Significant Business Tax Changes Under the Tax Act That Do Not Directly Affect the Choice of Entity Decision
Changes to the Use of Net Operating Loss Deductions
Three important changes have been made concerning the use of net operating losses (NOLs) by businesses.
First, the ability to carry back NOLs for up to two years from the year the NOLs are generated has been eliminated. Consequently, all NOLs must now be carried forward and used in years after those losses are generated.
Second, the 20 year limit for NOL carryforwards has also been eliminated. Consequently, NOLs can now be carried forward indefinitely and used in any future tax year to offset taxable income of the taxpayer.
Third, and most importantly, taxpayers will no longer be able to use NOL carryforwards to offset all of their taxable income in future years. Instead, beginning in 2018, taxpayers will be permitted to use NOL carryforwards from prior years to offset no more than 80 percent of their taxable income. This new limitation will apply regardless of whether the taxpayer is an individual operating a business through a flow-thru entity or is a C corporation.
Limits on Business Interest Deductions
Beginning in 2018, businesses (regardless of whether they are operated in C corporation or flow-thru form) will be permitted to take a deduction for business interest incurred during the taxable year only to the extent that the total amount of such interest does not exceed the sum of (i) the interest income of the business during that year; plus (ii) 30 percent of the business’s earnings before interest, tax, depreciation, and amortization (EBITDA). For tax years beginning after 2021, the EBITDA measurement will be replaced with earnings before interest and taxes (EBIT), which will have the effect of further restricting the deduction of business interest. Any interest that is disallowed in a taxable year as a result of the new limitation will be carried forward and can be used in any future year, subject to the limitation in that future year.
Among other planning techniques to reduce the burden of this new limitation, businesses will now look for additional ways to generate interest income and other types of income from financial products that might be considered interest income under IRS guidance that has yet to be issued.
Changes to Depreciation and Other Cost Recovery Provisions
Under the Tax Act, the currently-permitted deduction for “bonus depreciation” on new equipment and other tangible personal property will be increased to 100 percent (i.e., full expensing) for any assets purchased and placed in service during the tax years from 2018 through 2022. The bonus depreciation deduction will then be reduced by 20% per year in the years 2023 through 2026, and will no longer be available at all beginning in 2027. In addition, bonus depreciation deductions will now apply to used as well as new equipment. Special rules will apply to reduce the deduction for property purchased before 2018, but not placed in service until after the new Tax Act takes effect.
In addition to the changes in bonus depreciation, the limitations on the use of the “Section 179 deduction” (which has always allowed an immediate 100 percent deduction for certain items of new equipment), have been increased, which will allow more businesses to take advantage of that deduction for more of their property purchases. In particular, eligible businesses can now fully expense up to $1,000,000 of their purchases (increased from the previous $500,000 limit), and the deduction will not begin to be phased out until the total of such purchases during the year exceeds $2,500,000 (up from the $2,000,000 threshold in place before the Tax Act). In addition, certain improvements to real property (including roofs, HVAC equipment, and security and alarm systems) will now be eligible for the Section 179 deduction.
One other important change to the cost recovery provisions provides that most research and development (“R&D”) expenditures will no longer be fully deductible in the year they are incurred. Instead, beginning in 2022, such R&D expenditures must be amortized over a five-year period.
Changes to Capital Asset Treatment for Self-Created Assets
Because of the favorable capital gains rates that have existed since 1997, it has always been important when selling the assets of a business to make sure that the purchase price is allocated to the extent possible to assets that are considered “capital assets” for tax purposes. For the seller of the business, this has generally meant avoiding allocations of the purchase price to cash basis receivables, covenants not to compete, inventory, and personal property subject to ordinary income recapture. The Tax Act adds another significant category of assets that will generate ordinary income upon sale.
In particular, under the Tax Act “capital assets” will no longer include any “patent, invention, model or design (whether or not patented), secret formula or process,” to the extent that such property was created by the personal efforts of the taxpayer. This new ordinary income category would seem, at least at first glance, to cover a wide variety of a business’s property, although it remains to be seen precisely how broad this new category will be.
Changes to Section 1031 “Like-Kind” Exchanges
Beginning in 2018, the ability to do a tax-deferred like-kind exchange will be limited to exchanges of real property. Exchanges of personal property (including exchanges of business units) will no longer be eligible for tax deferred treatment.
Elimination of Deduction for Entertainment Expenses
Under the Tax Act, businesses will no longer be permitted to take deductions for the expenses of entertaining clients or customers, regardless of the connection between the entertainment and the business. Consequently, the always-cumbersome determination of whether an entertainment or recreational activity “directly precedes or directly follows a substantial and bona fide business discussion” will no longer be relevant.
For more information on this topic, please contact:
Denver Mike Dubetz 303.299.8464 firstname.lastname@example.org
Denver Steven Miller 303.299.8144 email@example.com
Denver John Birkeland 303.299.8225 firstname.lastname@example.org
Aspen Joe Krabacher 970.300.0123 email@example.com
Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.
January 4, 2018