November 6, 2017 House tax reform proposal could significantly affect accounting methods, Section 199 and similar provisions — Research credit largely unchanged On November 2, 2017, House Republicans unveiled their comprehensive tax reform bill called the "Tax Cuts and Jobs Act." (For an overview of the entire bill, see Tax Alert 2017-1831.) The bill contains many provisions that would affect accounting methods, Section 199 and other significant federal tax rules. Taxpayers should evaluate the proposed legislation and assess/model the impact of the provisions to enable timely action in case they are enacted. Repeal of Section 199 domestic production activities deduction Current law Section 199 allows taxpayers to claim a deduction equal to 9% (6% for certain oil and gas activities) of the lesser of the taxpayer's qualified production activities income or the taxpayer's taxable income for the tax year. The deduction is limited to 50% of the W-2 wages paid by a taxpayer during the calendar year. Qualified production activities income is derived from certain production activities and services performed (i.e., construction, engineering or architecture) in the United States, and, for tax years beginning before January 1, 2017, in Puerto Rico. Provision The provision would repeal Section 199 for tax years beginning after December 31, 2017. For production activities performed in Puerto Rico, however, the provision would also extend Section 199 to tax years beginning before January 1, 2018. Effective date The repeal provision would be effective for tax years beginning after December 31, 2017. Implications As foreshadowed by the Unified Tax Reform Framework (Framework), the bill would eliminate Section 199 for tax years beginning after December 31, 2017. According to the Framework, Section 199 is no longer necessary because of the across-the-board rate reduction on all business income. The Joint Committee on Taxation estimates that the elimination of Section 199 will increase tax revenues (relative to the baseline receipts projected for future years under present law) by $95.2 billion during the 2018-2027 budget period (see JCX-46-17, Nov. 2, 2017). Section 199 has been a recent focus of increased IRS examination activity, which has resulted in several cases pending in a variety of federal courts. Because the bill would eliminate Section 199 for tax years beginning after December 31, 2017, it is unclear how the IRS will examine and litigate Section 199 claims for tax years beginning before 2018. Because taxpayers can make amended return claims for Section 199 deductions, taxpayers with production or service activities that are within the scope of Section 199 may want to review the claims they have already made for additional opportunities or consider making an initial claim on an amended return for open tax years beginning before January 1, 2018. Research and development incentives Current law Section 41: Under current law, Section 41 provides a credit for certain qualified research expenses paid or incurred by a taxpayer in carrying on its trade or business (the research credit). There are multiple research credit methods available. Section 41(a) (the regular credit) equals 20% of the excess of the qualified research expenses for the tax year over a computed base amount. Section 41(c)(5) (the alternative simplified credit) equals 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three preceding tax years. Section 174: Under current law, Section 174 allows a taxpayer to treat research or experimental expenditures that it pays or incurs during the tax year in connection with its trade or business as deductible expenses, or to elect to capitalize and amortize these expenditures. Section 45C: Under current law, Section 45C allows a drug manufacturer to claim a credit equal to 50% of qualified clinical testing expenses (the orphan drug credit). Provision Section 41: The provision would retain the research credit under Section 41, but would modify the cost-of-living adjustment definition as part of the conforming amendments related to simplification of individual income tax rates, under Section 1005 of the bill. Section 174: As part of the conforming amendments to the repeal of the Alternative Minimum Tax (AMT), Section 2001 of the bill, the provision would delete the cross-reference in Section 174(f) to Section 59(e). Section 45C: The provision would repeal the credit for clinical testing expenses for certain drugs for rare diseases or conditions under Section 45C. Effective date The provisions would be effective for tax years beginning after December 31, 2017. Implications Sections 41 and 174 remain unchanged other than conforming amendments related to the modification of the inflation adjustment and the repeal of the AMT, respectively. The fact that the bill does not remove or modify these sections is consistent with the Framework released in September, which stated that the research credit would be preserved because the incentive has proven to be effective in promoting policy goals important in the American economy. The Tax Cuts and Jobs Act Policy Highlights released by the House Ways and Means Committee asserts that preserving the credit under Section 41 "[encourages] our businesses and workers to develop cutting-edge 'Made in America' products and services." Taxpayers that currently claim the orphan drug credit would be negatively affected by its repeal, but would still be able to claim tax benefits for their qualified clinical testing expenses under Sections 41 and 174 in tax years beginning after December 31, 2017. Expenses that qualify for the credit under Section 45C generally also qualify for the research credit under Section 41, and taxpayers could include what would have been treated as qualified clinical testing expenses as qualified research expenses when calculating the research credit. The research credit under Section 41, however, provides a substantially smaller benefit for these expenses than does the orphan drug credit under Section 45C. The Joint Committee on Taxation estimates that the elimination of Section 45C will increase tax revenues (relative to the baseline receipts projected for future years under present law) by $54 billion dollars during the 2018-2027 budget period (see JCX-46-17, Nov. 2, 2017). Cost recovery Immediate expensing of 100% of the cost of qualified property Current law Current law allows taxpayers to claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property (as described later) is placed in service through 2019 (with an additional year for qualified property with a longer production period, as well as certain aircraft). The bonus depreciation generally equals 50% of the cost of the property placed in service in 2017 and phases down to 40% in 2018 and 30% in 2019. Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS), certain off-the-shelf computer software, water utility property or qualified improvement property. Certain trees, vines, and fruit-bearing plants also are eligible for additional depreciation when planted or grafted. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer. Under current law, taxpayers have the option of making an annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Alternatively, taxpayers may elect under Section 168(k)(4) to accelerate AMT credits (as refundable credits) in lieu of claiming bonus depreciation with respect to qualified property. Such election comes with the added requirement to depreciate that qualified property using a straight-line recovery method. Provision The provision would allow taxpayers to immediately expense 100% of the cost 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). The provision also would expand the property eligible for immediate expensing by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for immediate expensing if it were the taxpayer's first use of that property. Qualified property would not include property used by a regulated public utility company or any property used in a real property trade or business (as defined in Section 469(c)(7)(C)). Additionally, the provision would repeal Section 168(k)(4) (i.e., the election to accelerate AMT credits in lieu of claiming bonus depreciation) for tax years beginning after December 31, 2017. However, the provision would retain the annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Effective date Generally, the provision would apply to property that is acquired and placed in service after September 27, 2017. Similar to prior bonus depreciation transition rules, property would not be treated as acquired after September 27, 2017, if a written binding contract for its acquisition was entered before September 27, 2017. The provision would apply to specified plants planted or grafted after September 27, 2017. The provision would allow taxpayers to elect to apply Section 168 of the Internal Revenue Code of 1986, without regard to the amendments made by the provision (i.e., the current law), to a taxpayer's first tax year ending after September 27, 2017. For taxpayers that instead choose to apply the provision to its first tax year ending after September 27, 2017, the provision would place limitations on the ability to carry back any losses attributable to the 100% expensing rules (by only allowing those taxpayers to carry back the portion of the loss that would have been generated under the current law). Implications The reinstitution of 100% bonus depreciation or immediate expensing for property meeting the definition of "qualified property" under Section 168(k)(2) would provide taxpayers acquiring that property with an immediate cash-tax benefit. Further, as the ability to elect out of the provisions of Section 168(k) would still be available, taxpayers that are in a loss position and would not otherwise benefit from immediate expensing of the above-referenced property would have the flexibility to elect not to apply the provisions of Section 168(k) and, instead, utilize the depreciation provisions as set forth in Section 168 generally. Of particular note is the effective date of the immediate expensing provisions described previously as part of the legislative language; specifically, the expensing provisions would apply to property acquired and placed in service after September 27, 2017. Couple this with what would be the effective date of the 20% maximum corporate income tax rate, which is set to apply to tax years beginning after December 31, 2017, and taxpayers would have a single, extremely limited opportunity to acquire qualified property now but before their 2018 tax year and benefit from expensing that property in the current tax year while a higher corporate tax rate is in play (the maximum corporate tax rate is currently 35%). Further, for the first time since Section 168(k) was enacted, used property would be qualified property and would be eligible for immediate expensing, provided the taxpayer itself had not previously used the property and/or the property is not acquired as part of certain carryover basis or related-party acquisition transactions. This expansion on the concept of original use would be a substantial benefit to taxpayers and could affect how taxpayers value and structure future transactions (as taxpayers would be able to immediately expense a significant portion of the consideration paid for assets acquired in applicable asset acquisitions, as defined in Section 1060(c)). Because the expensing provision would apply to qualified property acquired in a taxable acquisition such as 1060 transactions or deemed asset acquisitions (such as those under Section 338), capitalized costs incurred in these transactions would also be affected. In general, capitalized costs are added to the adjusted basis of acquired property, and, if added to the adjusted basis of qualified property, would be subject to the immediate expensing provisions. In Section 1060 transactions, specifically identifiable costs may be allocated to individual assets. To the extent there were specifically identifiable costs that were allocable to qualified property, they would also be subject to immediate expensing. In addition, as the immediate expensing provisions would only apply to qualified property that is acquired and placed in service after September 27, 2017, taxpayers would again need to ascertain when property was not only placed in service, but also when it was acquired, with a particular focus on when a written binding contract (if any) was entered into to acquire the property. This may significantly affect taxpayers that "acquire" property on or before September 27, 2017, but place it into service after September 27, 2017, as that property would not be subject to the immediate expensing provisions and would instead be subject to the current bonus depreciation percentages and corresponding phase downs (i.e., 50% bonus depreciation in 2017, phasing down to 40% in 2018, and 30% in 2019 generally). As noted, only "qualified property" would be subject to the immediate expensing provision. Property that does not meet the definition of "qualified property" would still need to be depreciated under Section 168 and its regulations. While the provision largely retains the same "qualified property" definition that exists under current law, it specifically excludes property used by a regulated public utility company or any property used in a real property trade or business (as defined in Section 469(c)(7)(C)). Accordingly, taxpayers with such property should evaluate whether it makes sense to take advantage of the transition election to apply Section 168 of the Internal Revenue Code of 1986, without regard to the amendments made by the provision (i.e., the current law), to their first tax year ending after September 27, 2017, as such election would still allow them to claim 50% bonus depreciation on eligible property placed in service after September 27, 2017, and before the end of the tax year (as opposed to 0%). Even if these taxpayers have current-year losses, the transition election could still be beneficial if they are contemplating an election to accelerate AMT credits under Section 168(k)(4) on their 2017 return. Finally, the provisions of Section 168(k)(4), which allow monetization of a portion of pre-2016 AMT credit carryforwards in lieu of claiming bonus depreciation, would be repealed for tax years beginning after December 31, 2017. Accordingly, the 2017 tax year would be the last year in which taxpayers could elect to apply Section 168(k)(4). The provision would, however, allow taxpayers to recover unused AMT credits through certain transition rules associated with AMT repeal. Such rules would allow taxpayers to recover any unused credits from 2019 through 2022 based on a specified formula. As such, taxpayers would need to evaluate whether it makes sense to attempt to recover AMT credits through a 2017 election under Section 168(k)(4) or simply wait until 2019 through 2022. The decision would largely depend on whether AMT credits recovered from 2019 through 2022 (under the AMT repeal transition rules) would be subject to a sequestration haircut, which is unclear. Expansion of Section 179 expensing Current law Businesses may elect to immediately expense up to $510,000 of the cost of any Section 179 property placed in service each tax year. If a business places in service more than $2,030,000 of Section 179 property in a tax year, the immediate expensing amount is reduced by the amount by which the Section 179 property's cost exceeds $2,030,000. Section 179 property includes tangible personal property or certain computer software that is purchased for use in the active conduct of a trade or business, as well as certain "qualified real property," which is defined as qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property that is depreciable and that is purchased for use in the active conduct of a trade or business. Provision The provision would increase the expensing limitation under Section 179 from $510,000 to $5 million with the phase-out increasing from $2,030,000 to $20 million for tax years beginning before January 1, 2023. Both amounts would be indexed for inflation. The provision also would modify the definition of "qualified real property" for purposes of Section 179 to include qualified energy-efficient heating and air-conditioning property. Qualified energy-efficient heating and air-conditioning property would be defined as any Section 1250 property: — For which depreciation is allowable Effective date The increases to the Section 179 expense limitations and related phase-out would be effective for tax years beginning after December 31, 2017, through tax years beginning before January 1, 2023. The change to the "qualified real property" definition in Section 179 to include qualified energy-efficient heating and air-conditioning property would be effective for property acquired and placed in service after November 2, 2017. Implications Although the provision amendments to Section 168(k) that would allow for the immediate expensing of 100% of the cost of qualified property would effectively nullify the impact that Section 179 would have for that property, the 10-fold increase to the expense limitations and related phase-out under Section 179 proposed for tax years 2018 to 2022, coupled with the revised definition of "qualified real property," also would provide immediate expensing to taxpayers that invest in certain "qualified real property." For example, as applicable, immediate expensing could apply to qualified restaurant property or qualified energy-efficient heating and air-conditioning property that would not otherwise meet the definition of qualified property under Section 168(k). In addition, the effective date for qualified energy-efficient heating and air-conditioning property would apply to such property acquired and placed in service after November 2, 2017, making such property eligible for Section 179 expensing under the current limitations for the 2017 tax year. Expanded availability of the overall cash method of accounting Current law Under the overall cash receipts and disbursements (cash) method of accounting, eligible taxpayers may recognize income and deduct expenses when cash is received or paid, instead of having to accrue income and expense. Sole proprietorships, partnerships (without a corporate partner) and S corporations may use the cash method of accounting. Presently, under Section 448, corporations and partnerships with a corporate partner may only use the cash method of accounting if their average gross receipts do no exceed $5 million for all prior years (including prior tax years with a predecessor of an entity). Farm corporations and farm partnerships with a corporate partner may use the cash method of accounting if their gross receipts do not exceed $1 million in any year. Under an exception, certain family farm corporations may qualify if their gross receipts do not exceed $25 million. Provision The provision would modify the gross receipts test by increasing the $5 million threshold for corporations and partnerships with a corporate partner to $25 million. Specifically, a corporation or partnership would meet the gross receipts test for any tax year if that entity's average annual gross receipts for the three-tax-year period ending with the tax year preceding that tax year does not exceed $25 million. The provision also would extend the $25 million threshold to farm corporations, farm partnerships with a corporate partner and family farm corporations. The provision would index the average gross receipts test for inflation, effective for tax years beginning after December 31, 2018. Effective date This provision would be effective for tax years beginning after December 31, 2017. Implications The increase to the current $5 million threshold and the indexing of the gross receipts test for inflation constitute an overdue modification to expand the availability of the cash method to eligible taxpayers under Section 448, which originally was enacted as part of the 1986 Tax Reform Act. Taxpayers and practitioners have long requested modifications to Section 448 to expand its applicability to a broader range of eligible taxpayers and ensure that the threshold reflects changes in the inflation rate over time. For additional discussion of use of the cash method, see the Accounting for inventories section of this Alert. Interest expense deductions Current law Current law allows business interest as a deduction in the tax year in which the interest is paid or accrued, subject to limitation rules, as applicable. Section 163(j) limits a corporation's ability to deduct disqualified interest (i.e., interest paid or accrued to a related party when no federal income tax is imposed on the interest) paid or accrued in a tax year if: (1) the payor's debt-to-equity ratio exceeds 1.5 to 1.0 (safe harbor ratio); and (2) the payor's net interest expense exceeds 50% of its adjusted taxable income. In general, adjusted taxable income is the corporation's taxable income calculated without taking into account deductions for net interest expense, NOLs, domestic production activities under Section 199, depreciation, amortization and depletion. Disallowed interest amounts may be carried forward indefinitely and any excess limitation may be carried forward for three years. Provision The provision would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjustable taxable income for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion. The provision would allow businesses to carry forward interest amounts disallowed under the provision to the succeeding five tax years and those interest amounts would be attributable to the business. The provision would include special rules to allow a pass-through entity's owners to use the unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level. The provision would exempt businesses with average gross receipts of $25 million or less from these rules. The provision also would not apply to certain regulated public utilities and real property trades or businesses; these businesses would be ineligible for full expensing. Additionally, the provision would repeal Section 163(j). For discussion of the additional limitation on deductibility of net interest expense in addition to this general limitation, see Tax Alert 2017-XXXX. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications If enacted, this provision would significantly affect highly leveraged taxpayers, as well as industries that traditionally consider the deduction of interest expense to be an important factor in their operating business decisions. Accounting for inventories In general Current law Current law requires businesses to use an inventory method if the production, purchase or sale of merchandise is a material income-producing factor to the business. Such businesses generally also must use an accrual method of accounting for tax purposes under the rules in Section 446. Under an exception, certain small businesses with inventory that have average gross receipts of not more than $1 million do not have to use an accrual method of accounting. Another exception also exempts businesses with inventories in certain industries (that are not otherwise prohibited from using the cash method) from having to use an accrual method of accounting if their annual gross receipts do not exceed $10 million. Businesses that meet one of the exceptions may account for inventory as materials and supplies that are not incidental. Provision The provision would add Section 471(c), which would exempt businesses with average gross receipts of $25 million or less from the requirement to maintain inventories. The provision would allow these businesses to: 1) treat inventories as non-incidental materials and supplies; or 2) follow the accounting method reflected on their applicable financial statements or books and records for the inventories. As they are not required to maintain inventories under Section 471, these entities would not be prohibited from using the cash method of accounting under the provision. Effective date This provision would be effective for tax years beginning after December 31, 2017. Implications Although the framework of Section 471 generally would not change, the new rules for small businesses would allow more taxpayers to be exempt from accounting for inventories under Section 471, and thus allow those businesses to use the cash method of accounting (given the identical increase in the gross receipts test under Section 448). Additionally, these entities would be given the option of: 1) treating inventories as non-incidental materials and supplies; or 2) following their book treatment with respect to the inventory. If enacted, the option to follow the book method could be beneficial to taxpayers if their book treatment departs favorably from non-incidental material and supply treatment (i.e., the costs of some goods are deducted currently). Capitalization and inclusion of certain expenses in inventory costs Current law The uniform capitalization (UNICAP) rules under Section 263A generally require a business to include certain direct and indirect costs associated with real or tangible personal property produced (either for sale or for use in the business (i.e., a self-constructed asset)) in the basis of that property. For real or personal property acquired for resale, the UNICAP rules require certain direct and indirect costs allocable to that property to be included in the basis of the inventory. A business with $10 million or less of average annual gross receipts, however, is not subject to the UNICAP rules for personal property acquired for resale. Provision The provision would exempt businesses with average gross receipts of $25 million or less from the UNICAP rules. The exemption would apply to real and personal property acquired for resale or produced by the business. The provision also would remove mining exploration and intangible drilling expenditures from the UNICAP rules. Effective date This provision would be effective for tax years beginning after December 31, 2017. Implications In general. Consistent with the benefits of the other small-business tax provisions (e.g., more small businesses able to use the cash method of accounting), this provision clarifies that these businesses would not be subject to the rules under Section 263A. This provision is significant for two reasons: 1) the threshold increase from $10,000,000 (generally) to $25,000,000 would expand the pool of taxpayers exempt from Section 263A; and 2) the provision would exempt small-business taxpayers from all requirements of Section 263A (inventory and self-constructed assets). Under the current rules, small taxpayers are only exempt from the rules as they relate to resellers and certain producers of inventory. Additionally, while Section 174 costs and certain costs attributable to oil and gas wells, and mineral property, continue to be excluded from the Section 263A requirements, Section 263A would nevertheless be amended to remove its coordination with Section 59(e) (because this section would be repealed under the bill). LIFO inventory and Section 263A considerations. The rules for inventory valuation and identification remain largely unchanged. Therefore, all valuation methods would still be available (such as valuing at the lower of cost or market), along with all identification methods, such as the last in, first out method (LIFO method). Although the Senate bill could still include repeal of the LIFO method, the retention of the method in this bill should be considered a positive development. If the LIFO method ultimately is retained, taxpayers not currently using the LIFO method (such as certain foreign inbound companies or private companies) should analyze whether a LIFO method election makes sense for their 2017 tax year (i.e., assess whether the taxpayer experienced inflation with respect to its inventory in that year). The benefit obtained in 2017 with such an election would reverse in a lower-tax-rate landscape in 2018 or beyond, yielding a permanent tax benefit. Although business interest deductions could be limited (see prior discussion), taxpayers subject to the interest capitalization rules under Section 263A could nevertheless obtain an ancillary benefit with less interest available to be capitalized to designated property in production during the year. If this provision is enacted, these taxpayers will need to: 1) analyze and ensure they are taking into account the limitation in determining interest available to be capitalized to designated property, and 2) consider modeling different approaches to change capitalization. In addition, the Section 263A cost capitalization rules should be analyzed in conjunction with modeling for the potential excise tax on payments made by a US corporation to a related foreign corporation. Finally, any costs required to be capitalized to self-constructed assets under Section 263A may be eligible for the new 100% expensing provision as long as the costs are capitalized to qualified property under Section 168(k) (see prior discussion). Accounting for long-term contracts Current law Generally, taxable income from a long-term contract is determined by using the percentage-of-completion method, which allows businesses to take deductions and recognize income based on the percentage of the contract completed each tax year. Section 460(f)(1) defines the term "long-term contract" as any contract for the manufacture, building, installation or construction of property if that contract is not completed within the tax year in which the contract is entered. Generally, taxpayers determine the percentage of the contract completed during the year by comparing the contract costs incurred during the year with the estimated total contract costs. An important exception from the percentage-of-completion method applies to certain businesses with average annual gross receipts of $10 million or less in the preceding three years. Under the exception, a business may use the completed contract method, instead of the percentage-of-completion method, for contracts that are expected to be completed within two years. Under the completed contract method, a taxpayer does not take into account the gross contract price and allocable contract costs until the contract is complete, even though progress payments are received in years before completion. Gross contract price includes all amounts (including holdbacks, retainages and reimbursements) that a taxpayer is entitled by law or contract to receive, whether or not the amounts are due or have been paid. Provision The provision would increase the $10 million average gross receipts exception to the percentage-of-completion method to $25 million. If a taxpayer meets the increased average gross receipts test, the provision would allow the taxpayer to use the completed contract method (or any other permissible exempt contract method). Effective date This provision would be effective for tax years beginning after December 31, 2017. Implications This provision is highly favorable to eligible small taxpayers that would benefit from the opportunity to defer recognition of long-term contact income until completion. The provision generally cross references the rules under Section 448(c) for purposes of the gross receipts test. Meal and entertainment expenses Current law Current law prohibits a deduction for expenses related to entertainment, amusement or recreation activities, or facilities (including membership dues), unless the taxpayer shows that the item was directly related to the active conduct of the taxpayer's trade or business. If the taxpayer is able to show that the item is directly related to its trade or business, the taxpayer may deduct up to 50% of meal and entertainment expenses. An item is directly related if it is associated with a substantial and bona fide business discussion. Additionally, current law allows a taxpayer to deduct the cost of certain fringe benefits provided to employees (e.g., employee discounts, transportation fringe benefits, qualified moving expenses), even though the benefits are excluded from the employee's income under Section 132. A taxpayer also may deduct expenses for goods, services and facilities to the extent the expenses are reported as compensation and wages to an employee or are includable in the gross income of a recipient who is not an employee. Current law also allows taxpayers to deduct certain reimbursed expenses, including reimbursement arrangements in which an employer reimburses the expenses incurred by a subcontractor's employees, as long as the expenses are properly substantiated as required by Section 274 and not treated as income to the employee. Provision The provision would still permit a 50% deduction for food or beverage expenses that qualify as a business expense (or a 100% deduction for certain Section 119 expenses and certain Section 132(d) expenses). The provision would not, however, allow a deduction for any expenditure that represents entertainment, amusement, recreation, or membership dues (i.e., membership dues paid to organizations organized for business, pleasure or recreation). The provision would further disallow a deduction for reimbursed expenses, transportation fringe benefits, on-premises gyms and other athletic facilities, or any other amenities provided to an employee that are not directly related to the employer's trade or business, unless the benefit were treated as taxable compensation to the employee. Any amounts for goods, services or facilities that were treated as compensation to an employee or includible as income to a non-employee would remain deductible. Effective date This provision would be effective for tax years beginning after December 31, 2017. Implications Under the provision, no deduction would be permitted for entertainment, amusement or recreation expenses. Examples of such expenses would include, but not be limited to, sporting event tickets, theatre tickets, golf green fees, etc. This would be a significant departure from current law, which allows a 50% deduction for qualified client entertainment and recreation; further, taxpayers may currently deduct 100% of qualified employee recreation expenses. The provision appears to eliminate a deduction for these expenses, except a 50% deduction potentially might be allowed for food and beverage consumed at such events if they are deemed business expenses. Repeal of deduction for local lobbying expenses Current law Generally, lobbying and political expenditures for influencing legislation and promoting (or opposing) candidates for political office are not deductible. An exception currently exists, however, that allows taxpayers to deduct lobbying expenses for legislation before local government bodies (including Indian tribal governments) as ordinary and necessary business expenses paid or incurred in connection with carrying on a trade or business under Section 162. Provision The provision would repeal Section 162(e)(2), thereby prohibiting deductions for lobbying expenses for legislation before local government bodies (including Indian tribal governments). Effective date The provision would be effective for amounts paid or incurred after December 31, 2017. Implications The repeal of the deduction for local lobbying expenses represents a revenue raising provision for the government and an additional review step for taxpayers to properly add back a larger pool of lobbying activities and expenses as non-deductible for tax. The Joint Committee on Taxation estimates that this repeal will provide $800 million in additional tax revenue over the next 10 years (see JCX-46-17, Nov. 2, 2017). Like-kind exchanges of real property Current law Under current law, no gain or loss is generally recognized to the extent that property held for productive use in the taxpayer's trade or business or for investment purposes is exchanged for property of a like-kind that is also held for productive use in a trade or business or for investment. The taxpayer then utilizes a carryover basis in the property acquired in the exchange equal to the basis of the property exchanged, decreased by the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange, if any. The like-kind exchange rules under Section 1031 generally apply to tangible property (both real and personal), as well as certain intangible property. Provision The provision would modify Section 1031 so that its provisions would only apply to like-kind exchanges of real property. Effective date The provision would be effective for like-kind exchanges completed after December 31, 2017, although the provision would not apply to any like-kind exchange if the taxpayer has either: (1) disposed of the relinquished property; or (2) acquired the replacement property on or before December 31, 2017. Implications The repeal of Section 1031 for all exchanges of property other than real property immediately affects taxpayers that are contemplating exchanges of tangible personal as well as intangible property. This includes taxpayers that would participate in a mass asset like-kind exchange program, as well as taxpayers that would otherwise participate in an exchange that contains both real as well as personal and/or intangible property. The adverse impact of the provision may be offset by the immediate expensing provisions set forth by modifications made to Section 168(k) as part of the bill. Treatment of contributions to capital Current law Under Section 118 and its regulations, a corporation's gross income does not include contributions to its capital (i.e., transfers of money or property to the corporation by a shareholder or non-shareholder). Instead, the taxpayer excludes that amount from income and the basis in property contributed (or acquired with contributed money) is modified in accordance with Section 362(c) and its regulations. Provision The provision would replace Section 118 with Section 76. Under new Section 76, gross income includes contributions to the capital of any entity (both those operating in corporate form as well as non-corporate entities). In addition, Section 76 provides that transfers of money or other property to a corporation solely in exchange for stock in the corporation is not a contribution to the corporation's capital and, thus, is not required to be recognized as income to the corporation but only to the extent that the amount of money and fair market value of property contributed to the corporation does not exceed the fair market value of any stock issued in exchange for the money or property. Further, Section 362(c) would be modified to provide that, if property (other than money) is provided as a contribution to capital (and thus is recognized as income) to a taxpayer, then the basis of that property in the hands of the taxpayer would equal the greater of: (1) the basis in the hands of the transferor plus the gain recognized by the transferor on the transfer, or (2) the amount included as income by the taxpayer as a result of Section 76. Effective date The provision would be effective for contributions made, and transactions entered, after the date of enactment. Implications The repeal of Section 118 and replacement with Section 76 would eliminate the ability of taxpayers to take the position that certain contributions of property or money may be excluded from gross income as contributions to their capital when those amounts are provided by non-shareholders (for example, governmental entities, etc.). With the repeal of Section 118, taxpayers taking or considering taking positions under any of its provisions should assess the impact the proposed Section 76 might have on the taxability as gross income of the payments or property received. Modification to net operating loss deduction Current law Under current law, Section 172 allows taxpayers to carry back a net operation loss (NOL) arising in a tax year for two years and carry forward the NOL for 20 years to offset taxable income. Generally, an NOL is the excess of the taxpayer's business deductions over its gross income. Section 172 also provides special provisions modifying the carryback period for specific types of losses or losses arising in particular years. Included in these special provisions is Section 172(f), which allows a 10-year carry back of losses arising from specified liabilities. The AMT rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%. Provision The provision, Section 3302 of the bill, would allow indefinite carry forward of NOLs arising in tax years beginning after December 31, 2017. The provision also would repeal all carrybacks for losses generated in tax years beginning after December 31, 2017, but would provide a special one-year carryback for small businesses and farms for certain casualty and disaster losses. The provision would define an eligible disaster loss in Section 172(b) as an NOL attributable to federally declared disasters. The provision would limit the amount of all NOLs that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction) for tax years beginning after December 31, 2017. In addition, the provision would permit NOLs arising in tax years beginning after 2017 and carried forward to be increased by an interest factor to preserve the NOL value. As part of the repeal of NOL carrybacks, the provision would repeal Section 172(f), the special rule allowing a 10-year carryback of specified liability losses. Effective date The indefinite carry forward and general repeal of carrybacks (including the repeal of Section 172(f)), and the special one-year carryback rule for casualty and disaster losses would be effective for losses arising in tax years beginning after December 31, 2017. The 90% limitation rule would be effective for tax years beginning after December 31, 2017. The annual increase of carry forward amounts would apply to amounts carried to tax years beginning after December 31, 2017. Implications In general. The Framework released in September did not specifically address changes to the NOL deduction, but did state that numerous special exclusions and deductions would be repealed or restricted. The provision would reduce some of the incentives under current law to accelerate the utilization of NOLs. The 90% limitation on the utilization of NOL carryforwards would effectively impose a minimum tax for corporate taxpayers, even though the provision proposed to eliminate the corporate AMT (see Section 2001). The elimination of the ability to carry back NOLs to prior years, other than in relation to small businesses and farms for certain casualty and disaster losses, would eliminate opportunities for immediate cash refunds. By allowing for the indefinite carryforward of NOLs with interest, the proposal has the effect of confirming that the net present value of the NOL deduction remains constant over time. The Joint Committee on Taxation estimates that the modification of Section 172 will increase tax revenues by $156 billion dollars during the 2018-2027 budget period (see JCX-46-17, Nov. 2, 2017). The effective date language for the 90% limitation for the use of NOLs implies that the limitation would not only apply to losses arising in tax years beginning after December 31, 2017, but to losses arising in tax years before January 1, 2018, and carried forward to tax years beginning after December 31, 2017. Specified liability losses. Specified liability losses are limited deductible expenditures for product liability, land reclamation, nuclear power plant decommissioning, dismantlement of drilling platforms, remediation of environmental contamination, and workers' compensation payments. Although the proposed bill would preserve a majority of the NOL provisions under the Code, the repeal of Section 172(f) would have the greatest impact on the power and utilities, agriculture, oil and gas, construction, consumer products and retail industries that incur the types of liabilities eligible for the extended carryback benefit under Section 172(f). Taxpayers would not be able to rely on specified liability losses as a source of cash tax savings for eligible liabilities that generate losses in tax years beginning after December 31, 2017. Certain self-created property not treated as a capital asset Current law Section 1221 treats a self-created patent, invention, model or design, or secret formula or process as a capital asset. Copyrights, literary, musical or artistic compositions and letters or memoranda are not capital assets and any gain or loss recognized as a result of the sale, exchange or other disposition of the property is ordinary in character. Current law, however, allows the creator of musical compositions or copyrights in musical works to elect to treat that property as a capital asset. Provision The provision would no longer treat a self-created patent, invention, model or design, or secret formula or process as a capital asset. As such, gain or loss from the disposition of the property would be ordinary in character. Those items of property also would be excluded from the definition of property used in the trade or business under Section 1231. Additionally, the provision would repeal the election to treat musical compositions and copyrights in musical works as a capital asset. Effective date The provision would be effective for dispositions of a self-created patent, invention, model or design, or secret formula after December 31, 2017. Implications Long-term capital gains are taxed at more favorable rates than ordinary income. Currently, the long-term capital gains tax rates are a maximum of 20%, while the rates for ordinary income range from 10% to 39.6%. As such, the provision would subject the aforementioned assets to newly applicable ordinary rates. ———————————————
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