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December 17, 2017
2017-2131

Tax reform conference bill significantly affects accounting methods, Section 199, research and development incentives and similar provisions

On December 15, 2017, the House and Senate conferees to the "Tax Cuts and Jobs Act" (H.R. 1) signed and released a Conference Agreement. The final Conference Agreement contains many provisions that would affect accounting methods, Section 199, research and development incentives 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, as currently anticipated. For a comprehensive discussion of the Conference Agreement, see Tax Alert 2017-2130.

Lower tax rates

The Conference Agreement would lower the corporate tax rate to 21%, down from 35%, which today is the highest in the industrialized world. The Conference Agreement also would deliver significant tax relief by offering a first-ever 20% tax deduction that applies to the first $315,000 of joint income earned by all businesses organized as S corporations, partnerships, LLCs, and sole proprietorships. For affected taxpayers with income above this level, the Conference Agreement would generally provide a deduction for up to 20% on business profits, reducing their effective marginal tax rate to no more than 29.6%.

Fiscal year taxpayers subject to "blended" tax rate for tax years that include January 1, 2018

Existing Section 15, which governs rate changes and was not amended by the Conference Agreement, will require a "blended" tax rate for fiscal year taxpayers for their fiscal year that includes January 1, 2018. The effective date provision has caused some confusion because the Conference Agreement language provides that the new, lower rate would apply for "taxable years beginning after December 31, 2017," which most people assume (quite reasonably, based on the effective date language) means the lower rate does not apply to fiscal tax years that begin prior to January 1, 2018 (that is, the 21% rate applies for calendar year taxpayers for their tax years beginning on and after January 1, 2018, and for fiscal year taxpayers only for their tax years beginning after January 1, 2018). However, that reading is incorrect with respect to fiscal year taxpayers, as Section 15 redefines the effective date in this context.

Section 15(a) of the Code provides that, "[i]f any rate of tax imposed by this chapter changes, and if the taxable year includes the effective date of the change (unless that date is the first day of the taxable year), then — (1) tentative taxes shall be computed by applying the rate for the period before the effective date of the change, and the rate for the period on and after such date, to the taxable income for the entire taxable year; and (2) the tax for such taxable year shall be the sum of that proportion of each tentative tax which the number of days in each period bears to the number of days in the entire taxable year." Section 15(c) provides, in part, that "[f]or purposes of subsection … (a) … if the rate changes for taxable years 'beginning after' or 'ending after' a certain date, the following day shall be considered the effective date of the change."

For example, assume the ABC Company's tax year ends June 30, 2018, and its taxable income is $10,000,000, and assume the Conference Agreement is signed into law next week. Because of the rate change provided for in the Conference Agreement, ABC's tax is computed using an average of the rate schedule before and after January 1, 2018 (the effective date of the rate change for purposes of Section 15(a) as determined pursuant to Section 15(c)). To compute the tax with a "blended rate," ABC first determines the tax on the taxable income of $10,000,000 based on the pre-2018 rates. The tax of $3,500,000 is multiplied by the ratio of 184 days in ABC's 2017 tax year over 365 to arrive at $1,764,384. Next, the tax on the taxable income of $10,000,000 based on the 2018 rates is determined. The tax of $2,100,000 is multiplied by the ratio of 181 days in ABC's 2017 tax year over 365 to arrive at $1,041,370. ABC then adds $1,764,384 and $1,041,370 to determine total tax due of $2,805,754. Dividing the total tax of $2,805,754 by taxable income of $10,000,000 yields a blended statutory rate of 28.06% for a fiscal year ending on June 30, 2018. By operation of the weighted average calculation, the blended statutory rate drops by roughly 1.17% per month ((35%-21%)/12)), i.e., a fiscal May year end will have a blended rate roughly 1.17% higher than a fiscal June year end.

Repeal of Section 199 domestic production activities deduction

Current law

Section 199 allows a taxpayer to claim a deduction equal to 9% (6% for certain oil and gas activities) of the lesser of the taxpayer's taxable or qualified production activities income subject to a limitation of 50% of W-2 wages paid by the taxpayer during the calendar year that are allocable to the taxpayer's domestic production gross receipts. Qualified production activities income is derived from certain production activities and services performed in the United States and, for tax years beginning before January 1, 2017, in Puerto Rico.

Provision

The provision would repeal Section 199.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The Conference Agreement follows the House bill provision repealing Section 199, but does not include the separate provision in the House bill that would have retroactively extended Section 199 for one year to domestic production gross receipts from Puerto Rico. The Joint Committee on Taxation estimated that repealing Section 199 would increase tax revenues by $95.2 billion over the 2018-2027 budget period (JCX-65-17, Dec. 11, 2017), while the extension for Puerto Rico would decrease revenues by approximately $1.1 billion dollars over the same period. According to the Unified Tax Reform Framework, Section 199 will no longer be necessary after the rate reduction on business income goes into effect.

Section 199 may be claimed for any open tax years beginning before January 1, 2018. Accordingly, taxpayers with production or service activities that are within the scope of Section 199 should consider claiming the Section 199 deduction for current years or reviewing claims made in prior tax years and, where warranted, filing amended returns.

Research and development incentives

Modification of orphan drug credit

Current law

Under current law, Section 45C allows a drug manufacturer to claim a credit equal to 50% of qualified clinical testing expenses incurred in connection with the testing of a drug for a rare disease or condition (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 person test").

Provision

The provision would limit the orphan drug credit to 25% of the amount of qualified clinical testing expenses for the tax year. 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.

Effective date

The provision would apply to amounts paid or incurred in tax years beginning after December 31, 2017.

Implications

The provision would cut the orphan drug credit in half, but it foregoes the more complicated elements that were in the Senate bill and is clearly more taxpayer favorable than the full repeal of the credit first introduced by the House.

Amortization of research or experimental expenditures

Current law

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

The provision 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.

Effective date

The provision would apply to amounts paid or incurred in tax years beginning after December 31, 2021.

Implications

For expenditures paid or incurred in tax years beginning after 2021, taxpayers would be required to capitalize and recover such costs over five (or 15) years. The provision would remove 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 would require amortization of these expenditures and disallow 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 would provide that, upon disposition, retirement or abandonment, no deduction is allowed and the amortization would have to 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.

The provision's five-year amortization requirement could 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.

Cost recovery

Bonus depreciation for qualified property

Update: Please note that a tax alert was released detailing an oversight in the legislation in regards to Qualified Improvement Property. You can read the alert here.

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 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 bonus depreciation when planted or grafted. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer (i.e., used property does not qualify).

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.

Provision

The provision would extend the additional first year depreciation deduction through 2026 (2027 for longer production period property and certain aircraft). The provision would allow taxpayers to claim 100% bonus depreciation with respect to 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 would phase down bonus depreciation to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027 (with an additional year to place in service available for long production period property and certain aircraft associated with each phase-down percentage). The provision also would apply to certain plants planted or grafted after September 27, 2017, and before January 1, 2027, with similar bonus percentages in place.

The provision would also expand the current law definition of qualified property by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for 100% bonus depreciation if it is the taxpayer's first use of such property (provided that such "used" property is not acquired from a related party or in a carryover basis transaction). The provision would further expand the current law definition of qualified property to include certain qualified film and television productions, as well as certain qualified theatrical productions.

While the provision would generally expand the definition of qualified property, it specifically states that 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. Additionally, the provision states that qualified property would not include any property used in a trade or business that has had floor plan financing indebtedness (as defined in paragraph (9) of Section 163(j)), if the floor plan financing interest related to such indebtedness was taken into account in computing the interest limitation under Section 163(j). Further, a real property trade or business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate qualified improvement property under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation). Lastly, a farming business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate its property with a recovery period of 10 years or more under the alternative depreciation system (and thus, such property would not be eligible for bonus depreciation).

The provision also would repeal the election to accelerate AMT credits in lieu of bonus depreciation under Section 168(k)(4).

Effective date

The provision would apply to property acquired and placed in service after September 27, 2017, as well as specified plants planted or grafted after that date. Property would not be treated as acquired after the date on which a written binding contract is entered into for its acquisition. For property acquired prior to September 27, 2017, (e.g., property for which a binding written contract was entered into prior to September 27, 2017, to purchase the property), such property would be subject to the bonus depreciation rules in place prior to the enactment of the provision (as described under the "Current Law" section above). A transition rule would allow a taxpayer to elect to utilize 50% bonus depreciation, instead of 100%, for qualified property placed in service during the first tax year ending after September 27, 2017.

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 such property with an immediate cash-tax benefit. Further, as the legislative language provides 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 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. Such election, along with other Section 168 elections to "slow down" depreciation (e.g., annual election to use the alternative depreciation system), will become more relevant in tax years beginning on or after January 1, 2022, when depreciation deductions will reduce "adjusted taxable income" for purposes of the 30% interest deduction limitation under Section 163(j). Companies will want to carefully model out the impact that depreciation elections will have on interest deductibility.

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 21% 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 time 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, not only will certain film, television, and theatrical productions be able to benefit from bonus depreciation, but the original use requirements around what is considered qualified property would be loosened under the legislative language. Specifically, as previously noted, used property would now be considered qualified property eligible for immediate expensing provided that 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.

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 will also be subjected to immediate expensing.

Note that property acquired and/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. Further, note that the provisions of Section 168(k)(4), which provide for the ability to elect to utilize 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. This is largely due to the fact that the AMT repeal transition rules provide a mechanism for taxpayers to fully refund any unused AMT credits between 2018 and 2021.

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 $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.

The provision 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:

— Roofs
— Heating, ventilation and air-conditioning property
— Fire protection and alarm systems
— Security systems.

Effective date

The provision would apply to property placed in service in tax years beginning after December 31, 2017.

Implications

The provision amendments to Section 168(k) that would allow for the immediate expensing of 100% of the cost of qualified property (including but not limited to tangible personal property with a recovery period of 20 years or less under MACRS, computer software, and qualified improvement property) effectively nullify the impact that Section 179 would have for such property. However, 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

Current law

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.

Provision

The provision would increase the depreciation limitations that apply to passenger automobiles. As such, for passenger automobiles 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 would retain 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.

Effective date

The provision would be effective for property placed in service after December 31, 2017, for tax years ending after such date.

Implications

The provision would increase 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 provision 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 that are subject to its provisions.

Modifications of treatment of certain farm property

Current law

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.

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. Further, as noted above, a farming business that elects not to be subject to certain interest provisions of Section 163(j) would have to depreciate its property with a recovery period of 10 years or more under the alternative depreciation system.

Effective date

The provision would be effective for property placed in service after December 31, 2017.

Implications

The provision 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

Current law

Under current law, 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. Further, qualified improvement property may be recovered under the general depreciation system over either a 15 or 39-year period, depending on whether such property meets the definition of qualified leasehold improvement property or not (and thus is treated as nonresidential real property).

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. Under the alternative depreciation system, nonresidential real property and residential rental property are recovered over 40 years, while qualified leasehold improvement property is recovered over 39 years.

Provision

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 15-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. The provision also would modify the recovery period for residential rental property under the alternative depreciation system to 30 years.

The provision also would require a real property trade or business that elects out of the limitation on the interest deduction under Section 163(j) to use the alternative depreciation system to depreciate any of its nonresidential real property, residential rental property, and qualified improvement property.

Effective date

The provision would be effective for property placed in service after December 31, 2017.

Implications

The provision streamlines the treatment of certain real property by utilizing a qualified improvement property definition and provides taxpayers a benefit by providing qualified improvement property, which is subject to less onerous requirements than the prior definition of qualified leasehold improvement property, with a 15-year recovery period. The modification to the recovery period under the alternative depreciation system for residential rental property, as well as providing a 20-year recovery period to qualified improvement property for alternative depreciation system purposes, also provides taxpayers in a real property trade or business that elect out of the limitation on the interest deduction under Section 163(j) with the ability to recover real property over shorter recovery periods in certain instances when compared with current law.

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. 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.

Provision

The final provision adheres to the more generous House bill gross receipts threshold of $25 million and 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 $25 million for the three prior tax-year period. The $25 million amount would be indexed for inflation for tax years beginning after 2018.

The provision also would extend the $25 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 farm corporations.

Effective date

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.

Implications

As noted, the increase from the current $5 million threshold to a $25 million threshold expands the availability of the cash method to eligible taxpayers under Section 448. This is higher than the $15 million threshold previously proposed in the Senate bill. Importantly, the provision provides 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

Current law

Generally, taxable income from a long-term contract is determined by using the percentage-of-completion method, which requires 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 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 $25 million gross receipts test.

In the context of certain exceptions for long-term contracts entailing a reference to Section 448, the final provision indicates that, in the case of any taxpayer that is not a corporation or a partnership, the gross receipts test of Section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.

Effective date

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 implemented on a cut-off basis, meaning a Section 481(a) adjustment would not be necessary for contracts entered into before January 1, 2018.

Implications

If a taxpayer meets the increased average gross receipts test of $25 million, 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

Current law

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.

Provision

The provision, which originated solely in the Senate bill, 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 for special methods of accounting, including but not limited to, long-term contract income to which Section 460 applies as well as installment sales under Section 453, would apply. Also, in the case of a contract that has multiple performance obligations, the provision would require the taxpayer to allocate the transaction price in accordance with the allocation made in the taxpayer's applicable financial statement.

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 special rules under part V of subchapter P, which in addition to the original issue discount rules, also includes rules regarding the treatment of market discounts on bonds, discounts on short-term obligations, OID on tax-exempt bonds, and stripped bonds and stripped coupons.

The provision would provide an exception for any item of gross income in connection with a mortgage servicing contract.

Effective date

The provision generally would apply to tax years beginning after December 31, 2017. In the case of income from a debt instrument having OID, the provision would apply to tax years beginning after December 31, 2018. Application of these rules would be a change in the taxpayer's accounting method for Section 481 purposes.

Implications

This provision originated in the Senate bill 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.

Interest

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. Adjusted taxable income for purposes of this provision is modified from the Senate bill and 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) any business interest or business interest income; (iii) NOLs; (iv) the amount of any deduction allowed under Section 199A; (v) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion; and (vi) such other adjustments as provided by the Secretary. Adjusted taxable income also would not include the Section 199 deduction, as it would be repealed.

The provision would exempt taxpayers with average annual gross receipts of $25 million or less for the three-tax-year period ending with the prior tax year. The limitation would not apply, at the taxpayer's election, to any farming business or to a real property trade or business as defined in section 469(c)(7)(C). The limitation also would not apply to certain regulated public utilities.

For purposes of defining floor plan financing, the provision would modify the definition of motor vehicle by deleting specific references to an automobile, a truck, a recreational vehicle and a motorcycle because those terms are encompassed in "any self-propelled vehicle designed for transporting persons or property on a public street, highway, or road."

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.

It should be noted that, in the context of disallowed business interest, Section 381 also would be modified to provide that the acquiring corporation shall take into account, as of the close of the day of distribution or transfer, the carryover of disallowed business interest under Section 163(j)(2) to tax years ending after the date of distribution or transfer.

Effective date

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The provision generally adheres closely to the Senate bill, but modifies the definition of adjusted gross income to be computed without regard to deductions allowable for depreciation, amortization and depletion, as well as any modifications made by the Secretary.

As currently drafted, the provision does not include a grandfather rule for existing debt obligations.

The provision would reduce the advantage of financing merger and acquisition 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.

Taxpayers facing deferral or disallowance of interest deductions generally would have incentives to increase their net interest income, either by converting interest into another type of deductible expense or by converting another type of income into effectively tax-free interest income.

The treatment of disallowed interest carryovers as pre-change losses significantly broadens the relevance of Section 382. Because any carryforward of disallowed interest is subject to limitation under Section 382, it appears likely that highly leveraged companies will be subject to Section 382 solely as a result of having disallowed interest.

Accounting for inventories

In general

Current law

Current law requires businesses to maintain an inventories 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 exempt businesses from the requirement to maintain inventories if they meet the $25 million average gross receipts test (i.e., annual average gross receipts that do not exceed $25 million for the three prior tax-year period). The $25 million amount would be indexed for inflation for tax years beginning after 2018. 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.

Effective date

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.

Implications

The provision would continue to retain the framework of Section 471 and provide 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 (noting that the Conference Agreement adopted the threshold of $25 million proposed originally by the House bill).

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).

Uniform Capitalization - 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.

Section 263A provides a number of exceptions to the general uniform capitalization requirements. One such exception exists for certain small taxpayers who acquire property for resale and have $10 million or less of average annual gross receipts; such taxpayers are not required to include additional Section 263A costs in inventory. Another exception exists for taxpayers who raise, harvest, or grow trees. Under this exception, Section 263A does not apply to trees raised, harvested, or grown by the taxpayer (other than trees bearing fruit, nuts, or other crops, or ornamental trees) and any real property underlying such trees. Similarly, the uniform capitalization rules do not apply to any plant having a preproductive period of two years or less or to any animal, which is produced by a taxpayer in a farming business (unless the taxpayer is required to use an accrual method of accounting under Section 447 or 448(a)(3)). Freelance authors, photographers and artists also are exempt from Section 263A for any qualified creative expenses. There is no exception for taxpayers being required to apply Section 263A to self-constructed assets.

Provision

The provision would expand the exception from the uniform capitalization rules for small taxpayers. Under the provision, any producer or reseller that meets the $25 million gross receipts test would be exempt from the application of Section 263A. The provision also would retain the exemptions from the UNICAP rules that are not based on gross receipts.

Effective date

This provision generally 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.

Implications

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 to $25 million 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.

Production period for beer, wine, and distilled spirits

Current Law

The UNICAP rules, which were enacted as part of the Tax Reform Act of 1986, require certain direct and indirect costs allocable to real or tangible personal property produced by the taxpayer to be included in either inventory or capitalized into the basis of such property, as applicable. For real or personal property acquired by the taxpayer for resale, Section 263A generally requires certain direct and indirect costs allocable to such property to be included in inventory. In the case of interest expense, the UNICAP rules apply only to interest paid or incurred during the property's production period and that is allocable to property produced by the taxpayer or acquired for resale which: (1) is either real property or property with a class life of at least 20 years; (2) has an estimated production period exceeding two years; or (3) has an estimated production period exceeding one year and a cost exceeding $1,000,000. The production period with respect to any property is the period beginning on the date on which production of the property begins, and ending on the date on which the property is ready to be placed in service or held for sale. In the case of property that is customarily aged (e.g., tobacco, wine, and whiskey) before it is sold, the production period includes the aging period.

Provision

The provision would exclude the aging periods for beer, wine, and distilled spirits from the production period for purposes of the UNICAP interest capitalization rules. Thus, under the provision, producers of beer, wine and distilled spirits would be able to deduct interest expenses (subject to any other applicable limitation) attributable to a shorter production period. The provision would not apply to interest costs paid or accrued after December 31, 2019.

Effective Date

The provision for aging periods of beer, wine and distilled spirits would be effective for interest costs paid or incurred after December 31, 2017 and would expire for tax years beginning after December 31, 2019.

Implications

In General. Producers of beer, wine and distilled spirits are able to deduct interest expenses (subject to any other applicable limitation) attributable to a shorter production period.

Other LIFO inventory and Section 263A considerations. Under the Conference Agreement, the rules for inventory valuation and identification continue to 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 is significant that the final Conference Agreement retained the provision. With the LIFO method 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. Taxpayers should analyze and ensure they are taking into account the limitation in determining interest available to be capitalized to designated property and consider modeling different approaches to change capitalization.

In addition, taxpayers subject to the new base erosion anti-abuse tax (BEAT) could benefit from Section 263A inventory planning, as amounts paid to foreign related parties, which are allocable to inventory and reduce income through cost of goods sold, are not subject to BEAT. Taxpayers should identify amounts paid to foreign related parties and determine whether such amounts are capitalized under present Section 263A inventory methodologies, and if not, whether they should be. An accounting method change would likely be needed to change any Section 263A inventory methodology (e.g., to begin to capitalize costs not previously capitalized). Examples of costs paid to foreign related parties that likely are (at least in part) allocable to inventory transactions are royalties (sales-based royalties with no minimum royalty payments are allocable only to cost of goods sold, but nevertheless allocable to inventory) and payments for services (e.g., purchasing activities or various general and administrative activities). 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

Current law prohibits a deduction for expenses related to meals, entertainment, amusement or recreational activities, or facilities (including membership dues), unless such expenses are ordinary, necessary and directly related to the active conduct of the taxpayer's trade or business. If the taxpayer is able to demonstrate that such expenses are ordinary, necessary and directly related to its trade or business, the taxpayer may deduct up to 50% of such meal and entertainment expenses.

Although most meals and entertainment expenses are only 50% deductible, current law allows a taxpayer to deduct 100% for qualified employer-provided de minimis meals and entertainment, such as (1) qualified transportation fringe benefits, and (2) meals provided on or near the business premises (e.g. meals provided in a qualified employer-operated eating facility). In addition, the following expenses are currently 100% deductible: (1) amounts reported as compensation to an employee; (2) amounts includable in the gross income of a recipient who is not an employee; (3) certain reimbursed expenses, including reimbursement arrangements in which an employer reimburses the expenses incurred by a subcontractor's employees; and (4) 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)).

Provision

The provision provides that no deduction would be allowed with respect to: (1) an activity generally considered to be entertainment, amusement or recreation; (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes; or (3) a facility or portion thereof used in connection with any of the above items. Thus, the provision would repeal the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer's trade or business (and the related rule applying a 50% limit to such deductions). In addition, the provision would disallow a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer and, except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee's residence and place of employment. Taxpayers would still be able to generally deduct 50% of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work related travel). For amounts incurred and paid after December 31, 2017 and until December 31, 2025, the provision would expand this 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. Such amounts incurred and paid after December 31, 2025, would not be deductible.

Effective date

The provision generally would apply to amounts paid or incurred after December 31, 2017. However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimisfringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025, would not be deductible.

Implications

Taxpayers would be allowed a 50% deduction for business meals and beverages; however, taxpayers would no longer be able to deduct expenses 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.

The provision would permit taxpayers to continue deducting 100% for: (1) amounts reported and included in compensation of employees; (2) amounts includable in income of non-employees; (3) qualified reimbursed expenses; and (4) qualified employee recreation.

One major change to current law relates to de minimis employer-provided fringe benefits. Under current law, many of these expenses are 100% deductible, but the provision reduces the deduction from 100% to 50% (for expenses inured or paid after December 31, 2017) for meals provided on or near the business premises (this includes an employer-operated eating facility such as a qualified cafeteria). This deduction is further reduced to zero for amounts incurred or paid after December 31, 2025. Another major change relates to meals provided for the convenience of the employer. Taxpayers are currently able to deduct 100% of this expense, but under the Conference Agreement, this deduction would be reduced to 50% effective January 1, 2018 and reduced to zero after December 31, 2025. Many industries such as technology giants, the managed healthcare industry, and any entity that has an employer-operated cafeteria or provides meals for their convenience will be particularly impacted. Many of these industries/entities currently take a 100% deduction for food and beverages provided to their employees. Typically, taxpayers take the position that these meals are provided for the convenience of the employer; however, under the provision, effective January 1, 2026, meals provided for the convenience of the employer would be non-deductible.

These provisions are also a significant departure from current law, which allows a 50% deduction for qualified client entertainment and 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. The provision would entirely eliminate all deductions for such expenses; presumably, if taxpayers are able to prove that these expenses are for business, the taxpayers would be permitted to deduct 50% for food and beverages consumed at the events.

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 current Sections 162(e)(2) and 162(e)(7), thereby prohibiting deductions for lobbying expenses for legislation before local government bodies (including Indian tribal governments).

Effective date

The provision would apply to amounts paid or incurred on or after the date of enactment.

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.

Like-kind exchanges of real property

Current law

Under current law, generally no gain or loss is 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 by the amount of gain or decreased by 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 that is not held primarily for sale.

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 with the exception of exchanges of real property has 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, as well as taxpayers that would otherwise participate in an exchange that contains both real and personal 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 the modifications made to Section 168(k).

Treatment of contributions to capital

Current law

Under Section 118 and the regulations promulgated thereunder, a corporation's gross income does not include any contributions to its capital (i.e., transfers of money or property to the corporation by a shareholder or non-shareholder). Instead, the taxpayer excludes such amount from its income with the basis in property contributed (or acquired with contributed money) being modified in accordance with Section 362 and the regulations promulgated thereunder. Under Section 118, a contribution to capital does not include any contribution in aid of construction or any other contribution as a customer or potential customer.

Provision

The provision would retain the language in Section 118 specifying that a contribution to capital does not include any contribution in aid of construction or any other contribution as a customer or potential customer. Further, the provision would modify Section 118 to specify that a contribution to capital does not include any contribution by any governmental entity or civic group, other than a contribution made by a shareholder operating in its capacity as a shareholder.

Effective date

The provision would be effective for contributions made, and transactions entered into, after the date of enactment. The provision would not impact any contribution made by a governmental entity after the date of enactment of the provision, which is made pursuant to a master development plan that had been approved by the governmental entity prior to the date of enactment of the provision.

Implications

The modifications made to Section 118 would eliminate the ability of taxpayers to argue for the exclusion of amounts of property or money from gross income as contributions to their capital where such amounts are provided by a governmental entity or civic group, provided such amounts were not provided pursuant to a master development plan that had been approved by a governmental entity prior to the date of the enactment of the provision. This position has been argued by a number of taxpayers in a myriad of different contexts for decades, and has been a point of contention with the Service for decades as well. With the modifications made to Section 118, taxpayers taking or considering taking positions under its provisions would need to immediately reassess whether such amounts would potentially be excluded under Section 118 as modified, under another Code provision or under other common law theories, or whether such amounts would now need to be considered gross income.

Modification to net operating loss deduction and limitation of losses for non-corporate taxpayers

Current law

Net operating loss deduction

Under current law, Section 172 allows taxpayers to carry back a net operating 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%.

Loss limitation

Under current law, Sections 469 and 461(j) limit trade or business losses for certain types of activities. Section 469 limits passive activity losses of some taxpayers such that deductions attributable to passive activities, to the extent they exceed the income from passive activities, may not be deducted against other income. The excess losses from passive activities in a tax year can be carried forward to offset income from passive activities in future years, or can be recovered upon the taxpayer's disposition of its entire interest in the passive activity. Similarly, Section 461(j) limits excess farming trade or business losses of non-C corporation taxpayers. Excess farming losses are the excess of deductions attributable to farming businesses over the sum of gross income or gain from farming businesses and a "threshold amount." The threshold amount is the greater of $300,000 ($150,000 in the case of married individuals filing separately), or the excess of the aggregate amount of farming trade or business income or gain over the aggregate amount of farming trade or business deductions for the five tax years preceding the tax year.

Provision

Net operating loss deduction

The provision would allow indefinite carry forward of NOLs arising in tax years ending after December 31, 2017. The provision also would repeal all carrybacks for losses generated in tax years ending after December 31, 2017, but would provide a special two-year carryback for certain losses incurred in the trade or business of farming. For losses arising in tax years beginning after December 31, 2017, the provision would limit the amount of NOLs that a taxpayer could use to offset taxable income to 80% of the taxpayer's taxable income.

Net operating losses that are farming losses for any tax year would be treated as a separate net operating loss to be taken into account after the remaining portion of the net operating loss for such tax year.

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.

Non-corporate loss limitation

The provision would limit excess business losses for non-corporate taxpayers for tax years beginning after December 31, 2017 and before January 1, 2026. Excess business losses are defined as the excess of the taxpayer's aggregate deductions attributable to trades or businesses of the taxpayer over the excess of aggregate gross income or gain of such taxpayer for the tax year that is attributable to such trades or businesses, plus $250,000 (200% of such amount in the case of a joint return). Disallowed excess business losses would be treated as a net operating loss carryforward to the next year under Section 172.

The provision also provides that the farming loss limitation of Section 461(j) would not apply for tax years beginning after December 31, 2017 and before January 1, 2026.

For partnerships and S-corporations, the provision would be applied at the partner or S-corporation owner level. The provision would be applied after the application of Section 469 (the passive loss limitation rules).

The provision would require the Treasury Department to prescribe reporting requirements, as necessary, to carry out the purposes of the provision.

The provision would apply to tax years beginning after December 31, 2017.

Effective dates

The indefinite NOL carry forward, general repeal of NOL carrybacks (including the repeal of Section 172(f)), and the special NOL carryback rule for certain farming losses would be effective for losses arising in tax years ending after December 31, 2017. The 80% NOL limitation rule would be effective for losses arising in tax years beginning after December 31, 2017. The loss limitation provision would apply to tax years beginning after December 31, 2017.

Implications

Net operating loss deduction

The Conference Agreement generally follows the Senate bill provision. The Senate Finance Committee's explanation of the Senate bill provision states the following with respect to the purpose of the proposed amendment to Section 172: "The Committee believes that, except in limited circumstances of disaster losses for farms, NOLs should be carried forward, but not back. The Committee also believes that taxpayers should pay some income tax in years in which the taxpayer has taxable income [ ]. Therefore, the Committee believes that the NOL deduction should be limited to a certain percentage of taxable income … " The Conference Agreement does not include a provision under the House bill that allowed amounts carried forward to be increased by an interest factor in order to preserve the net-present value of the NOLs.

The modification of Section 172 related to carryover and carryback changes applies to NOLs arising in tax years ending after December 31, 2017. Therefore, a fiscal taxpayer with a tax year ending after December 31, 2017 (a retailer with a January 31, 2018 year end, for example) would not be allowed to carryback NOLs arising in the February 1, 2017-January 31, 2018 period and would not be allowed to carryback NOLs arising in that period that are specified liability losses for the 10-year period currently allowed. A calendar year taxpayer, however, with a tax year ending December 31, 2017 would be able to use the current carryback and specified liability loss provisions for losses arising in the January 1, 2017-December 31, 2017 period. The 80% limitation applies to losses arising in tax years beginning after December 31, 2017. Therefore, carryover losses from tax years beginning before December 31, 2017 are not subject to the 80% limitation.

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 ending after December 31, 2017. The Joint Committee on Taxation estimated that the Senate proposal to modify Section 172 increases tax revenues by $157.8 billion dollars during the 2018-2027 budget period (see JCX-65-17, Dec. 11 2017).

Non-corporate loss limitation

The Conference Agreement follows the Senate bill provision. The Senate Finance Committee's explanation of the Senate bill provision states the following with respect to the purpose of the proposed amendment to Section 461: "The Committee believes that excess business losses of taxpayers other than corporations should be carried forward rather than bunched in the year of loss." The provision temporarily replaces the current farming loss limitation regime under Section 461(j) with a new regime, and limits using non-passive business losses in the year they are incurred. The Joint Committee on Taxation has estimated that the provision would increase tax revenues by $137.4 billion over the 2018-2027 budget period (JCX-65-17, Dec. 11, 2017).

Repeal of deduction for certain fines, penalties and other amounts

Current law

Section 162(f) prohibits the deduction of eligible fines or penalties paid to a government for the violation of a law.

Provision

The provision would deny a deduction for otherwise deductible amounts paid to a government or "specified nongovernmental entity" for violating a law or in relation to an investigation or inquiry by the government or entity into a potential violation of a law. Specifically, the provision indicates that the following nongovernmental entities shall be treated as governmental entities: (1) any nongovernmental entity that exercises self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange (as defined in Section 1256(g)(7)); and (2) to the extent provided in regulations, any nongovernmental entity that exercises self-regulatory powers (including imposing sanctions) as part of performing an essential governmental function.

The provision would create exceptions for: (1) payments that the taxpayer establishes are either restitution or amounts required to come into compliance with a law that was violated or involved in the investigation or inquiry; (2) amounts paid or incurred as a result of a court order in a suit in which no government or governmental entity is a party; and (3) amounts paid or incurred as taxes due.

If a payment is considered restitution for failure to pay a tax, the restitution would be deductible only to the extent the restitution payment would have been allowed as a deduction if it had been timely paid.

The provision would apply only when a government or other entity treated in the same manner as a government is a complainant or investigator for violation or potential violation of a law. The provision would require government agencies or entities treated as agencies to report to the IRS and the taxpayer the amount of each settlement agreement or order entered into in which the aggregate amount required to be paid is at least $600 (or another amount that may be specified by the Secretary). The report would have to separately identify any amounts that are for restitution or remediation of property or correction of noncompliance. The provision would require the report to be made at the time the government or entity and the taxpayer enter into the agreement.

Effective date

The provision would be effective for amounts paid or incurred after the enactment date, except it would not apply to amounts paid or incurred under a binding order or agreement entered into before the enactment date. The exception, however, would not apply to an order or agreement requiring court approval unless the approval was obtained before the enactment date.

Implications

The new provision specifically addresses restitution payments and expressly expands the present language of Section 162(f) to certain specified nongovernmental entities. Deductibility of payments under Section 162(f) historically has been an area of ongoing controversy between the IRS and taxpayers.

The Conference Agreement retains a provision introduced in the Senate that extends the current denial of a deduction for fines, penalties and other amounts paid to the government to amounts paid at the direction of the government. The provision would continue to allow as deductions those amounts paid that are deemed to be restitution (including remediation of property) or amounts required to come in compliance with any law that was violated. There are reporting requirements for the exemptions and reporting requirements for government agencies entering into settlement agreements with taxpayers.

Settlements paid in connection with sexual harassment or sexual abuse

Current Law

Section 162 permits a taxpayer to deduct eligible ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.

Provision

Proposed Section 162(q) in the Conference Agreement would deny taxpayers an ordinary and necessary deduction under Section 162 for settlement payments and legal fees paid in connection with cases of sexual harassment or sexual abuse if such payment is subject to a nondisclosure agreement.

Effective Date

The provision would be effective for amounts paid or incurred after the date of enactment.

Implications

This provision was originally proposed in the Senate version of the Tax Cuts and Jobs Act, and has been retained in the Conference Agreement. Given the current national attention on issues of sexual harassment and sexual assault in the workplace, it is important for affected taxpayers to be aware of the potential effect of this provision on settlement payments and associated legal fees.

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 is consistent with the House bill and 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.

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

The provision is taxpayer-unfavorable and would subject the aforementioned assets to newly applicable, higher ordinary rates.

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Contact Information
For additional information concerning this Alert, please contact:
 
National Tax Quantitative Services
Scott Mackay(202) 327-6069;
Ken Beck(202) 327-7964;
Susan Grais(202) 327-8782;
Don Reiris(732) 516-4522;
Alexa Claybon(303) 906-9721;
Alison Jones(202) 327-6684;
Allison Somphou(801) 350-3302;
Kristine Mora(202) 327-6092;
Sam Weiler(614) 232-7105;
   • Any member of the Quantitative Services group, at (202) 327-6000;.
Research Credit Services
David Hudson(202) 327-8710;
Craig Frabotta(216) 583-4948;
   • Any member of the Research Credit Services group, at (202) 327-6000;.
 

 


 

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