On December 22, 2017, H.R. 1, the Tax Cuts and Jobs Act (the “Tax Act”) was signed into law. As the first comprehensive U.S. federal income tax reform in over thirty years, the Tax Act includes dramatic changes to tax provisions applicable to businesses and their owners as well as individuals. The Tax Act is expected to materially affect both domestic and cross-border activities and investments and to have a significant impact on the state income tax landscape.
While the impact of these significant changes will not be known in many cases until further guidance is issued, taxpayers and their advisors must already operate within this dramatically changed framework. We intend to cover the more significant of those changes through a series of alerts, the first of which is focusing on certain changes that impact the taxation of corporations.
These alerts are not intended to provide legal advice, and no legal or business decision should be based on their contents. If you have any questions concerning the content of this alert, please contact your regular Mintz Levin attorney or one of the members of the Mintz Levin tax team listed above.
Reduced Corporate Income Tax Rates & Repeal of AMT
As one of the most important aspects of the tax reform, the Tax Act adopts a single corporate income tax rate of 21% (down from a top corporate income tax rate of 35% under prior law). Prior to the enactment of the Tax Act, the U.S. had one of the highest (nominal) corporate income tax rates in the world. Together with the other changes included in the Tax Act, the reduction in the corporate income tax rate is expected to significantly change the after-tax landscape for corporations and will significantly impact the choice of entity decision making for new ventures as well as existing businesses. The reduction in the federal income tax rate also increases the relative impact (and hence the importance) of applicable state income tax on the overall tax cost.
The Tax Act fully repeals the corporate alternative minimum tax (or “AMT”) regime for tax years beginning in 2018. Corporate AMT credit carryover paid in prior years is usable (and refundable) against regular income tax liability (up to 50% of the regular tax liability in tax year 2018 – 2020 and 100% thereafter).
Dividend Received Deduction
To reflect the lower corporate income tax rate, the amount that can be claimed as a dividend received deduction (“DRD”) with respect to a distribution to a corporation from a domestic corporate subsidiary (other than a wholly-owned corporate subsidiary) has also been reduced. The Tax Act allows a DRD of 65% (down from 80%) if the corporation owns 20% or more of the corporate subsidiary or a DRD of 50% (down from 70%) if the corporation owns less than 20% of the corporate subsidiary. As was the case before, under the Tax Act, a corporation is generally entitled to a 100% DRD on a distribution from its wholly-owned domestic corporate subsidiary.
Net Operating Losses
The Tax Acts applies different rules for the utilization of net operating losses (“NOL”) generated in tax years ending after December 31, 2017 (“Post-Act NOL”) and NOL generated in tax years ending on or before December 31, 2017 (“Pre-Act NOL”). In all cases, the utilization of NOL remains subject to the limitations under Section 382 of the Code1 and the first-in, first-out rule (which were not amended by the Tax Act).
Post-Act NOL can be carried forward indefinitely but generally may not be carried back (a limited carryback exception applies to certain specific categories, such as property and casualty insurance companies). The annual utilization of Post-Act NOL is however generally limited to 80% of the taxpayer’s taxable income. Under prior law, the annual limitation was 90% and applied only to the taxpayer’s AMT.
Pre-Act NOL are subject to the prior 20-year carryforward rules and may generally be carried back under the prior two-year carryback rule (subject to the limited exceptions available under the prior rule).
The Tax Act generally extends bonus depreciation through December 31, 2026. In general, the Tax Act permits taxpayers to immediately expense (rather than depreciate over a period of years) 100% of the cost of certain tangible property that has a depreciable life of 20 years or less and that was acquired and placed in service after September 27, 2017, through December 31, 2022. The 100% bonus deprecation is phased down by 20% per calendar year for qualified property placed in service in taxable years beginning 2023 through 2026.
Importantly, the Tax Act expanded bonus depreciation to most acquisitions of used property from an unrelated party (under prior law, bonus depreciation was only available to first users of eligible property). Consistent with such expansion and in order to limit opportunities for manipulation of the rules, the Tax Act requires that the property was never used by the acquiring taxpayer and that it was not acquired in an exchange between related parties and/or members of a controlled group of corporations.
Subject to issuance of additional guidance on this point, the expansion of bonus depreciation to acquisition of used property could make bonus depreciation available to transactions involving the acquisition of stock that are treated as an acquisition of assets for tax purposes, including a stock acquisition where a Section 338 or 336(e) election is made. If bonus depreciation is permitted in such cases, it could make such election potentially more attractive. It should be noted, however, that bonus depreciation is not available for intangible property (such as goodwill).
Limitations on Interest Deductibility
The Tax Act significantly modified and expanded the limitations under Section 163(j) for taxable years beginning after December 31, 2018. In general, subject to a small business exception, the Tax Act limits the annual utilization of net business interest expenses to 30% of the taxpayer’s “adjusted taxable income.” Any excess non-deductible net business interest expense will be carried over indefinitely and will be treated as paid or accrued in such subsequent year.
Under the Tax Act, adjusted taxable income generally includes taxable income for the previous year, taking into account interest income or expense and before certain deductions (such as depreciation, amortization, depletion and NOL). For taxable years beginning December 31, 2021, deductions for depreciation, amortization and depletion are taken into account, thereby lowering a taxpayer’s adjusted taxable income.
The Tax Act does not define what constitutes interest for this purpose, and it will be important to learn from future guidance whether items such as original issue discount and debt issuance costs will be treated in a similar way. This limitation on the deductibility of interest may have a significant effect on leveraged acquisitions, leveraged recapitalizations and similar transactions.
A small business exception from the said rules generally applies to businesses with an average gross receipt of $25 million or less. Exceptions are also available to business operating in certain industries, namely, regulated public utilities and real estate (development, management, rental acquisition and construction of real estate).
Certain Research and Development Credits
In general, the Tax Act kept research and development (“R&D”) credits unchanged. For tax years beginning after December 31, 2021, certain R&D expenses must be capitalized over a 60-month period (15 years in the case of certain foreign R&D expenses).
For tax years beginning after December 31, 2017, the Tax Act reduces the orphan drug credit to 25% of qualified clinical testing expenses (down from 50% under prior law). The Tax Act provides for a new election to take reduced credit in lieu of reducing qualified testing deductions (which may be beneficial for state tax purposes).
The Tax Act significantly expands the limitation on deductions under Section 162(m) for executive compensation in excess of $1 million. Importantly, the Tax Act eliminates the performance-based compensation exceptions under Section 162(m). As a result, all compensation paid to covered employees, including compensation attributable to the exercise of stock options, will generally be subject to the $1 million deduction limitation. The Tax Act expands the scope of Section 162(m) to include companies with any class of securities registered under Section 12 of the Exchange Act and companies required to file reports under Section 15(d) of the Exchange Act (e.g., companies with publicly traded debt).
In addition, the Tax Act expands the definition of “covered employee” to include a company’s chief financial officer and all individuals who were covered employees in any prior year beginning after December 31, 2016, regardless of whether their compensation level or position would cause them to otherwise be a covered employee in a subsequent year.
The Tax Act grandfathers remuneration payable pursuant to a written binding contract that was in effect on November 2, 2017. However, any material modifications to such contract after such date and any renewal of a contract after such date (even under the same terms) would subject the arrangements to the expanded rules of Section 162(m) as modified by the Tax Act.
1 Unless otherwise provided, all Section references are to the Internal Revenue Code of 1986, as amended (the “Code”)