifies the IRS position in Revenue Ruling 91-32 and rejects the recent Tax Court decision, Grecian Magnesite Mining v. Commissioner, 149 T.C. Memo No. 3 (July 13, 2017), which rejected this IRS position.

Our Initial Observations:

The Act imposes FIRPTA-type withholding and certification rules to foreign partner sales, exchanges and dispositions of interests in partnerships engaged in U.S. trades or businesses.

Because the IRS position in this area has been known for more than 25 years and was only recently rejected by the recent Tax Court decision, which is being appealed, most well-advised partnerships and foreign partners were already treating as ECI gains from the sale of interests in partnerships that generate ECI.

In addition to imposing a withholding obligation on transferees of partnership interests sold, exchanged or disposed of by foreign transferors, the partnership itself will also have a withholding obligation in the case where the transferee fails to comply with its withholding obligation. Accordingly, among other things, partnerships should review their partnership agreements to confirm that the partnership has sufficient control over partnership interest transfers and admissions of new partners to compel compliance and are able to make only the transferee bear the cost of any noncompliance.

5.  Act re-affirms that Section 118 exempts only capital contributions made to corporations, not to partnerships or limited liability companies

Section 118 provides that the gross income of a corporation does not include any contribution to its capital. In addressing the amendment to Section 118 regarding non-shareholder contributions made by governmental entities or civic groups, the Joint Explanatory Statement re-affirmed that Section 118 and its general exclusion of capital contributions from gross income, applies only to contributions made to corporations.

Our Initial Observations:

In the absence of any express provision applicable to non-corporate entities (e.g., partnerships/limited liability companies) that receive money or other property for no equity interest or other consideration, Section 118 is sometimes cited as support (and even authority) for the position of non-taxability of such receipts. Although not apparent on its face, it may be that Congress simply wanted to re-affirm the IRS position that such “gratuitous” capital contributions made to a non-corporate entity are not excludible from gross income.

B.  Corporate Taxpayers

1.  Reduction in corporate tax rate; elimination of corporate alternative minimum tax; limitation on net operating losses; reduced dividends-received deductions

Effective for taxable years beginning after December 31, 2017 (with no sunset), the corporate income tax rate is permanently reduced to 21% (from 35%) and the corporate alternative minimum tax is repealed. [15] Also, for losses arising in tax years beginning after December 31, 2017, a corporation’s net operating loss deduction is limited to 80% of taxable income (determined without regard to the net operating loss deduction). Also, a corporation’s dividends-received deduction is reduced to 50% (from 70%) and 65% (from 80%) for dividends received from a 20%-or-more owned domestic corporation.

Our Initial Observations:

Due to this substantial reduction in the corporate income tax rate, non-corporate taxpayers might want to consider whether it might make sense to conduct a business or hold an investment in a taxable C corporation, rather than a partnership, limited liability company or S corporation. See above for some of the considerations that would be relevant in making this determination.

An S corporation considering converting to a taxable C corporation needs to also consider the impact of any resulting Section 481(a) adjustment. Under the Act, any Section 481(a) adjustment of an eligible terminated S corporation [16] attributable to the revocation of its S corporation election – i.e., a required change from the cash method to the accrual method [17] – would be required to be taken into account ratably during the six-taxable year period (instead of the normal four-taxable year period) beginning with the first taxable year for which the corporation’s taxable income is required to be computed under a different method than the prior year. Also, in the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account is allocated to such distribution and the distribution is chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount of the accumulated earnings and profits.

2.  Corporations subject to tax on non-shareholder contributions by governmental entities or civic groups

Section 118 provides that the gross income of a corporation does not include any contribution to its capital. Effective for contributions made after the Act’s enactment date, corporations are subject to tax on their receipt of contributions made by governmental entities or civic groups for no corporate stock or other consideration .

Our Initial Observations:

The original House bill provided that any capital contribution made to a corporation for no corporation stock or other consideration would be taxable to the corporation. The Conference Agreement purportedly took “a different approach” from the House bill in subjecting to tax only contributions made by governmental entities or civic groups for no corporation stock or other consideration. [18]

C.  Applicable To Both Non-Corporate and Corporate Taxpayers

1.  Survival of Tax-Free Section 1031 Like-Kind Exchanges for Real Property Only/Elimination of technical terminations of partnerships

For exchanges completed after December 31, 2017, Section 1031 will only apply to exchanges of non-dealer real property. [19]

The Act also repeals Section 708(b)(1)(B) and, as a result, a partnership will no longer terminate for income tax purposes upon the sale or exchange of 50% or more of interests in its capital and profits within a 12-month period.

Our Initial Observations:

The survival of like kind exchanges for non-dealer real property is the culmination of an intense and ultimately successful lobbying effort on the part of real property owners and investors (including real estate investment trusts) and Section 1031 qualified intermediaries, among others.

One of the Section 1031 requirements that continues and is not impacted by the Act is that the taxpayer that held and disposed of the “relinquished property” must be the same taxpayer that acquires and holds the “replacement property”. Although a partnership’s technical termination is not directly related to Section 1031, many tax practitioners working in the Section 1031 area believe that a partnership’s technical termination – e.g., where new investors buy-out outstanding partnership interests representing at least 50% of the partnership’s capital and profits – occurring sufficiently proximate in time (either before or after) to the occurrence of a Section 1031 exchange could result in the creation of a new taxpayer for Section 1031 purposes and, thus, disqualify the exchange. The Act’s repeal of partnership technical terminations removes one potentially disqualifying event for partnerships desiring to do a tax-free 1031 exchange of non-dealer real property.

Regardless of whether real property is owned by a corporate or non-corporate taxpayer, the federal income tax rates remain sufficiently high, including for corporate taxpayers at their reduced 21% rate – not to mention the prospect of state and local corporate or franchise taxes – to make a like-kind exchange of real property an important tax planning tool for both corporate and non-corporate taxpayers in disposing of unwanted real property.

2.  Limitation on Deductibility of Business Interest

Effective for tax years beginning after December 31, 2017, the amount of business net interest that may be deducted is limited to 30% of adjusted taxable income. Adjusted taxable income is the taxable income of the trade or business without regard to: (a) income, gain, deduction or loss not properly allocable to the trade or business; (b) any interest income or interest expense of the trade or business; (c) net operating losses; (d) the amount of any Section 199A deduction allowed (i.e., the new 20% deduction for non-corporate taxpayers); (e) for tax years beginning before 2022, any depreciation, amortization or depletion deductions; and (f) such other adjustments provided by the Secretary.

An exclusion is provided for taxpayers with average annual gross receipts of not more than $25 million for the three tax year period ending with the prior tax year. This limitation will also not apply to certain regulated public utilities or, at the taxpayer’s election, to any farming business or real property trade or business (within the meaning of Section 469(c)(7)(C)).

Disallowed interest amounts will be able to be carried forward indefinitely. Any carryforward of disallowed interest will be an item taken into account in the case of certain corporate acquisitions described in Section 381 (e.g., tax-free corporate reorganizations and liquidations) and will be treated as a "pre-change loss" subject to limitation under Section 382. Special rules will allow a pass-through entity's owners to use unused interest limitation for the tax year and to ensure that net income from pass-through entities will not be double-counted at the partner level.

Finally, Section 381 will provide that the acquiring corporation will take into account, as of the close of the day of distribution or transfer, the carryover of disallowed business interest under Section 163(j)(2) to tax years ending after the date of distribution or transfer.

Our Initial Observations:

First, the Act does not “grandfather” existing debt obligations. Thus, interest on existing debt obligations will also need to be taken into account when applying the new 30% deductibility limitation.

More generally, for most businesses, this provision will reduce the benefit of using debt to finance merger and acquisition transactions.

However, taxpayers engaged in a real property trade or business (within the meaning of Section 469(c)(7)(C)) may elect for this 30% interest deductibility limitation to not apply, with the cost of such election being having to depreciate qualified improvement property under the alternative depreciation system and thereby being ineligible to claim bonus depreciation. Given that real property is often highly-leveraged, this election potentially constitutes a tremendous benefit to owners of real property trades or businesses that is not afforded to owners of other non-farming businesses.

This interest deductibility limitation applies only to interest paid or accrued on indebtedness properly allocable to a trade or business, and not to investment interest (within the meaning of Section 163(d)). Footnote 688 of the Joint Explanatory Statement provides that since Section 163(d) applies only to non-corporate taxpayers, a corporation will neither have investment interest nor investment income within the meaning of this section and, thus, interest income and interest expense of a corporation is properly allocable to a trade or business, absent some explicit exclusion (e.g., a real property trade or business that the taxpayer elects to exclude).

Although not clear at this point, a partnership/limited liability company might be able to avoid this interest deductibility limitation by structuring a borrowing as a capital investment providing for Section 707(c) guaranteed payments or preferred, priority returns of partnership income/profits. [20]

3.  Depreciation and Expensing

The Act extends the additional first-year bonus depreciation deduction through 2026 (2027 for longer production period property and certain aircraft) – from 2019 (2020 for longer production period property and certain aircraft).

However, taxpayers will be able to claim 100% bonus depreciation – that is, immediate expensing – of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). This bonus depreciation is phased down to 80% for qualified property placed in service before January 1, 2024, 60% for qualified property placed in service before January 1, 2025, 40% for qualified property placed in service before January 1, 2026, and 20% for qualified property placed in service before January 1, 2027 (with an additional year to place in service available for longer production period property and certain aircraft associated with each phase-down percentage).

The definition of qualified property is also expanded to include previously-used property acquired by the taxpayer from a third party and not in a carryover basis transaction, as well as certain qualified film, television and qualified theatrical productions (but does not include property used by a regulated public utility company nor certain other types of property). Bonus depreciation is not available for amortizable goodwill or other amortizable intangible assets under Section 197.

A real property trade or business (as defined in Section 469(c)(7)(C)) that elects not to be subject to the 30% interest deductibility limitation will have to depreciate qualified improvement property under the alternative depreciation system, thus rendering such property ineligible for bonus depreciation. [21]

The Act also repeals the election to accelerate alternative minimum tax credits in lieu of bonus depreciation under Section 168(k)(4).

These new depreciation provisions apply to property acquired and placed in service after September 27, 2017. Property will not be treated as acquired after the date on which a written binding contract is entered into for its acquisition. For property acquired prior to September 27, 2017 (e.g., property for which a binding written contract was entered into prior to September 27, 2017, to purchase the property), such property is subject to the bonus depreciation rules in place prior to the enactment of the Act, except that a transition rule allows taxpayers to elect to use 50% (instead of 100%) bonus depreciation for qualified property placed in service during the first tax year ending after September 27, 2017.

Our Initial Observations:

The 100% bonus depreciation of “qualified property” will provide taxpayers acquiring such property with a substantial and immediate federal income tax benefit, although the amount of such benefit being potentially and substantially greater in the case of a non-corporate taxpayer subject to a higher marginal federal income tax rate – i.e., up to 29.6% on QBI and up to 37% on non-QBI, non-long-term capital gain – as compared to 21% in the case of a corporate taxpayer (although this relative benefit doesn’t factor in state and local taxes).

Further, as provided under current law, taxpayers may elect out of bonus depreciation. To this end, in conjunction with the application of the new 30% interest deductibility limitation, this election, along with other Section 168 elections providing for a “slowing down” of depreciation deductions, will become more relevant for those taxpayers subject to this limitation for tax years beginning after 2021 when depreciation deductions will be taken into account in determining the taxpayer’s “adjusted taxable income” (i.e., depreciation will reduce the taxpayer’s “adjusted taxable income”) and, thus, the amount of interest that the taxpayer may deduct for such year.

4.  Financial statement conformity for income recognition

Effective for taxable years beginning after December 31, 2017 (in the case of income from a debt instrument having original issue discount (OID), this provision is effective for taxable years beginning after December 31, 2018), accrual method taxpayers subject to the “all events test” for an item of gross income will recognize such income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement (e.g., Form 10-K or audited financial statement) or another financial statement under rules specified by the Secretary. This effectively results in income being recognized by an accrual method taxpayer with an applicable financial statement upon the earlier to occur of when earned, when due, when received or when recognized as revenue in such statement.

For those taxpayers without an applicable financial statement or other specified financial statement, it is intended that this provision apply to items of gross income for which the timing of income inclusion is determined using the all events test.

This provision provides for additional rules regarding financial statement conformity as pertaining to the recognition of OID, market discount, discounts on short-term obligations, OID on tax-exempt bonds, and stripped bonds and stripped coupons and codifies the deferral method of accounting for advance payment for goods, services, and other specified items provided in Revenue Procedure 2004-34, as modified and clarified by Revenue Procedures 2011-18 and 2013-29. This provision does not apply to any item of gross income received in connection with a mortgage servicing contract.

II.  NON-BUSINESS TAX PROVISIONS

A.  Limitation on deductibility of non-trade or business state and local taxes

For tax years beginning after December 31, 2017 and before January 1, 2026, individual taxpayers may deduct state, local or foreign property or sales taxes paid or accrued in carrying on a trade or business or in an activity described in Section 212 (expenses incurred for the production of income) and, as an itemized deduction, up to $10,000 ($5,000 if married filing separately) of other real property taxes, state and local income taxes and sales taxes. Furthermore, taxpayers may not prepay in 2017 and claim as a 2017 itemized deduction state or local income taxes imposed for a tax year beginning after December 31, 2017.

Our Initial Observations:

Unaffected by this limitation are real property and other non-income taxes paid or incurred in connection with a trade or business or for-profit activity, including the rental of real property. In addition, real property taxes that are associated with a non-rental investment real property would seemingly still be considered taxes paid or incurred in an investment activity and, thus, might continue to be deductible as an itemized deduction.

It would also seem that those state and local taxes tied to income and imposed on businesses conducted through or by an unincorporated entity (e.g., a partnership or limited liability company) or individual but which are not itemized deductions – e.g., the New York City unincorporated business tax and metropolitan commuter transportation mobility tax – should remain fully deductible. According to footnote 172 of the Joint Explanatory Statement, taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive share or pro-rata share of income or loss on a Schedule K-1 (or similar form) will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under pre-Act law.

As we had noted in our End of 2017 Summary, whereas prepaying 2018 state and local income taxes in 2017 was not going to result in a 2017 itemized deduction, prepaying 2018 real and personal property taxes may do so. However, and as our End of 2017 Summary further noted, on December 27, 2017, the IRS issued an advisory regarding the prepayment of real property taxes, which provided that a prepayment of anticipated real property taxes that have not been assessed – which, according to the advisory, generally occurs when the taxpayer becomes liable for such tax – prior to 2018 would not be deductible in 2017 and that for purposes of the federal deduction, state or local law determines whether and when a real property tax is assessed.

Finally, and as we had also noted in our End of 2017 Summary, it may be that prepayments of real property taxes will not yield any significant federal income tax savings for those taxpayers who will already be subject to alternative minimum tax in 2017.

B.  Limitation on Mortgage Interest Deduction

For tax years beginning after December 31, 2017 and before January 1, 2026, taxpayers may treat up to $750,000 (reduced from $1,000,000) of mortgage debt as acquisition indebtedness ($375,000 for married taxpayers filing separately), regardless of when the indebtedness is incurred. Also, taxpayers will not be permitted to claim any deduction for interest on home equity indebtedness (before the Act, the interest on up to $100,000 in home equity indebtedness could be deducted) for tax years beginning after December 31, 2017 and before January 1, 2026 and would apply to home equity indebtedness entered into after December 15, 2017.

These limitations will not apply to mortgages entered into on or before December 15, 2017 or to refinancings after such date so long as the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

Our Initial Observations:

Individuals with amortizing acquisition indebtedness in excess of $750,000 may want to consider refinancing their indebtedness with interest-only mortgages to preserve the deductibility of interest on the amount of such indebtedness between $750,000 and $1,000,000.

C.  Limitation/Elimination of Itemized Deductions Subject to 2%-of-Adjusted Gross Income (AGI) Floor

Under pre-Act law, in addition to any other applicable limitation, the total amount of itemized deductions – other than deductions for medical expenses, investment interest, and casualty, theft and wagering losses – that could be claimed by certain high-income taxpayers [22] was subject to an overall reduction equal to the lesser of 3% of AGI above the applicable threshold or 80% of the total itemized deductions otherwise allowable for the tax year. Effective for tax years beginning after December 31, 2017 and before January 1, 2026, this overall limitation on itemized deductions is repealed.

Also effective for tax years beginning after December 31, 2017 and before January 1, 2026, individual taxpayers may no longer claim deductions for miscellaneous expenses subject to the 2%-of-AGI floor. Such expenses include: (1) expenses for the production or collection of income (e.g., investment fees and expenses); (2) unreimbursed expenses attributable to the trade or business of being an employee; (3) tax preparation expenses; and (4) shares of deductible investment expenses from pass-through entities.

Our Initial Observations:

As we had previously advised in our End of 2017 Summary, those taxpayers who could have received a tax benefit for 2017 from their miscellaneous deductions subject to the 2%-of-AGI floor would have wanted to make efforts to try and arrange for the prepayment in 2017 of those 2018 costs and expenses that would give rise to such deductions.

In the case of private equity fund investors and investors in other funds constituting “investor funds”, rather than “trader funds”, for income tax purposes, the management and professional fees and other expenses of such funds are no longer deductible by such investors for tax years beginning after December 31, 2017 and before January 1, 2026.

Regarding estates and trusts, estates and trusts are not subject to the 2%-of-AGI floor for those of their costs incurred in connection with the administration of an estate or a trust that would not have been incurred if the trust’s property were not held in trust (including the portion of trustee commissions allocable to costs not subject to such floor), it is not clear from the Act whether the deduction disallowance applies to these costs as well. As such, and as we had also noted in our Previous Advisory, taxpayers would have wanted to consider paying 2018 trustee commissions and other 2018 costs and expenses (including, in particular, those costs and expenses not subject to the 2%-of-AGI floor) in 2017.

D.  Increase in Standard Deduction/Elimination of Personal Exemptions

Effective for tax years beginning after December 31, 2017 and before January 1, 2026, the standard deduction is increased to $24,000 for joint filers (up from $12,700), $18,000 for head of household filers (up from $9,350), and $12,000 for all other individual filers (up from $6,350). The standard deduction amounts are indexed for inflation for taxable years beginning after December 31, 2018 and will continue to be indexed for inflation after these higher basic standard deduction amounts no longer apply for tax years beginning after December 31, 2025.

Taxpayers will also no longer be able to claim personal exemption deductions for tax years beginning after December 31, 2017 and before January 1, 2026.

Our Initial Observations:

The increased standard deduction amounts, together with the $10,000 state and local tax deduction limitation, is expected to result in many more taxpayers claiming the standard deduction in lieu of itemizing their deductions. Accordingly, as we had previously noted in our End of 2017 Summary, if able to do so, taxpayers would have wanted to try to maximize their 2017 itemized deductions, e.g., for real property taxes [23] , charitable contributions, miscellaneous itemized deductions, to possibly receive a tax benefit from these deductions.

E.  Increase in Individual Alternative Minimum Tax (AMT) Exemption Amount and Exemption Amount Phase-Out Thresholds

Effective for tax years beginning after December 31, 2017 and before January 1, 2026, the AMT exemption amount for individuals is increased to $109,400 for married taxpayers filing jointly (up from $84,500 for joint and surviving spouse filers for 2017), $54,700 for married taxpayers filing separately (up from $42,250 for 2017), and $70,300 for all other taxpayers (except trusts and estates) (up from $54,300 for individual filers for 2017) and the phase-out threshold is increased to $1 million for married taxpayers filing jointly and $500,000 for all other taxpayers, except trusts and estates.

F.  Alimony payments no longer deductible by payor nor includible by payee

Under pre-Act law, alimony payments were deductible as an above-the-line deduction by the payor spouse and includible as ordinary income by the payee spouse. Effective for divorce decrees and separation agreements executed after 2018, as well as for any modification made after 2018 to a divorce decree or separation agreement if it expressly states that this change is intended, alimony payments will no longer be taxable to the payee spouse and no longer be deductible by the payor spouse. This amendment is permanent – it doesn’t sunset.

The Act does not change the treatment of child support payments, which remain neither deducible by the payor spouse nor includible by the payee spouse.

Our Initial Observations:

Income of the payor spouse used for alimony payments is taxed to the payor spouse and at the payor spouse’s marginal tax bracket. This amendment eliminates planning involving having the higher tax bracket spouse make increased alimony payments and receive a greater property settlement, with the two spouses then sharing in the net tax savings from this “arbitrage”. The changed tax treatment of alimony payments will undoubtedly impact the negotiating posture of spouses in a divorce proceeding.


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For more information concerning the matters discussed in this publication, please contact Marc Kushner (212-238-8766, kushner@clm.com, Jennifer MacDonald (212-238-8751; macdonald@clm.com ) or your regular Carter Ledyard attorney.


[1] This summary updates our summary dated December 28, 2017 (End of 2017 Summary).

[2] Because “architecture” and “engineering” were expressly removed from the list of those enumerated services deemed not to be a QTB, it would seem that an architectural or engineering firm would be treated as a QTB even where the firm’s principal asset is the reputation or skill of one or more of its employees or owners. However, this remains uncertain at this time.

[3] Any reference to “Section” refers to the Internal Revenue Code of 1986, as amended.

[4] “Qualified property” is defined to mean depreciable tangible property: (i) which is held by, and available for use in, the QTB, (ii) which is used at any point during the taxable year in the production of qualified business income, and (iii) the “depreciable period” for which has not ended before the close of the taxable year. “Depreciable period” is defined to mean the period beginning on the date the qualified property was first placed in service by the taxpayer and ending on the later of: the date that is 10 years after such date, or the last day of the last full year in the property’s otherwise applicable recovery period (but not under the alternative depreciation system).

[5] Although taxpayers deciding whether to go on a debt binge to finance qualified property purchases will want to, among other things, factor in the new 30% interest deductibility limitation imposed on business debt interest.

[6] However, this is currently subject to some uncertainty in the case of an accounting or engineering firm the principal asset of which happens to be the reputation or skill of one or more of its employees or owners.

[7] And in the case where an owner or other service provider would have taxable income too high to meet this limitation, the owner or other service provider and the firm might want to consider ways to reduce/defer taxable income to subsequent tax years (e.g., maximize deductible retirement account contributions; delay/defer compensation payments).

[8] Of course, there will undoubtedly be other, non-tax considerations that would also need to be considered – e.g., impact on lenders/existing loan agreements, existing contractual arrangements, licenses, etc. – and which non-tax considerations may, in fact, be determinative.

[9] Moreover, as addressed below, while not entirely certain, it may be that this unincorporated business tax will continue to be deductible in full.

[10] As addressed below, non-corporate taxpayers will be limited in the amount of their trade or business losses that can be applied to shelter their non-trade or business income.

[11] An “applicable partnership interest” does not include the following: (a) an interest held by a person employed by another entity that is conducting a trade or business (that is not an applicable trade or business) and who provides services only to the other entity, (b) an interest in a partnership directly or indirectly held by a corporation; or (c) any interest in a partnership to the extent that it gives the taxpayer a right to share in partnership capital commensurate with the amount of capital contributed (as of the time the partnership interest was received), or commensurate with the value of the partnership interest that is taxed under Section 83 on receipt or vesting of the interest.

[12] An “applicable trade or business” is very broad as it is defined to mean any activity that consists in whole or in part of the following: (1) raising or returning capital, and either (2) investing in (or disposing of) specified assets – generally, securities, commodities, rental or investment real estate, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing and a partnership interest (including any partnership interest not otherwise treated as a security) to the extent of the partnership’s proportionate interest in any of the foregoing (or identifying specified assets for investing or disposition), or (3) developing specified assets.

[13] This would also mean, however, that the partnership or limited liability company and its other partners/members would lose an ordinary compensation deduction.

[14] The parties to the transaction may apply to the IRS for a withholding certificate that allows for withholding at a reduced rate or exemption from withholding. Section 1446(f)(3).

[15] The Act also allows corporations an AMT credit to offset their regular tax liability for any taxable year and, further, provides for the refunding of the AMT credit for any taxable year beginning after 2017 and before 2022 in an amount equal to 50% (100% in the case of taxable years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability.

[16] An “eligible terminated S corporation” is any C corporation that (1) is an S corporation the day before the enactment of the Act, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election, and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

[17] As the Joint Explanatory Statement points out, the Act expands the universe of C corporations eligible to use the cash method to include C corporations with annual average gross receipts not exceeding $25 million for the three prior taxable year period and that a cash method eligible terminated S corporation able to meet this test may be able to remain on the cash method as a C corporation and, thus, would have no Section 481(a) adjustment.

[18] In that one would expect a contributor of money or property to a corporation for no equity or other consideration to be a governmental entity or civic group of some type, the approach of the Conference Agreement may not be as much of a “different approach” as might appear on its face.

[19] Amended Section 1031 does not apply any exchange if the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017 or the property received by the taxpayer in the exchange is received on or before such date.

[20] Section 707(c) provides that to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of Section 61(a) (relating to gross income) and, subject to Section 263, for purposes of Section 162(a) (relating to trade or business expenses).”

[21] A farming business that elects not to be subject to this interest deduction limitation will have to depreciate its property with a recovery period of 10 years or more under the alternative depreciation system thus rendering such property ineligible for bonus depreciation.

[22] For 2017, these thresholds were: (1) $261,500 for single taxpayers; (2) $313,800 for married couples filing jointly and surviving spouses; (3) $287,650 for heads of households; and (4) $156,900 for married taxpayers filing separately.

[23] But see above regarding the IRS advisory on the 2017 deductibility of prepaid real property taxes.

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Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2018 Carter Ledyard & Milburn LLP.
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