Following the passage of the Tax Cuts and Jobs Act (TCJA), we have covered its expected impact to taxpayers. Now, three-quarters of the way through 2018, we’ve summarized many of the additional changes to federal tax law as a result of the TCJA and what to expect next. See below for updates on the status of tax reform as it relates to further legislation, regulations, notices and other guidance in the areas of corporate, partnership, individual, ASC 740, accounting methods and periods, international, transfer pricing, state and local, research and development, and non-profit tax matters.
Corporate Tax: Updates on Debt-Equity and Interest Deductions
Proposed regulations withdrawing the Section 385 debt-equity documentation rules (Treas. Reg. Sec. 1.385-2) were received June 21 and have been reviewed by the Office of Management and Budget. The rules in the final debt-equity regulations (T.D. 9790) contain documentation requirements to treat some related-party interests in a corporation as debt and to reclassify some related-party debt as equity for federal tax purposes, and were targeted last October by a Treasury report on regulatory burdens. Taxpayers welcomed the revocation of the documentation rules and speculation quickly rose that the regulations most likely to be eliminated were those contained in Section 1.385-3, commonly known as the recharacterization rules. A six-year per se funding rule contained in those provisions would require taxpayers to collapse certain distributions and transfers with debt issuances to recharacterize the debt as equity, and appeared to many to capture nearly all debt instruments regardless of intent or connection with a transfer occurring within the six-year period. Many believe the regulation was in direct violation of Executive Order 13789, issued by President Trump on April 21 to eliminate regulations imposing an undue financial burden on U.S. taxpayers or adding undue complexity to the federal tax laws. It appears likely that the majority of the final debt-equity regulations will be uprooted. This is supported by a report issued by Treasury to the president on ‘Identifying and Reducing Regulatory Tax Burden,’ dated October 2, 2017, explaining that Section 1.385-3 was a blunt instrument designed to address inversions and foreign takeovers of U.S. corporations without any new investment. The Treasury report goes on to explain that tax reform was expected to eliminate the need for the Section 385 regulations, which practitioners believe was accomplished.
Treasury has indicated that it’s targeting proposed regulations under Section 163(j) by early fall. Due to the complexity of issues involved and the breadth and number of taxpayers the new limitation to interest deductions applies to, these regulations are highly anticipated and expected to address the following key issues: 1) treatment of all interest income and expense generated by a C corporation as business interest; 2) treatment of C corporation partners of a partnership, where limitations on business interest are applied at the partnership level; 3) consolidated return implications of Section 163(j) (joining or leaving a group, stock basis adjustments, Section 382, SRLY limitations, etc.); 4) allocation of interest expense between businesses exempt from Section 163(j) and those that are subject to the limitation; 5) potential application of limitations to CFCs; and 6) some of the matters where the Service has already decided what to do (e.g., certain issues relating to earnings and profits and carryovers from “old” Section 163(j)).
Partnership Tax: Qualified Business Income Deduction, Recharacterization of Capital Gains, and Other Impacts
The TCJA enacted Section 199A, which provides certain non-corporate taxpayers with a deduction equal to 20 percent of their qualified business income (QBI) from pass-through entities (e.g. partnerships, disregarded entities). As originally enacted, a number of questions and concerns arose regarding determination of the intended benefit (e.g. certain agricultural and horticultural cooperatives would be entitled to a deduction equal to 20 percent of the excess gross income over qualified cooperative dividends). Additionally, recipients of qualified cooperative dividends would be entitled to a deduction equal to 20 percent of such deductions. Further, Section 199A(c)(3)(B) provided that QBI specifically excluded certain investment items including any long term or short term capital gains or losses. Inclusion of the word “investment” created uncertainty as to whether, for example, Section 1231 gains and losses should be excluded from the definition of QBI.
On March 23, the Consolidated Appropriations Act, 2018 (Act) was signed into law. The Act significantly modified Section 199A to remove the deduction attributable to qualified cooperative dividends and re-work the manner in which agricultural and horticultural cooperatives are able to claim a reduced tax rate benefit on their earnings. Additionally, the Act struck the word “investment” from Section 199A(c)(3)(B), presumably intended to add clarity to the question of whether Section 1231 gains and losses should be excluded from the definition of QBI. On August 8, the IRS released proposed regulations under Section 199A, which taxpayers may rely upon until final regulations are published. Notice 2018-64, which provides methods for calculating Form W-2 wages to determine whether limitations for taxpayers otherwise eligible for the Section 199A deduction apply, was also released on August 8. See BDO's overview of Section 199A here.
Under Section 1061, certain capital gains attributable to assets held for less than three years may be subject to recharacterization as short-term capital gain. These rules are generally intended to apply to profits interest members of partnerships conducting activities involving the raising or returning of capital and either investing or developing specified assets, including securities, commodities, rental or investment real estate, cash or cash equivalents, options or derivative contracts with respect to the foregoing. Section 1061(c)(4)(A) provides an exception to these rules by excluding partnership interests held by corporations. Based on the plain language of the statute, it was not clear whether a partnership interest held by a corporation that has made an election to be taxed under subchapter S, i.e., an S corporation, would be excluded from these rules. Notice 2018-18 provides that Treasury and the IRS intend to issue regulations providing that the term “corporation” for purposes of Section 1061(c)(4)(A) does not include an S corporation. Although the authority for reaching this conclusion remains unclear, Treasury and the IRS appear set on preventing application of the Section 1061(c)(4)(A) exception to S corporations. To date, however, no proposed, temporary, or final regulations have been published.
The TCJA made a number of additional changes impacting entities taxed as partnerships. These changes include: 1) repeal of the technical termination rules under Section 708(b)(1)(B); 2) modification of the definition of substantial built-in loss under Section 743(d); 3) Section 704(d) basis limitation relating to charitable contributions and foreign taxes; 4) partnership implications resulting from business interest limitations under Section 163(j); 5) limitation of the Section 1031 like-kind exchange rules to exchanges involving real property not held primarily for sale; and 6) business loss limitation rules under Section 461(l). As these rules pertain to partnerships and their partners, no additional guidance or clarifications have been published by Treasury or the IRS. Information regarding these rules as enacted in TCJA can be found here.
High Net Worth Individuals: Further Regulations Issued Regarding Charitable Contributions for State Credits and Regulations Expected for Deductions Unique to Non-grantor Trusts and Estates
The IRS issued proposed regulations regarding the Section 170 individual state and local tax (SALT) deduction cap. The cap introduces a limitation on the deductibility of state and local property and income taxes from federal taxable income of $10,000, starting with taxable years beginning in 2018 and before 2026. Prior to issuance of the proposed regulations, the IRS released Notice 2018-54 to inform taxpayers of the IRS’s intent to publish proposed regulations to address attempts by state legislatures to avoid the limitation of deductions on state taxes through charitable deductions. The proposed regulations state that when a taxpayer receives or expects to receive a SALT credit in return for a payment or transfer to a Section 170(c) entity, this constitutes a quid pro quo that may preclude a full deduction under Section 170(a), and would reduce the federal charitable deduction amount equal to the SALT credit received. Taxpayers should be aware of their states’ approach and federal guidance on deductible payments for federal tax purposes in time for their 2018 tax returns.
In addition, the IRS released Notice 2018-61 indicating that the IRS and Treasury intend to publish regulations that will confirm that the deductions permitted under IRC Section 67(e) (dealing with expenses not commonly or customarily incurred by an individual) will not be considered miscellaneous itemized deductions. As such, non-grantor trusts and estates will be allowed to deduct those items. Generally, trusts are taxed like individuals and the deduction for miscellaneous itemized deductions for individuals has been suspended from 2018 through 2025. Thus, non-grantor trusts and estates will not be permitted a deduction for miscellaneous itemized deductions. There was some confusion as to whether the Section 67(e) exception afforded to non-grantor trusts and estates would continue to apply given the suspension of the deduction of miscellaneous itemized deductions. Notice 2018-61 announces a taxpayer-friendly resolution permitting non-grantor trusts and estates to continue to deduct those expenses falling within the Section 67(e) exception. The Notice also requested comments on the classification of excess deductions in the year of termination of a trust or estate. Under current rules, those excess deductions are considered miscellaneous itemized deductions in the hands of the beneficiaries of the terminating trust or estate.
ASC 740 Income Taxes: Clock is Ticking on Estimates under SAB 118
Neither the Securities and Exchange Commission (SEC) nor the Financial Accounting Standards Board (FASBI) have issued any further guidance to supplement that which was released by the SEC in December 2017 (Staff Accounting Bulletin 118 (SAB 118)) and by the FASBI in January 2018 (Accounting Standards Update 2018-05 which allows private business entities to adopt SAB 118). The provisions in SAB 118 allow companies to record an estimate of the impact of tax reform if they had not been able to complete the accounting for tax reform at the time it filed its financial statements. The Bulletin also required entities to disclose certain information in their financial statements regarding the impact of tax reform, including open items and the reason why they had not been completed.
As companies finalize their analyses of tax reform changes (e.g. a calendar year company in the preparation of its 2017 tax return), they should reflect the final accounting in their financial statements (a calendar year public company might include any change in its third quarter 10-Q along with the applicable disclosures required by SAB 118). Questions have arisen as to the applicability of SAB 118 in an entity’s first year, which does not include the enactment date of December 22, 2017, when other provisions of tax reform are effective such as GILTI and BEAT, as defined below. The provisions of the Bulletin are only applicable for the reporting year that includes the enactment date of December 22, 2017.
Companies need to continuously monitor guidance that is issued by Treasury or by state legislatures which might clarify the provisions of the TCJA and which could possibly change the accounting treatment of a particular provision. This is important in order for an entity to determine the appropriate period in which to record any adjustments related to such guidance.
International Tax: Section 965 Proposed Regulations Issued, Additional Proposed Regulations Expected under Sections 951A and 59A
In the international tax context, proposed regulations on the Section 965 transition tax were issued on August 1. The proposed regulations largely follow the guidance provided in previously released notices, and though it does not provide favorable relief to taxpayers in many situations, it provides welcome guidance and clarification on certain open issues. The IRS is accepting feedback and requests for a public hearing within 60 days of the regulations’ publication date. Section 965 applies to the last taxable year of deferred foreign income corporations that begins before January 1, 2018. For IRS guidance on Section 965 for 2017 tax returns, click here.
Taxpayers are awaiting guidance relating to various provisions of the TCJA including Section 951A (global intangible low-taxed income (GILTI) included in gross income of U.S. shareholders) and Section 59A (tax on base erosion payments of taxpayers with substantial gross receipts). Such guidance is likely to be issued in late 2018. With respect to GILTI, we anticipate forthcoming guidance that will address or clarify various open items including the application of foreign tax credit limitation rules relating to GILTI inclusions by corporate U.S. shareholders (including the basketing of the Section 78 gross-up) and individual U.S. shareholders that make a Section 962 election. Regarding Section 59A, we expect guidance to address, among other items, the scope of the services cost exception included in Section 59A(d)(2).
Sections 965, 951A, and 59A Impact on Transfer Pricing
The TCJA enacted several changes that will impact the way U.S. multinationals look at their transfer pricing. Many U.S. taxpayers with foreign related parties will be taking a closer look at their value chains, possibly altering those structures, to minimize the impact of GILTI and the Section 59A Base Erosion Anti-abuse Tax (BEAT), and take advantage of the Foreign Derived Intangible Income benefit under Section 250. In addition, the definition of an “intangible asset” is revised to include goodwill, going concern value, workforce in place, and any other item of value that is not attributable to tangible property and services for purposes of both Sections 367(d) and 482, which will impact the way in which Section 482 intangible asset valuations are performed. As discussed above with respect to International Tax, the proposed Section 965 regulations and forthcoming guidance related to Section 951A and 59A will also have Transfer Pricing implications.
Tax Reform Brings a Mixed Bag for Accounting Methods and Periods
A number of the tax reform provisions favorably impact accounting methods for federal income tax purposes, including full expensing and the small taxpayer simplification. First, the new law extends and modifies bonus depreciation through 2026 (or through 2027, for longer production period property and certain aircraft) under amended Section 168(k). The 50-percent bonus depreciation is increased to 100 percent for property acquired and placed in service after September 27, 2017, and before 2023 (before 2024 for longer production period property and certain aircraft). The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service in taxable years beginning after 2022 (after 2023 for longer production period property and certain aircraft). Bonus depreciation is now permitted on both new and used property acquired by purchase, provided the property was not used by the taxpayer before the taxpayer acquired it, and it was not used by a related party. Proposed regulations for bonus depreciation under amended Section 168(k) were issued on August 3, and taxpayers may rely on these regulations for their 2017 tax returns. The proposed regulations address the qualification of used property, such as whether bonus depreciation is available for property previously leased by the taxpayer who then subsequently purchases it. The proposed regulations also state that basis adjustments under Section 743(b) are eligible for bonus depreciation.
Second, effective for tax years beginning after December 31, 2017, all taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less are permitted to use the overall cash method for reporting taxable income. Under this threshold, taxpayers that produce or resell tangible property are exempted from keeping inventory under Section 471 and from capitalizing additional UNICAP costs under Section 263A. In addition, taxpayers that meet the $25 million threshold are exempted from using the percentage-of-completion method for small construction contracts entered into after December 31, 2017. On August 2, the IRS released procedural guidance regarding taxpayer-favorable method changes that taxpayers meeting the $25 million threshold may apply under Rev. Proc. 2018-40.
Other tax reform provisions impacting accounting methods are not as favorable to taxpayers. For instance, the new amended Section 451(b) rule applicable to accrual method taxpayers will result in the acceleration of certain income that were previously deferred for tax purposes. For tax years beginning after December 31, 2017, accrual basis taxpayers with applicable financial statements must now recognize income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement. Thus, taxpayers that previously accrued income for tax purposes at a later point in time than books (for example, involving contingent consideration) will no longer be permitted to do so. Additionally, the tax reform bill specifies that advance payments shall either be included in gross income in the taxable year received, or deferred under the codified one-year deferral method. This new rule effectively overrides any income deferral longer than one year, except if the taxpayer is using a special method of accounting such as Section 460 or Section 453. In the interim, the IRS issued Notice 2018-35 permitting taxpayers to rely upon Rev. Proc. 2004-34, rather than the code, until the IRS issues future guidance. Another provision involves the transition tax under Section 965, which requires various taxpayers that have untaxed foreign earnings and profits to pay a transition tax as if those earnings and profits had been repatriated to the United States. To prevent taxpayers from engaging in tax strategies (such as accounting method changes) designed to reduce the amount of earnings and profits and in turn the amount of the transition tax, the proposed Section 965 regulations provide that a change in method of accounting will be disregarded for purposes of determining a U.S. shareholder’s Section 965 tax liability if the change would otherwise reduce the Section 965 tax liability of such shareholder, unless the original and/or duplicate copy of any Form 3115 requesting the change was filed before November 2, 2017. Similarly, the IRS in Rev. Proc. 2018-17 precludes certain specified foreign corporations on the calendar year-end from changing the tax year to prevent the avoidance of the purposes of Section 965 transition tax.
SALT: A Year of State Tax Reform
State responses to federal tax reform have been three-fold: conforming with or decoupling from federal corporate income tax changes; developing workarounds to federal personal income tax changes; and stimulating state tax reform. On the corporate income tax front, following what has been one of the busiest, most contentious, and most productive state tax legislative seasons in decades, states have largely addressed conformity to the Internal Revenue Code, such as tailoring their own response to IRC Section 965 and continuing to decouple from federal bonus depreciation (which is now, generally, 100 percent depreciable). Some states have decoupled from other provisions of federal tax reform, such as IRC Section 163(j). As a result, corporate taxpayers will be confronted by a variety of state tax treatments with respect to deemed repatriations under IRC Section 965. Likewise, as corporations plan for 2018 and beyond, they will be confronted by a number of different state tax treatments and considerations with respect to their debt financing, state and local tax incentives, cost recovery, and cross-border operations as a result of how states are responding to federal tax reform. Many of these state responses to federal tax reform will have a significant impact on pass-through entities for 2018 and beyond.
The primary state response from a personal income tax perspective involves attempts by some blue states to enact workarounds to federal tax reform’s SALT deduction limitation. While Connecticut enacted a new, mandatory pass-through entity tax and New York enacted an optional payroll tax, these states and others such as New Jersey have enacted legislation authorizing contribution to charitable funds in lieu of the payment of state or local taxes. Proposed regulations were issued on August 23 regarding the SALT deduction cap. The year 2018 has shaped up to be the year of state tax reform.
All Quiet in R&D: Research and Development Tax Credit Impact Remains the Same
The TCJA did not directly change the federal R&D tax credit, and there have been no further changes as a result of tax reform to date impacting R&D. As we noted in our January Alert, the reduction in the maximum corporate tax rate and the repeal of the corporate AMT both increased the R&D credit’s value, however, these benefits are offset with the repeal of the research and experimental expenditures deduction for tax years beginning after 2021.
Non-profits Await Guidance on Losses Offsetting, Excise Tax on High-earning Employees, Unrelated Business Taxable Income, and Endowment Tax Calculations
The TCJA made significant changes in the tax-exempt area, and tax-exempt organizations are waiting for guidance on several provisions. The IRS has issued Notice 2018-67, which discusses and solicits comments regarding the new Section 512(a)(6) that allows the losses of one unrelated trade or business to only offset the gains from the same unrelated trade or business. Taxpayers are also waiting for guidance on IRC 4960 that would impose a 21 percent excise tax on the compensation of certain employees who earn over $1,000,000 a year and who receive certain parachute payments. To date, we have learned that the IRS contemplates that Form 4720 will be used to pay the excise tax.
The TCJA provides in Section 512(a)(7) that unrelated business taxable income (UBTI) is increased by any amount for which a deduction is not allowable because of Section 274 and which is paid or incurred by the organization after December 31, 2017, for any qualified transportation fringe, or any parking facility used in connection with qualified parking. For organizations with a fiscal tax year that begins in 2017, the IRS has indicated that the amount of any increase in UBTI as a result of this provision should be entered on line 12 of the 2017 Form 990-T. Also, fiscal year corporate filers must use blended corporate tax rates.
With regard to the Endowment Tax under Section 4968, the IRS has issued Notice 2018-55 which clarifies that educational institutions should calculate their net investment income for purposes of Section 4968 using the rules of IRS 4940(c).
For more information on how tax reform issues will impact your business or any other business tax services, please contact Lesley L. Price, CPA at (334) 887-7022 or by leaving us a message below.
This article originally appeared in BDO USA, LLP's insights, September 2018. Copywrite 2018 BDO USA, LLP. All rights reserved. www.bdo.com.
