November 13, 2017
Senate tax reform proposal and House markup significantly affect accounting methods, Section 199, research and development incentives and similar provisions
Note: The interest section of this Alert has been modified.
On November 9, 2017, Senate Republicans unveiled their tax reform plan (Senate Plan). On the same day, the House Ways and Means Committee passed the "Tax Cuts and Jobs Act" (House bill), which incorporated several amendments that were adopted during the House markup (House Amendments). The Senate Plan and House Amendments contain 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 should they be enacted. This Alert focuses primarily on the Senate Plan and House Amendments. For a full discussion of the House bill, see Tax Alert 2017-1843 from last week.
Repeal of Section 199 domestic production activities deduction
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.
Senate Plan provision
The provision would repeal Section 199.
The repeal provision would be effective for tax years beginning after December 31, 2018.
Similar to the proposal in the House bill, the Senate Plan also repeals the Section 199 deduction. While the House bill would eliminate Section 199 for tax years beginning after December 31, 2017, the Senate Plan delays the date of Section 199's repeal to tax years beginning after December 31, 2018. According to the Unified Tax Reform Framework, Section 199 will no longer be necessary after the House bill's across-the-board rate reduction on all business income goes into effect. Unlike the House bill, the Senate's proposal does not extend Section 199's applicability to activities performed in Puerto Rico to tax years prior to Section 199's repeal.
The Joint Committee on Taxation estimates the Senate Plan's elimination of Section 199 will increase tax revenues (relative to the baseline receipts projected for future years under present law) by $80.7 billion during the 2018-2027 budget period — $14.5 billion less than that projected by the House bill (see JCX-52-17, Nov. 9, 2017).
Because the Senate Plan would extend the Section 199 deduction by one year more than the House bill, taxpayers with production or service activities that are within the scope of Section 199 may want to review claims they have already made for additional opportunities or consider making an initial claim. In addition, taxpayers with production or service activities may want to consider filing amended returns for open tax years beginning before January 1, 2019.
Research and development incentives
Modification of credit for clinical testing expenses for certain drugs for rare diseases or conditions
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). Qualified clinical testing expenses are costs incurred to test an orphan drug after the drug has been approved for human testing by the Food and Drug Administration (FDA), but before the drug has been approved for sale. A rare disease or condition is one that (1) affects fewer than 200,000 persons in the United States, or (2) affects more than 200,000 persons, but for which there is no reasonable expectation of recouping the costs of developing a drug for such disease or condition from sales of the drug in the United States (collectively, the "200,000 persons test").
Senate Plan provision
The provision would limit the orphan drug credit to 50% of the amount of qualified clinical testing expenses for the tax year that exceeds 50% of the average qualified testing expenses for the three tax years preceding the tax year for which the credit is being determined. If there are no qualified clinical expenses during at least one of the three preceding tax years, the credit would equal 25% of qualified expenses. The provision would allow taxpayers to elect a reduced credit in lieu of reducing allowable deductions in a manner similar to the Section 280C election for the research credit.
The provision also would limit qualified clinical testing expenses to the extent the testing is related to the use of a drug that has been previously approved under Section 505 of the Federal Food, Drug, and Cosmetic Act for use in the treatment of any other disease or condition. All such diseases or conditions in the aggregate (including the rare disease or condition with respect to which the credit is otherwise being determined) affect more than 200,000 persons in the United States.
The provision would apply to amounts paid or incurred in tax years beginning after December 31, 2017.
The provision proposes a modified orphan drug credit calculated in a manner similar to the alternative simplified credit (ASC) under Section 41(c)(5). Expenses that qualify for the credit under Section 45C generally also qualify for the research credit under Section 41, but the ASC provides a 14% credit whereas the orphan drug credit is 50%. Further, the ASC is limited to 6% if there are no qualified expenses in any one of the three prior years, whereas the orphan drug credit is limited to 25%. Therefore, eligible taxpayers would be better off claiming the orphan drug credit than the research credit.
As a result of the provision's credit computation, aggregation and certain other rules similar to those in Section 41(f) would apply where there are controlled groups, mergers and acquisitions, and short tax years. These rules are currently referenced in Section 45C, however, they have little applicability outside of intra-group transactions due to the present credit's lack of a base amount computation.
Notably, the provision would introduce a new limitation on the credit that would apply to drugs that were previously approved for any other condition, seemingly even if only approved for another rare disease or condition. If a drug is approved for its treatment of any condition and later receives an orphan drug designation for its treatment of a rare disease or condition, both the approved condition and the rare disease or condition are aggregated for purposes of the 200,000 persons test. This new requirement does not factor in the expected recovery of costs of developing the drug for the orphan condition, and appears to be strictly limited to 200,000 affected persons in the United States. This would severely limit the orphan drug expenses eligible for the credit, as it is common to identify a drug's therapeutic benefit for a rare disease or condition after it has been approved and marketed for treatment of a different condition.
The provision would have the effect of reducing the orphan drug credit, but is clearly more taxpayer-favorable than the full repeal of the credit that was proposed in the House bill. The Joint Committee on Taxation estimates that the modification of Section 45C will increase tax revenues (relative to the baseline receipts projected for future years under present law) by $29.7 billion dollars during the 2018-2027 budget period (see JCX-52-17, Nov. 9, 2017).
Section 174 research or experimental expenditures
Certain expenditures associated with the development or creation of an asset having a useful life extending beyond the current year generally must be capitalized and depreciated over that useful life under Sections 167 and 263(a). Under current law, Section 174 provides that a taxpayer may treat research or experimental expenditures that are paid or incurred during the tax year in connection with a trade or business as deductible expenses under Section 174(a), or the taxpayer may elect to capitalize and amortize these expenditures ratably under Section 174(b) over a period of not less than 60 months. Taxpayers, alternatively, may elect to amortize their research expenditures over a period of 10 years. See Sections 174(f)(2) and 59(e). Section 174 applies only to the extent that the expenditure is reasonable under the facts and circumstances.
However, under Sections 174(c) and (d), Section 174 does not apply to expenditures for the acquisition or improvement of land or of depreciable or depletable property, regardless of whether it is used in connection with any research or experimentation, and does not apply to expenditures incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.
Provision in the House Amendments
Under Section 3315 of the House bill, Section 174 would require taxpayers to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years in the case of foreign research). The provision would also modify Section 174 to require that all software development costs be treated as research or experimental expenditures. Any capitalized research or experimental expenditures relating to property that is disposed of, retired, or abandoned during the amortization period must continue to be amortized throughout the remainder of the period, under the provision. Under the provision, Section 174 would continue to be inapplicable to expenditures: (1) for the acquisition or improvement of land; (2) for the acquisition or improvement of property to be used in connection with research and development and is subject to the allowance for depreciation under Sections 167 or 616; or (3) for exploration expenditures to ascertain the existence, location, extent, or quality of any deposit of ore or other minerals (including oil and gas).
As part of the conforming amendments to the repeal of the alternative minimum tax (Section 2001 of the House bill), the cross-reference in Section 174(f) to Section 59(e) would be deleted, eliminating the elective 10-year amortization of research or experimental expenditures.
The amendments made by the provisions to Section 174(f) would apply to tax years beginning after December 31, 2017. Section 174(f), however, would be repealed for, and the other changes to Section 174 would apply to, amounts paid or incurred during tax years beginning after December 31, 2022.
The provision is similar to draft legislation introduced by Congressman Dave Camp in 2014 as the "Tax Reform Act of 2014," aside from the phase-in approach for domestic research under the Camp proposal. These provisions would be effective beginning in 2023. For tax years after the effective date, some correction may be needed to Section 41(d)(1), which defines qualified research (for purposes of the research credit) by reference to "research with respect to which expenditures may be treated as expenses under section 174," because Section 174 will no longer treat any expenditures as "expenses."
For expenditures paid or incurred in tax years beginning after 2022, taxpayers would be required to capitalize such costs and recover such costs over five (or 15) years. The provision removes the ability for taxpayers to recover costs incurred for research and development in the year they are incurred, a considerably negative impact for taxpayers currently treating such costs as deductible expenses. Significantly, the provision both requires amortization of these expenditures and disallows basis recovery if the property with respect to which the research or experimental expenditures are incurred (e.g., a patent) is sold, retired or abandoned. This is a departure from the general rules of basis recovery. Specifically, the provision provides that, upon disposition, retirement or abandonment, no deduction is allowed and the amortization must continue for the remainder of the amortization period.
Further, the provision would add a new subsection to Section 174 that specifically includes any amount paid or incurred in connection with software development as a research or experimental expenditure (and, therefore, within the scope of the provision). Presently, these costs may be deducted currently pursuant to Revenue Procedure 2000-50. Generally, purchased software may be amortized over just 36 months pursuant to Section 167(f)(1), so the provision would put taxpayers that develop their own software in a tax position that is less favorable than taxpayers who acquire it.
Clearly, the provision's five-year amortization requirement would have a dramatic effect on taxpayers currently deducting their research or experimental expenditures under Section 174. Taxpayers with significant foreign research will feel an even greater impact, as the provision provides a much longer recovery period for foreign research, presumably to incentivize domestic research.
These modifications to Section 174 were not reflected or addressed in the Senate Plan.
The 100% bonus depreciation, or immediate expensing, provisions set forth in the House bill were modified to add to the list of trades or businesses for which immediate expensing is unavailable " … a trade or business that has had floor plan financing indebtedness" if such trade or business takes the interest related to such indebtedness into account under Section 163(j)(1)(C) (as modified by the House bill).
Immediate expensing of 100% of the cost of qualified property
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 to place the property in service for qualified property with a longer production period, as well as certain aircraft). 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 alternative minimum tax (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.
Senate Plan provision
The provision would extend the additional first year depreciation deduction through 2022 (2023 for longer production period property and certain aircraft). 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 apply to certain plants planted or grafted after September 27, 2017, and before January 1, 2023.
Qualified property would not include property used by a regulated public utility company in the trade or business of the furnishing or sale of: (1) electrical energy, water or sewage disposal services; (2) gas or steam through a local distribution system; or (3) transportation of gas or steam pipeline, if the rates for the furnishing or sale of such services have been established or approved by a state or political subdivision thereof, by an agency or instrumentality of the United States or by a public service or utility commission or other similar body of any state or political subdivision thereof.
The provision also would repeal the election to accelerate AMT credits in lieu of bonus depreciation under Section 168(k)(4).
The provision would apply to property placed in service after September 27, 2017, as well as specified plants planted or grafted after that date. A transition rule would allow taxpayers to elect to use 50% bonus depreciation for the first tax year ending after September 27, 2017.
The details on bonus depreciation provided by the Senate thus far closely mirror the details provided within the House bill related to bonus depreciation amounts as well as the timing of its effective date. The Senate details provided, however, are silent as to how "original use" of such property will be determined (i.e., under the House bill, there is the potential that used property may be eligible for bonus depreciation if the use of the property, even if not new, is the first use by the taxpayer). 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 such property with an immediate cash-tax benefit. Further, as the Senate Plan appears to provide for the ability to elect out of the provisions of Section 168(k) consistent with current law, taxpayers that are in a loss position and that 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 above 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 such property in the current tax year where a higher corporate tax rate is in play (currently set at a 35% maximum corporate tax rate). Further, for the first time since Section 168(k) was enacted, the original use requirements around what is considered qualified property would be loosened under the legislative language. Specifically, used property would now be considered qualified property eligible for immediate expensing provided that the taxpayer itself had not previously used the property 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.
Note that property acquired or placed in service on or before September 27, 2017, as well as property that does not meet the definition of "qualified property" under Section 168(k)(2) would not be subject to the immediate expensing provisions detailed above and, thus, would still need to be depreciated under Section 168 and the regulations promulgated thereunder. Further, note that the provisions of Section 168(k)(4), which provide for the ability to elect to use straight-line depreciation associated with bonus-eligible property and monetize a portion of pre-2016 AMT credit carryforwards, would be repealed under the legislative language.
Because the expensing provision applies to qualified property acquired in a taxable acquisition, such as Section 1060 transactions or deemed asset acquisitions (such as those under Section 338), capitalized costs incurred in these transactions are also 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 are specifically identifiable costs that are allocable to qualified property, they also will be subject to immediate expensing.
Expansion of Section 179 expensing
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.
Senate Plan provision
The provision would increase the expensing limitation under Section 179 from $510,000 to $1 million with the phase-out increasing from $2,030,000 to $2.5 million for tax years beginning after 2017.
The provision would reduce the $1 million amount (but not below zero) by the amount by which the cost of the qualifying property placed in service during the tax year exceeds $2.5 million. Both expensing limitation amounts would be indexed for inflation for tax years beginning after 2018. The provision also would index the $25,000 sport utility vehicle limitation for inflation for tax years beginning after 2018.
Additionally, the provision would modify the definition of Section 179 property to include certain tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. In addition, it would modify the definition of qualified real property to: (1) eliminate references to qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, replacing such references with a reference to qualified improvement property, and (2) include the following improvements to nonresidential real property placed in service after the date the property was first placed in service:
The provision would apply to property placed in service in tax years beginning after December 31, 2017.
The details on Section 179 expensing provided by the Senate thus far are significantly different from the details provided within the House bill with respect to expensing limitations as well as definitions of what is considered "qualified real property." While the provision amendments to Section 168(k) that would allow for the immediate expensing of 100% of the cost of qualified property effectively nullify the impact that Section 179 would have for such property, the increases to the expense limitations and related phase-out under Section 179, coupled with the revised and expanded definition of "qualified real property" would still provide immediate expensing to taxpayers that invest in certain "qualified real property" (that may not otherwise meet the definition of qualified property under Section 168(k)).
Modifications to depreciation limitations on luxury automobiles and personal use property
Section 280F(a) limits the amount of depreciation taxpayers may claim for certain passenger automobiles. For passenger automobiles placed in service in 2017, and for which the additional first year depreciation deduction under Section 168(k) is not claimed, the maximum amount of allowable depreciation is $3,160 for the year in which the vehicle is placed in service, $5,100 for the second year, $3,050 for the third year, and $1,875 for the fourth and later years in the recovery period. The limitation is indexed for inflation and applies to the aggregate deduction provided for depreciation and Section 179 expensing.
For passenger automobiles that qualify for the additional first-year depreciation allowance in 2017, the first-year limitation is increased by $8,000.
Special rules pertaining to business use and, correspondingly, the use of the general vs. alternative depreciation system, along with related substantiation requirements, apply to listed property, which includes: (1) any passenger automobile; (2) any other property used as a means of transportation; (3) any property used for entertainment, recreation or amusement purposes; (4) any computer or peripheral equipment; and (5) any other property of a type specified in Treasury regulations.
Senate Plan provision
The provision would increase the depreciation limitations that apply to passenger automobiles. As such, for passenger automobiles placed in service after December 31, 2017, and for which the additional first-year depreciation deduction under Section 168(k) is not claimed, the maximum amount of allowable depreciation would be $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period.
The provision would index the limitations for inflation for passenger automobiles placed in service after 2018. The provision also provides for the retention of the $8,000 increase in the first-year limitation for passenger automobiles that qualify for the additional first-year depreciation allowance.
In addition, the provision would remove computer or peripheral equipment from the definition of listed property and, thus, remove such property from the special rules referenced above.
The provision would be effective for property placed in service after December 31, 2017.
The details provided by the Senate thus far detailing modifications to Section 280F are different from the modifications to Section 280F set forth in the House bill, but both suggest an increase in the depreciation that may be claimed by taxpayers on passenger automobiles (i.e., automobiles that do not fit one of the exceptions out of the Section 280F regime). With this said, given the immediate expensing provisions provided by the Senate for bonus eligible property (which would otherwise include most automobiles), Section 280F, even if so modified, still represents a significant impediment for taxpayers that acquire high-cost automobiles subject to its provisions.
Modifications of treatment of certain farm property
Under current law, taxpayers must capitalize the cost of property used in a trade or business or held for the production of income and recover the cost over time through deductions for depreciation or amortization. A seven-year recovery period applies to: (1) machinery and equipment, grain bins and fences that are used in the production of crops or plants, vines and trees; (2) livestock; (3) the operation of farm dairies, nurseries, greenhouses, sod farms, mushroom cellars, cranberry bogs, apiaries and fur farms; and (4) the performance of agriculture, animal husbandry and horticultural services. The seven-year recovery period also applies to cotton ginning assets.
The 150-percent declining balance method applies to any property (other than nonresidential real property, residential rental property, and trees or vines bearing fruits or nuts) used in a farming business.
Senate Plan provision
The provision would shorten the recovery period from seven to five years for any machinery or equipment (other than grain bins, cotton ginning assets, fences or other land improvements) used in a farming business, the original use of which commences with the taxpayer and is placed in service after December 31, 2017. It also would repeal the required use of the 150-percent declining balance method for property used in a farming business. The 150-percent declining balance method, however, would continue to apply to 15-year or 20-year property used in the farming business to which the straight line method does not apply. Additionally, the 150-percent declining balance method would continue to apply to property for which the taxpayer elects the use of the 150-percent declining balance method.
The provision would be effective for property placed in service after December 31, 2017.
While not addressed as part of the House bill, the modifications proposed to certain farm property as detailed by the Senate to date and referenced above would provide accelerated recovery to taxpayers that utilize farm property as part of their trade or business, particularly in years in which immediate expensing under the bonus depreciation provisions, as referenced above, are no longer in effect (i.e., after December 31, 2022, for most property).
Applicable recovery period for real property
Under current law, the recovery period for most real property is 39 years for nonresidential real property and 27.5 years for residential rental property, and taxpayers must use the straight line depreciation method and mid-month convention for such real property.
Section 168(e) contains separate definitions for qualified improvement property, qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. Specifically, qualified improvement property is any improvement to the interior of a building that is nonresidential real property if the improvement is placed in service after the date the building is first placed in service.
The alternative depreciation system must be used for tangible property used predominantly outside the United States, certain tax-exempt use property, tax-exempt bond financed property and certain imported property covered by an Executive Order. In addition, taxpayers may elect to use the alternative depreciation system for any class of property for any tax year.
Senate Plan provision
The provision would shorten the recovery period for determining the depreciation deduction for nonresidential real and residential rental property to 25 years. The provision also would change the statutory recovery period for nonresidential real and residential rental property to 25 years for purposes of determining whether a rental agreement is a long-term agreement under Section 467 (generally relating to certain payments for the use of property by lessors or lessees).
Additionally, the provision would eliminate the separate definitions of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. Instead, it would provide a general 10-year recovery period (utilizing a straight-line recovery method and half-year convention generally) for qualified improvement property and a 20-year alternative depreciation system recovery period (utilizing a straight-line recovery method and half-year convention generally) for such property. Note that any property that currently meets the definition of qualified restaurant property but does not meet the definition of qualified improvement property would be recovered over 25 years as non-residential real property.
The proposal also would require a real property trade or business that elects out of the limitation on the interest deduction to use the alternative depreciation system to depreciate any of its nonresidential real property, residential rental property, and qualified improvement property.
The provision would be effective for property placed in service after December 31, 2017.
While not addressed as part of the House bill, the modifications proposed to the recovery of real property as detailed by the Senate to-date and referenced above would provide significant cash-tax benefits to taxpayers in the form of accelerated depreciation deductions. Specifically, providing 25-year recovery period for nonresidential real property effectively shortens the recovery period of such property by approximately 35%. In addition, providing for 10-year recovery for qualified improvement property provides taxpayers with the ability to depreciate such property over a much shorter recovery period than that utilized under current law for qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property (15-year recovery period), as well as residential rental property (27.5-year recovery period) and nonresidential real property (39-year recovery period), and will be of significant benefit to taxpayers once the 100% bonus depreciation provisions proposed by the Senate sunset (i.e., after December 31, 2022, generally). While not addressed in the Senate details provided to-date, assuming the alternative depreciation system maintains the recovery periods currently in the Code (set at 40 years for nonresidential real and residential rental property, and 39 years for qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property), taxpayers wishing to maximize deductions will want to work to ensure that their real property does not fall within the alternative depreciation system provisions.
Expanded availability of the overall cash method of accounting
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. Other limited exceptions apply to the Section 448 statutory gross receipts threshold, for example, in the context of certain taxpayers with inventories, pursuant to IRS published guidance.
Senate Plan provision
The provision would allow more taxpayers to use the cash method of accounting. Under the provision, taxpayers, other than tax shelters, would be allowed to use the cash method of accounting if they satisfy the gross receipts test. Taxpayers would satisfy the gross receipts test if their annual average gross receipts do not exceed $15 million for the three prior tax-year period. The $15 million amount would be indexed for inflation for tax years beginning after 2018.
The provision also would extend the $15 million threshold to any farming C corporation or farming partnership with a C corporation partner. The provision would retain the $25 million limit for family farming corporations.
The provision would apply to tax years beginning after December 31, 2017. Application of this provision would be a change in the taxpayer's accounting method for purposes of Section 481.
The increase to the current $5 million threshold to expand the availability of the cash method to eligible taxpayers under Section 448 is not as generous as the $25 million proposal in the House bill. Importantly, however, both provisions provide for indexing of the gross receipts threshold to reflect changes in the inflation rate over time. See, also, the discussion of use of the cash method under the Accounting for Inventories section of this alert.
Accounting for long-term contracts
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.
Senate Plan provision
The provision would exempt small construction contracts from the requirement to use the percentage-of-completion method if the contract: (1) at the time it is entered into, is expected to be completed within two years of the commencement of the contract and (2) is performed by a taxpayer that meets the $15 million gross receipts test.
This provision would apply to contracts entered into after December 31, 2017. Application of this provision would be a change in accounting method, but it would be applied on a cutoff basis for all similarly classified contracts, meaning a Section 481(a) adjustment would not be necessary for contracts entered into before January 1, 2018.
The House bill, in contrast, provides for a $25 million average gross receipts exception to the percentage-of-completion method, compared to the proposed $15 million threshold under the Senate provision. 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). This provision is favorable to eligible small taxpayers that would benefit from the opportunity to defer recognition of long-term contact income until completion, for example, if the completed contract method is used.
Special rules for tax year of income inclusion
A cash basis taxpayer includes an amount in income when the amount is actually or constructively received. A taxpayer generally is in constructive receipt of an amount if the taxpayer has an unrestricted right to demand payment. An accrual basis taxpayer includes an amount in income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy, unless an exception allows deferral or exclusion. For example, several exceptions allow tax deferral for advance payments of income.
Senate Plan provision
The provision would modify the recognition of income rules by requiring a taxpayer to recognize income no later than the tax year in which the income is taken into account as income on an applicable financial statement or another financial statement under rules provided by the Secretary. An exception would apply for long-term contract income to which Section 460 applies.
Additionally, the provision would codify the deferral method of accounting for advance payments for goods and services contained in Revenue Procedure 2004-34. Under that method, taxpayers would be permitted to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if the income is deferred for financial statement purposes.
The provision also would require taxpayers to apply the revenue recognition rules under Section 451 before applying the Section 1272 original issue discount rules.
The provision would apply to tax years beginning after December 31, 2017. Application of these rules would be a change in the taxpayer's accounting method for Section 481 purposes.
This provision is unique to the Senate Plan and would generally result in an earlier accrual of income to the extent amounts are accrued earlier for financial statement purposes than currently required under Section 451. Taxpayers should consider this provision in conjunction with their ASC 606 adoption as the potential for an acceleration of taxable income exists. The exception for certain advance payments of income is an important one, preserving the current, widely applied favorable federal income tax treatment for such items. Advance payments governed by Revenue Procedure 2004-34 include amounts received for services, the sale of goods, the use of intellectual property (e.g., by license or lease), the occupancy or use of property if ancillary to the provision of services, the sale, lease or license of computer software, certain ancillary guarantee or warranty contracts, and eligible subscriptions and memberships.
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.
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. Adjusted taxable income for purposes of this provision would be a business's taxable income calculated without taking into account (i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, (ii), business interest expense, (iii) business interest income, (iv) the 17.4% deduction for certain pass-through income, and (iv) NOLs. The provision would allow businesses to carry forward interest amounts disallowed under the provision to succeeding tax years indefinitely. Any carryforward of disallowed interest is an item taken into account in the case of certain corporate acquisitions described in Section 381 and is treated as a "pre-change loss" subject to limitation under Section 382.
The provision would include special rules to 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 would not be double-counted at the partner level.
The provision would exempt businesses with average gross receipts of $15 million or less from these rules. The provision also would not apply to certain regulated public utilities and, at the taxpayer's election, any real property trades or businesses.
The provision would be effective for tax years beginning after December 31, 2017.
— The House Ways and Means and Senate versions of this provision differ in certain key respects. First, although both versions of the provision would limit the deduction for net business interest expense to 30% of a taxpayer's adjusted taxable income for the tax year, they define adjusted taxable income differently. The Ways and Means version defines adjusted taxable income computed without regard to (i) business interest expense, (ii) business interest income, (iii) NOLs, and (iv) depreciation, amortization, and depletion. In contrast, the Senate version defines adjusted taxable income as taxable income computed without regard to (i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, (ii) business interest expense, (iii) business interest income, (iii) the proposed 17.4% deduction for certain pass-through income, and (iv) NOLs. Notably, by not accounting for depreciation, amortization, and depletion, the Senate version's definition of adjusted taxable income is less generous than the definitions under current law and the Ways and Means version.
Second, whereas under the Ways and Means version, disallowed interest amounts may be carried forward five years, under the Senate version, such amounts may be carried forward indefinitely.
— As currently drafted, the proposal does not include a grandfather rule for existing debt obligations. Therefore, it appears that the limitation on interest deductibility would apply to such debts. Companies with significant leverage should assess the potential impact of this proposal on their cost of capital.
— The proposal would reduce the advantage of financing M&A transactions with debt. To the extent the acquirer cannot deduct interest on acquisition debt, the economic cost of a debt-financed acquisition would be greater than under current law. Moreover, because increased expensing does not extend to taxpayers that buy preexisting qualified property, the loss of interest deductions would not be offset by the benefits of increased expensing (as compared to depreciation and amortization). Finally, the book cost of debt-financed acquisitions would also go up compared to current law.
— Companies facing deferral or disallowance of interest deductions would have incentives to: (i) decrease their interest expense by converting non-deductible interest expense into deductible non-interest expense; and (ii) increase their interest income by converting taxable non-interest income into interest income. Strategies for realizing these incentives could involve the use of financial products, as well as changes to a variety of ordinary course business arrangements.
— The treatment of disallowed interest carryovers as pre-change losses significantly broadens the relevance of Section 382 ( Limitation on net operating loss carryforwards and certain built-in losses following ownership change). It is likely that highly leveraged companies will be subject to Section 382 solely as a result of having disallowed interest.
Accounting for inventories
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.
Senate Plan provision
The provision would exempt businesses from the requirement to maintain inventories if they meet the $15 million average gross receipts test. The provision would allow these businesses to: 1) treat inventories as non-incidental materials and supplies; or 2) follow their financial accounting treatment of inventories.
This provision would be effective for tax years beginning after December 31, 2017. Application of this provision would be a change in the taxpayer's accounting method for purposes of Section 481.
Similar to the House bill, the Senate Plan generally retains the framework of Section 471, but provides new rules for small businesses, allowing more taxpayers to be exempt from accounting for inventories under Section 471. Such exempted businesses would be eligible to use the cash method of accounting given the identical increase in the gross receipts test under Section 448 (although, as previously noted herein, the increase in threshold by the Senate is $15 million, compared to $25 million under the House bill).
Additionally, exempted 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
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.
The provision would exempt businesses with average gross receipts of $15 million from the UNICAP rules. The provision also would retain the exemptions from the UNICAP rules that are not based on gross receipts.
This provision would be effective for tax years beginning after December 31, 2017. Application of this provision would be a change in the taxpayer's accounting method for purposes of Section 481.
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 million (generally) to $15 million would expand the pool of taxpayers exempt from Section 263A (but is not as generous as the expansion proposed by the House); 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 the House bill would repeal Section 59(e), the Senate Plan does not indicate such a repeal; therefore, the coordination with Section 59(e) under Section 263A would be retained. Notwithstanding, Section 174 costs and certain costs attributable to oil and gas wells, and mineral property would continue to be excluded from the Section 263A requirements.
LIFO inventory and Section 263A considerations. Similar to the House bill, 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). With LIFO repeal consistently included in tax reform proposals for the last several years, it's significant that both the House and the Senate have proposed to retain the provision. 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 proposed inclusion of global intangible low-taxed income (GILTI) (requiring a US shareholder to consider the adjusted basis of depreciable property held by applicable CFCs, which could include self-constructed assets subject to Section 263A). Although the new base erosion minimum tax (which is intended to have a similar effect as the excise tax proposed by the House) does not appear to consider inventory transactions, to the extent the depreciable property acquired through a base erosion payment is considered a self-constructed asset of the taxpayer (i.e., because it was produced for the taxpayer under a contract), Section 263A modeling could be beneficial. 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.)
Meal and entertainment expenses
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 100% of the cost of certain qualified employer-provided fringe benefits (e.g., employee discounts, transportation, moving expenses) and meals provided in a qualified employer-operated eating facility, even though the benefits are excluded from the employee's income under Section 132. A taxpayer also may deduct 100% of 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 100% of 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(d) and not treated as income to the employee.
Current law also allows taxpayers to deduct 100% for qualified employee recreation, social, or similar activities (including facilities therefor) primarily for the benefit of employees (other than employees who are highly compensated employees (within the meaning of Section 414(q)).
Senate Plan provision
The House and Senate provisions would still permit a 50% deduction for food or beverage expenses that qualify as a business expense. The House provision would permit a 100% deduction for qualified employer-provided de minimis fringe benefits, meals provided in a qualified employer-operated eating facility and meals furnished for the convenience of the employer under Section 119, while the Senate provision would expand the 50% limitation to these expenses.
The House and Senate provisions would not 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 House and Senate provisions would further disallow a deduction for transportation fringe benefits and expenses incurred for providing transportation (or reimbursement) for commuting between an employee's residence and place of employment. The House and Senate provisions specifically strikes Section 274(e)(4), which currently also allows taxpayers to deduct 100% for qualified employee recreation.
The provision would apply to amounts paid or incurred after December 31, 2017.
Both the House bill and Senate Plan would allow a 50% deduction for business meals and beverages. They both, however, disallow any deduction for entertainment, amusement or recreation expenses, membership dues for clubs (including clubs organized for business, pleasure or social purposes), and facilities used in connection with entertainment, amusement or recreation. Examples of such expenses would include, but not be limited to, sporting event tickets, theatre tickets, golf green fees, and license fees paid to sporting arenas, etc. While the House bill would still allow a 100% deduction for costs of certain qualified employer-provided fringe benefits and meals provided in a qualified employer-operated eating facility, the Senate Plan would impose a 50% deduction limitation.
These provisions are a significant departure from current law, which allows a 50% deduction for qualified client entertainment and recreation and a 100% deduction for qualified employee recreation. Many taxpayers have licensing arrangements with sporting venues and performance arenas and taxpayers often entertain clients in luxury suites and skyboxes at sporting events. Both the House and Senate provisions would entirely eliminate all deductions for such expenses; presumably, taxpayers would only be permitted to deduct 50% for food and beverages consumed at these events. Likewise, taxpayers often host entertainment events for employees, such as holiday parties and summer outings. The provisions would eliminate any deduction for such events. Taxpayers, however, would be entitled to a 50% deduction for food and beverages at such events, provided the event is deemed a business purpose. Any costs for entertainment, such as musical entertainment, however, would presumably be zero deductible.
Another significant implication relates to qualified employer-operated eating facilities and meals provided for the convenience of the employer. Many taxpayers, especially technology giants, take a 100% deduction for food and beverages provided to their employees. Under the Senate provision, these expenses would be 50% deductible.
Like-kind exchanges of real property
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.
Senate Plan Provision
The provision would modify Section 1031 so that its provisions would only apply to like-kind exchanges of real property that is not held primarily for sale.
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.
The repeal of Section 1031 for all exchanges of property with the exception of exchanges of real property, which is proposed by both the House and Senate, would have an immediate impact on taxpayers that are contemplating exchanges of tangible personal as well as intangible property (including taxpayers that participate in a mass asset like-kind exchange program). It also would affect taxpayers that would otherwise participate in an exchange that contains both real as well as personal and/or intangible property. With this said, taxpayers that would otherwise complete one or multiple exchanges of tangible personal property, wherein the acquired property would be considered qualified property for bonus depreciation purposes, will be able to offset the taxpayer-unfavorable impact of not being able to utilize Section 1031 by utilizing the immediate expensing provisions set forth by modifications made to Section 168(k) as part of the House bill and Senate Plan.
Modification to net operating loss deduction
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, a 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 carryback of losses arising from specified liabilities. The alternative minimum tax rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%.
Senate Plan Provision
The provision 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 (see below for complete discussion of effective dates), but would provide a special two-year carryback for certain losses incurred in the trade or business of farming. 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.
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.
The indefinite carry forward, general repeal of carrybacks (including the repeal of Section 172(f)), and the special carryback rule for certain farming losses would be effective for tax years beginning after December 31, 2017. The 90% limitation rule would be effective for losses arising in tax years beginning after December 31, 2017.
In General. The Joint Committee on Taxation's description of the Senate Finance Committee's Chairman's mark indicates that the Senate Plan is largely consistent with the House bill, with the exception of a few provisions.
Under the House bill, carrybacks for losses generated in tax years beginning after December 31, 2017 are disallowed. Instead, the proposal provides a special one-year carryback for small businesses and farms incurring certain casualty and disaster losses. In addition, NOLs arising in tax years beginning after 2017 and carried forward are increased by an interest factor in order to preserve the net-present value of the NOLs.
The Senate Plan does not include a provision to make annual increases to the carryforward amounts. In addition, the Joint Committee on Taxation's description of the Senate's proposals indicates that the Senate Plan will include a special two-year carryback provision, limited to losses incurred in the trade or business of farming. Last, there appear to be inconsistent effective dates between the House and Senate provisions related to modifications to Section 172. A plain reading of the House bill provides that the modification of Section 172 related to carryover and carryback changes applies to NOLs arising in tax years beginning after December 31, 2017, and the 90% limitation applies to tax years beginning after December 31, 2017. However, the Senate Plan indicates that the modifications to Section 172 related to carryover and carryback changes are effective for tax years beginning after December 31, 2017, and that the 90% limitation applies to losses arising in tax years beginning after December 31, 2017.
The Joint Committee on Taxation estimates that the Senate proposal to modify Section 172 increases tax revenues by $170.4 billion dollars during the 2018-2027 budget period (see JCX-52-17, Nov. 9, 2017), which is $14.4 billion more than the estimate for the House bill ($156.0 billion) for the same budget period (see JCX-46-17, Nov. 2, 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) is expected to have the greatest impact on the power and utilities, agriculture, oil and gas, construction, consumer products, and retail industries, which incur the types of liabilities eligible for the extended carryback benefit under Section 172(f). Taxpayers will 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.
House Amendments address law firms and S corporations generally
Law firm expense advances
In general, a taxpayer may not deduct an expenditure that otherwise would be deductible if the taxpayer is entitled to be reimbursed (unless the reimbursement is included in gross income). As a consequence, a deduction is not permitted for law firm advances on behalf of clients for which reimbursement is due.
The Tax Court and other courts in a line of cases have held that no immediate deduction is allowable for law firm expense advances made on behalf of clients in the context of contingent fee litigation, as described herein. The Ninth Circuit has reached a different result. In so-called "net fee" contracts, advanced expenses (i.e., by a law firm, on behalf of its client) are reimbursed to the attorney before the attorney takes the contractual share of the proceeds from the successful litigation. The majority of courts have concluded that such contracts generally do not allow attorneys to deduct expense advances paid on behalf of their clients because such advances are subject to reimbursement. In contrast, "gross fee" contracts do not provide for reimbursement of expense advances before the litigation proceeds are divided between the client and attorney. Rather, the contracts provide the attorney with a percentage of recovery sufficient to cover advanced expenses, but otherwise no specific provision is made for such expenses.
The Tax Court, in Boccardo v. Comm'r., 65 TCM 2739 (1993), denied a deduction for the advanced expenses in a net fee arrangement, stating that the payments were advances made with a substantial expectation of reimbursement from the client's funds. To the court, the difference between a gross fee and a net fee contract affects only the extent of the contingent nature of the reimbursement, but does not affect the existence of the reimbursement right itself. In litigation before the Tax Court concerning the deductibility of expense advances for contingent fee personal injury litigation, Boccardo had changed from his previous use of a net fee contract to a gross fee contract, in which the contract merely provided for a percentage attorney's fee, but the percentage was set at a level sufficient to cover the amount of any advanced expenses. On appeal, the Ninth Circuit, in Boccardo v. Comm'r., 56 F.3d 1016, (9th Cir. 1995), reversed the Tax Court and upheld the taxpayer's asserted gross fee contract deductions by finding that the gross fee contract did not involve advances with the implication of a loan where, as a matter of law, there was no obligation on the client's part to repay the money expended. Under a 1997 field service advice (1997 FSA 442 (June 2, 1997)), the Office of Chief Counsel indicated that it would not follow the Boccardo appellate court position, except in the 9th Circuit, and would continue to follow the position of the Tax Court.
Provision in House Amendments
The provision would add new Section 162(q) and thereby provide a special rule for "contingency fee cases," under which no deduction will be allowed under Section 162(a) for any expense: (1) paid or incurred in the course of the trade or business of practicing law, and (2) resulting from a case for which the taxpayer is compensated primarily on a contingent basis, until such time as such contingency is resolved.
This provision would apply to tax years beginning after the enactment date.
As currently drafted, the provision would not permit a deduction by law firms for expense advances in contingent fee cases until the time that the case contingency is resolved, which is generally consistent with the majority of case law.
Conversion from S Corporation to C Corporation Status
Under current law, when an S corporation becomes a C corporation, it is required to change to the overall accrual method in the event such method is not presently used and an exception under Section 448 or IRS published guidance does not apply. A Section 481(a) adjustment would apply and, in general, any positive Section 481(a) adjustment would be taken into account ratably over four tax years.
Provision in House Amendments
The provision would add new Section 481(d) to address adjustments attributable to a conversion from S corporation to C corporation status for an "eligible terminated S corporation." For purposes of this subsection, the term "eligible terminated S corporation"' means any C corporation that: (i) was an S corporation on the day before the date of the enactment of the House bill, and (ii) during the two-year period beginning on the date of such enactment makes a revocation of its election under Section 1362(a), and (iii) the owners of the stock of which, determined on the date such revocation is made, are the same owners (and in identical proportions) as on the date of such enactment. Under the provision, any increase attributable to an adjustment that is attributable to such corporation's S corporation status revocation, would be taken into account ratably during the six-tax year period beginning with the year of change.
The provision provides a beneficial rule for certain S corporation conversions that is not present in the House bill.
Note: The interest section of this Alert has been modified.