December 13, 2019
The Tax Cuts and Jobs Act (“TCJA”) was signed into law at the end of 2017, meaning the 2018 tax year saw the initial impact of the TCJA and raised many questions regarding the implementation of its various provisions. During 2019, most taxpayers filed their first returns that applied these changes, including those for which no guidance had yet been issued. Needless to say, it was a challenging filing season for all involved.
Throughout 2018 and 2019, our tax professionals have been working diligently with clients to explain the changes, modify client organizational structures, adjust their tax compliance reporting systems, and maximize their available tax benefits. We have addressed such diverse issues as whether or not to make certain elections with respect to foreign sourced income, aggregation elections related to the qualified business income deduction, filing for change in accounting methods, and establishing trusts in states that do not have state income taxes.
We have issued Tax Alerts, held webcasts and had many, many individual conversations and meetings with you to address the impact of the TCJA and maximize the benefits afforded by it. We continue to monitor legislative and regulatory activity and, as always, will share our insights with you. We will also be keeping a careful eye on the upcoming presidential elections, as the outcome could have an impact on future legislation.
This 2019 Tax Planning Guidelines for Individuals and Businesses contains a summary of the current individual and business tax landscape, commentary regarding the TCJA and observations on its impact and the ongoing clarifications from the IRS, as well as considerations for the future.
We thank you for continuing to rely on us as your trusted advisor. Please enjoy this annual publication at your leisure, and we wish you and your families, the best for the upcoming holidays, and a Happy and Healthy New Year.
Partner, Tax Thought Leadership Committee Chairman
Individual Income Tax Planning
Individual & Fiduciary Income Tax Rates
The TCJA lowered the top individual income tax rate to 37% from 39.6%. The new income tax brackets and rates for 2019 and 2020 are detailed below.
Capital Gains Tax Rates
Short-term capital gains are taxed at ordinary income tax rates (see Individual & Fiduciary Income Tax Rates section above).
Long-term capital gains and qualified dividends are taxed at 0%, 15% or 20%, depending on your taxable income and filing status.
Capital gains are also subject to net investment income tax.
Net Investment Income Tax
As in 2018, taxpayers with qualifying income are liable for the 3.8% net investment income (“NII”) tax on certain items of unearned income. The tax is levied on the lesser of NII or the amount by which modified AGI exceeds certain threshold amounts.
Investment income for NIl purposes is (1) gross income from interest, dividends, annuities, royalties, and rents (other than from a trade or business); (2) other gross income from a passive activity or a trade or business of trading in financial instruments; and (3) net gain attributable to the disposition of property other than property attributable to an active trade or business. Some items not included in net investment income include: distributions from certain qualified retirement plans and individual retirement accounts; amounts subject to self-employment tax; and municipal bond interest.
Standard vs. Itemized Deduction
Most taxpayers may claim a standard deduction or choose to itemize their deductions
Note that there is an additional standard deduction for taxpayers who are age 65 or over, or blind, at the end of the tax year, which is $1,300 for each married taxpayer for tax year 2019 or $1,650 for unmarried taxpayers.
The TCJA brought about many changes affecting individual taxpayers, most of which became effective for tax year 2018, with regulations and other clarifying documents issued in 2019 to address some of the outstanding questions.
Following is a brief discussion of some of the major changes, including planning implications.
Net Operating Losses
One of the lesser publicized provisions of the TCJA, the change in the rules relating to Net Operating Losses (“NOLs”) has had a major impact. A NOL is generated when, during any tax year, a taxpayer’s allowable business deductions exceed his/her business income. This result, modified by certain adjustments, is referred to as a NOL.
Prior to the TCJA, a NOL had to be carried back two tax years to get a refund of taxes previously paid (or the carryback can be waived) and any remaining NOL was carried forward to future tax years with no limitation. The NOL was allowed to be carried forward for 20 years.
Under the new rules, NOLs generated in tax year 2018 or later may no longer be carried back to earlier tax years. Additionally, all post 2017 NOLs will now only offset up to 80% of future taxable income. Post 2017 NOLs will never expire as long as the taxpayer remains alive.
Another of the lesser publicized provisions is the new limitation on business losses. Under this rule, a married couple filing a joint tax return can only deduct business losses up to business income plus $510,000 ($255,000 for all other filing statuses) in any one tax year. The aforementioned figures are for the 2019 tax year and are indexed for inflation. Any net business loss in excess of these limitations is carried forward to the next taxable year where it is treated as if it is a NOL.
Assume Joe, a single individual, buys a lottery ticket and wins a $1 million prize which is considered non-trade or business income. Joe invests the $1 million in a partnership that operates a trade or business. The partnership allocates a $1 million loss to Joe in the same tax year. Joe earned no additional income for the year nor did he incur any additional deductions.
If this occurred in 2017, Joe would have had zero taxable income assuming he was active in the partnership’s trade or business.
If this occurred in 2018, Joe would be required to pay tax on $750,000 of adjusted gross income less his standard deduction, since the deductible business loss would be limited to only $250,000. The remaining $750,000 loss from the partnership would carry forward to future tax years (where it is treated the same as a NOL).
Qualified Business Income (“QBI”) Deduction
The TCJA created a new QBI deduction for owners of qualifying businesses that operate as sole proprietors (including single member LLCs), partnerships and S Corporations. The QBI deduction permits certain eligible taxpayers to reduce their qualified business income from the above entities by up to 20%.
- For owners with taxable income under $321,400 for joint filers, $160,725 for married filing separately and $160,700 for other filers, the 20% deduction applies to all qualified business income.
- For owners with taxable income over $421,400 for joint filers, $210,725 for married filing separately and $210,700 for other filers, the 20% deduction is limited to the greater of (a) 50% of W-2 wages or (b) 25% of W-2 wages and 2.5% of the unadjusted basis of investment assets (UBIA) used in the business. In addition, certain “specified service trades or businesses” do not qualify for the 20% deduction.
- For owners with taxable income between the amounts above, a complex set of phase-out rules apply, so that a portion of specified service trade or business income qualifies for the deduction and the W-2 or W-2/UBIA limits apply in part.
Some taxpayers may not be able to maximize the 20% QBI deduction as a result of their taxable income and the organizational structure of their businesses. For instance, their taxable income may exceed $415,000 and an unprofitable trade or business may have significant wages while a profitable trade or business may have very limited wages and/or depreciable assets.
To provide potential relief for situations such as this, the IRS issued regulations permitting eligible taxpayers to make a binding aggregation election which, for purposes of these rules, has the effect of viewing more than one trade or business “as if” they were one combined trade or business.
The five specific requirements which all must be satisfied in order to aggregate trade or businesses under these rules are:
- The same person or group of persons must own 50% or more (directly or indirectly) of each trade or business that is to be aggregated.
- The 50% or more ownership must exist for a majority of the taxable year including the last day of the tax year.
- The aggregated trades or businesses must report items within the same taxable year.
- None of the aggregated trades or businesses can be a specified service trade or business (“SSTB”).
– A SSTB is a trade or business involving the performance of services in the fields of health, law, accounting,
actuarial science, performing arts, consulting, athletics, financial services, investing, investment
management, trading or any trade or business where the principal asset is the reputation or skill of one of
more of its employees or owners.
- Two of the following three requirements must also be satisfied:
– The trades or businesses must provide products, property or services that are similar or customarily offered
– The trades or businesses share facilities or centralized business elements (i.e., accounting, personnel, legal,
– The trades or businesses are operated in coordination with or reliance upon one or more businesses in the
For the 2018 tax year only, the IRS will allow taxpayers to amend their tax returns to elect aggregation. Going forward, any new aggregation elections must be made on timely filed tax returns (including extensions).
While aggregation elections are binding, it may be possible to break such an election if there is a change in circumstances in a future year making the entities ineligible to aggregate.
In addition, certain eligible taxpayers are entitled to receive a QBI deduction for 20% of their qualified REIT dividends and 20% of qualified income from publicly traded partnerships.
Not all states have incorporated the QBI deduction into their law. Consequently, taxpayers need to be careful when analyzing the overall potential tax savings of the QBI deduction.
In situations where a taxpayer receives certain partnership interests (held directly or indirectly) in exchange for services performed, unless that partnership interest is held for more than 3 years, the gain on the sale will be taxed as ordinary income rather than at the preferential capital gain rates. This is a change from the old rules requiring that the security be held for longer than one year to receive preferential capital gains treatment. Note there are many exceptions to this new rule.
Beginning January 1, 2019, alimony or separation maintenance payments are no longer deductible from the income of the payer spouse, or includable in the income of the receiving spouse, if made under a divorce or separation agreement executed after December 31, 2018. This also applies to a divorce or separation agreement executed on or before December 31, 2018 and modified after December 31, 2018 as long as the modification:
- Changes the terms of the alimony or separate maintenance payments and
- States that the alimony or separate maintenance payments are not deductible by the payer spouse or includable in the income of the receiving spouse
Itemized Deductions vs. Standard Deduction
Most taxpayers must choose whether to deduct their actual itemized deductions or the standard deduction (a set reduction from their adjusted gross income to arrive at their taxable income). As a result of the TCJA significantly increasing the standard deduction (see table in Standard vs. Itemized Deduction section above) and limiting the amount of allowable itemized deductions, fewer taxpayers are now itemizing their deductions because their itemized deductions do not exceed the standard deduction amounts.
Below is a brief discussion of some of the itemized deductions.
State and Local Income Taxes
One of the better publicized changes under the TCJA was the limitation of the deduction for state and local income taxes, nonbusiness state and local real estate taxes and personal property taxes. The deduction for the above (combined) taxes is capped at $10,000 per year ($5,000 for married couples filing separate tax returns) beginning in the 2018 tax year.
Several states have established workarounds intended to circumvent this limitation – for example, some permitted taxpayers to make charitable gifts to state sponsored funds which would be deductible at the federal level as a charitable contribution while being treated similar to a state tax payment on the taxpayer’s state income tax returns. However, Treasury Regulations and other guidance has been issued in 2019, indicating that many such plans do not provide the anticipated savings unless certain very specific requirements are met.
Many individual taxpayers that are currently domiciled in a high income tax state are considering changing their domicile as a result of the loss of the deduction for state and local income taxes, especially when a significant taxable event (such as the sale of a business) is expected to occur in the near future.
A change in one’s domicile is often subject to challenge by the state one is leaving. Consequently, we recommend that anyone considering such a change seek professional advice from their tax advisor well in advance of the actual change.
Mortgage Interest / Home Equity Indebtedness
The TCJA reduced and restricted the amount of mortgage interest taxpayers are permitted to deduct. One former deduction no longer available to many taxpayers is the deduction for interest paid on home equity loans. This is a change from the pre-2018 law, which permitted taxpayers to deduct the interest paid on up to $100,000 of home equity debt regardless of how the proceeds were used.
For new home mortgage interest loans, you can deduct home mortgage interest on the first $750,00 ($375,000 if married filing separately) of indebtedness. The higher limitations of $1 Million ($500,000 if married filing separately) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017 (or certain indebtedness where there was a binding contract to close on the purchase of a principal residence before December 15, 2017 as long as certain requirements are satisfied).
In order to maximize one’s interest expense deduction, careful attention should be given to both the timing and amount of your outstanding debt. Taxpayers who find their interest deduction is being limited, may benefit from a review of their loans to see if it is possible to restructure their debt. Consideration should also be given to the interest tracing rules.
As noted previously, fewer taxpayers are itemizing their deductions. In order to receive a tax benefit from charitable contributions, taxpayers can utilize a bunching strategy in which they combine two of more years of charitable contributions into one tax year, thus ensuring they can itemize their deductions in at least one tax year while claiming the standard deduction in other tax years.
This strategy works extremely well with taxpayers who utilize private foundations or donor advised funds to make their charitable gifts. With both of these arrangements, the donor receives an income tax deduction equal to the amount contributed to the private foundation or donor advised fund (limited to a percentage of their adjusted gross income). The private foundation or donor advised fund can then distribute the funds to charitable organizations over a period of years subject to certain rules.
Another consideration would be to contribute appreciated marketable securities you have held long-term (generally for more than one year) to a private foundation or donor advised fund (or even directly to the charity of your choosing). This strategy enables you to deduct the full fair market value of the security as a charitable contribution and you do not have to pay income tax on the built-in appreciation.
To be deductible, medical expenses must now exceed 10% of your adjusted gross income (“AGI”) as opposed to the 7.5% threshold that was in place for tax year 2018.
Individuals should also consider other items such as cryptocurrency transactions, health insurance and retirement planning as detailed below.
Sales of Cryptocurrency
The use of cryptocurrency has increased over the years. Cryptocurrency is considered property for federal income tax purposes and the sale or exchange of cryptocurrency results in a taxable capital gain or loss that must be reported on the seller’s income tax return.
The IRS has ramped up their enforcement efforts to ensure compliance with these rules. During 2019, the IRS has started sending educational letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.
Effective for tax year 2019, the penalty for the failure to have the proper level of health insurance coverage under the Affordable Care Act mandate has been repealed.
Conventional tax planning includes a review of retirement assets to ensure there will be adequate funds available when it is time to retire. Proper planning includes a review of the retirement plan options best suited for your tax situation including the type of plan, the amount to be funded and whether to contribute on a pre or post tax basis.
Due to the new limitations on NOL carryforwards and business losses, the timing of converting individual retirement accounts to Roth IRAs needs to be reconsidered.
Estate and Gift Tax Planning
Although estate plans should be reviewed on a fairly regular basis, a major tax overhaul such as the TCJA provides an opportune time for taxpayers to take a detailed look at their estate plan and gifting techniques to help maximize tax savings and transfer more wealth tax-free.
Increased Exemption Under the TCJA
The lifetime exemption for both gift and estate tax increased from $5 million, indexed for inflation, to $10 million, indexed for inflation. As a result of the TCJA, the exemption is now $11.4 million ($22.8 million for a married couple) for tax year 2019 and will gradually increase, based on inflation, through 2025. The exemption amount for 2020 is scheduled to be $11.58 million ($23.16 million for a married couple). The increase in the gift, estate and generation-skipping transfer tax exemption sunsets after December 31, 2025, at which point it reverts back to $5 million, indexed for inflation, unless Congress renews the provision.
For transfer tax purposes, the IRS has released guidance confirming that taxpayers will be allowed to fully utilize their exemption between 2018-2025 without fear of any kind of “clawback” if the taxpayer dies in a later year, when the exemption is lower.
Although the provision is set to sunset after December 31, 2025 it is important to remember that legislation can change existing tax laws at any time. In addition, the 2020 presidential election could potentially change the political landscape and cause the enactment of changes to existing law. Careful consideration should be given with respect to when to utilize one’s lifetime exemption.
Increased Annual Exclusion
The annual gift exclusion is $15,000 for 2019 and 2020. This exclusion is the amount you can give away per year tax-free to an unlimited number of donees. In addition, married couples can elect to split gifts which allows married taxpayers to gift up to $30,000 (in 2019) to an individual without gift tax. The amount a spouse can give to his or her non-US citizen spouse each year increased from $152,000 in 2018 to $155,000 in 2019. This amount will increase to $157,000 in 2020. To qualify for the “annual exclusion,” the gift must be a present interest, meaning the donee must have an immediate right and access to the gifted property.
Annual gifting is a simple way to reduce the value of a taxpayer’s gross estate over time, without reducing one’s lifetime exemption and thereby lowering the amount subject to estate tax upon death. Consideration should be given to making annual exclusion gifts early in the year to utilize the annual exclusion before the potential passing of a taxpayer. It is important to remember that you can give away $15,000 to as many individuals as you like. Failure to utilize the annual exclusion can be costly for a taxpayer who can potentially make gifts to multiple donees in a single year. Separately, taxpayers can make unlimited direct payments for medical and tuition expenses without being subject to gift tax.
Trusts and Estates Tax Rates
The TCJA did not change the gift, estate, or GST tax rate, which remains at 40% top rate.
The maximum income tax rate for trusts and estates was reduced to 37% at the top bracket in 2018 and remains as such for 2019. The law indexes the new brackets for inflation. The various income tax rates and brackets are detailed in the Individual and Fiduciary Income Tax Rate section above.
Section 199A and Trusts
On January 18, 2019, the IRS issued Final Regulations under new Section 199A (“FINAL REGULATIONS”). The deduction under Section 199A, discussed in the Qualified Business Income (“QBI”) Deduction section above, also applies to fiduciary income tax returns.
In order to maximize the Section 199A deduction, taxpayers should consider utilizing various non-grantor trusts to own pass-through entities. The Final Regulations generally retain the rules set forth in the Proposed Regulations under Section 199A which prevent a taxpayer from establishing multiple trusts that have substantially the same grantors and primary beneficiaries for the principal purpose of avoiding income tax. Additionally, the Final Regulations specifically provide that for purposes of determining whether a trust or estate has taxable income that exceeds the threshold amount, the taxable income of the trust or estate is determined after taking into account any distribution deduction under Sections 651 or 661. Careful consideration of the Section 199A deduction should also be performed before making a Section 645 election to treat both a trust and estate as one entity for income tax purposes.
Portability simply allows a surviving spouse to make use of both his or her individual federal estate tax exemption and the exemption granted to a first-to-die spouse. The portability rules were not changed by the tax reform. Through use of portability, a married couple can take advantage of the full $22,800,000 exemption available in 2019 and $23,160,000 in 2020.
Although many estates will not be subject to estate tax with the increased exemption amount, the only way to elect portability is by filing an estate tax return, so it is important to considering filing regardless of the size of the estate. The IRS has issued guidance on the ability to make a late portability election where no election was made due to the estate not having a filing requirement, other than to elect portability.
Despite the generous federal-level transfer tax exemption, states that continue to impose their own estate taxes have largely decided against matching the federal exemption, and many have decoupled from the TCJA for various income tax provisions.
New Jersey: Estate tax repeal took effect in 2018 so decedents dying on or after January 1, 2018 are no longer subject to New Jersey estate tax. The New Jersey inheritance tax remains in place so bequests to non-lineal beneficiaries will still be subject to a transfer tax.
New York: The estate tax exemption has been increased to $5.74 million for deaths occurring on or after January 1, 2019 to catch up to the federal exemption under pre TCJA law. Also, decedents with dates of death between January 1, 2019 and January 15, 2019 will not be required to include the amounts of any gifts made during their lifetime in the calculation of their New York gross estate. Those dying after January 15, 2019 are once again subject to the three-year lookback rule, which means all gifts made in the three years prior to death will be added back to the New York taxable estate. New York State has also decoupled from certain federal tax changes and is allowing trusts and estates deductions subject to 2% that were eliminated under the TCJA, as well as allowing state and local real estate tax paid over the $10,000 federal cap. Trusts and estates are required to add back into income the Section 199A deduction, discussed earlier in the Individual Income Tax Planning section.
Maryland: Maryland has decoupled from federal estate tax and set its exemption at $5,000,000 in 2019 and beyond (an increase of $1 million from 2018). In addition, Maryland will allow for spousal portability that matches the federal portability rules to allow a surviving spouse to take advantage of his or her deceased spouse’s unused exemption beginning in 2019.
Connecticut: During the 2018 legislative session, the Connecticut General Assembly passed two bills amending the estate and gift tax thresholds and enacting two different schedules of rates for 2020 and thereafter. Connecticut has now confirmed that the gift and estate tax exemptions will gradually increase from $3,600,000 in 2019 and $5,100,000 in 2020, to the federal exemption as of January 1, 2023.
The disparity between the federal estate tax exemption amount and a particular state’s amount may cause a decedent’s estate to be liable for a state estate tax even though no federal estate tax is due. Careful consideration needs to be given to state estate taxes when one’s taxable estate is below the federal exemption amount, but above the state estate tax exemption amount
On June 21, 2019, the US Supreme Court issued a unanimous opinion in North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, holding that the North Carolina statute subjecting the trust to state income taxation, based solely on the trust beneficiary’s residence in the state, violates the Fourteenth Amendment’s Due Process Clause. The trust was created by a New York resident, had no North Carolina source income nor were any distributions made to the North Carolina resident beneficiary.
On June 28, 2019, the U.S. Supreme Court denied the Minnesota Department of Revenue’s request to review the July 18, 2018 ruling by the Minnesota Supreme Court in Fielding v. Commissioner which stated that it was unconstitutional, under the due process clause, for Minnesota to tax four non-grantor trusts, created after December 31, 1995 by a grantor who was a Minnesota resident when the trust became irrevocable, as resident trusts. The court held that the statute, as applied, was unconstitutional because the trustee did not have sufficient contact with the state of Minnesota to satisfy due process requirements. Specifically, Minnesota could not tax the trusts on all of their income based solely on the grantor’s domicile when the trusts were created.
Clearly, the decisions in these cases are a taxpayer victory. But the question remains as to under what circumstances the state taxation of a trust’s accumulated income satisfies the Due Process Clause. It is critical to analyze the facts and circumstances of each trust, especially when choosing a trustee whose residency could impact the taxation in a particular state.
Other Gift, Estate and GST Planning Considerations
- Review of current estate planning documents: One should review their current Last Will and Testament in light of the significant increase in the estate tax exemption. If the current Last Will and Testament contains formula clauses for determining how much is bequeathed to certain beneficiaries and/or trusts, the increased exemption amount may cause too much to be transferred to certain beneficiaries, such as children, and not enough to be transferred to other beneficiaries, such as one’s spouse.
- Consider Basis Step-up: The step-up of income tax basis to fair market value on death remains unchanged. Consideration should be given to what types of assets are being gifted in order to take advantage of the basis step-up at death.
- Swapping assets with a grantor trust: A grantor can put the Grantor Trust “swap power” to use and swap high basis assets, held individually, for low basis ones held by one’s grantor trust. The benefit of this is that the low basis asset would now be includible in the grantor’s estate and get stepped up to fair market value at death, thus minimizing income taxes. Contributing rapidly appreciating assets to a trust is an appropriate estate planning technique to remove future appreciation from a taxable estate. If the original asset transferred is no longer appreciating, it may be wise to swap different assets into the trust that have a higher future potential for appreciation to further reduce your taxable estate.
- Grantor Retained Annuity Trusts (GRATs): GRATs can be used to transfer future appreciation of an asset to beneficiaries. These trusts generally work best with assets that are likely to appreciate quickly and during a time (such as now) when interest rates are low.
- Front Loading Section 529 Plans: A section 529 plan is a plan established to put aside funds for college. A transfer to a section 529 plan is considered a gift and qualifies for the annual exclusion discussed above. Five years’ worth of gifts can be made at one time, thereby allowing a married couple to gift up to $150,000 to a 529 plan in 2019. This gift would not generate a tax or use one’s lifetime gift tax exemption. Instead, the gift is treated as having been made over 5 years. For instance, if you gave $75,000 to a section 529 plan before the end of 2019, you would be deemed to have given a $15,000 annual exclusion gift that year and for the following 4 years. Consideration should be given to the taxpayer’s state income tax rules when analyzing this strategy.
- Spousal Lifetime Access Trust (SLAT): SLATs can potentially be useful in allowing taxpayers to take advantage of the full transfer tax exemption before it expires after 2025. A SLAT is an irrevocable trust in which the taxpayer’s spouse is a potential beneficiary. A transfer to a SLAT removes the transferred asset and its future appreciation from the taxpayer’s taxable estate. However, assets in the SLAT could be distributed to the taxpayer’s spouse should the family need funds in the future. The risk of divorce and death of the non-donor spouse must be considered when implementing this type of trust.
Domestic Business Planning
It’s been nearly two years since the TCJA made sweeping changes to the business tax landscape. While promising to simplify the tax code, it introduced several new code sections, tax forms, concepts, definitions, phase-ins, phase-outs, and other limitations. Familiar deductions such as meal and entertainment and interest expense are no longer so straight-forward.
One of the most significant changes was the decrease in the corporate tax rate, which dramatically reduced the effects of double taxation on C-corporations. Many companies took advantage of the generous depreciation deductions for businesses making capital investments. This provided significant cash flow benefits by accelerating deductions and immediately reducing current tax liabilities.
Smaller companies took advantage of the simplified tax accounting and inventory methods. Pass-through entities such as partnerships and S-Corporations wrestled with the new Qualified Business income rules to make sure their owners had all the information needed to claim the 20% Qualifies Business Income Deduction. Many pass-through entities wanted to know if they should convert their businesses to C corporations to take advantage of the lower tax rates, but most found their current structure to still be more tax efficient.
The TCJA also brought us new limitations on businesses such as the interest expense deduction limitation, net operating loss limitations, and further limitations on meals and entertainment deductions. These were all meant to reduce deductions and potentially increase taxable income.
Traditional planning strategies that made sense in the past may not anymore. With tax deductions being accelerated all into one year or deferred into later years, businesses must carefully plan how all these provisions affect current and future taxes. Volatile swings in taxable income and liabilities may disrupt cash flow planning and long-term objectives. Action may be required before year-end to fully take advantage of benefits or minimize unexpected consequences.
Corporate Tax Rate Cuts
For tax years starting in 2018 or later, the graduated tax rates applicable to C corporations with a top rate of 35% is replaced with a flat 21% corporate rate. This rate also applies to Personal Service Corporations.
The tax rate decrease means that many C corporations will pay significantly less tax, and many companies will see a significant impact on the value of deferred tax assets and liabilities.
The reduction of the corporate tax rate also brings into question whether it is more advantageous for an entity to be taxed as a C corporation or as a pass-through entity. However, taxpayers should keep in mind the effect of double taxation applicable to C corporations and their owners. While the corporate tax rates were reduced, taxes on dividend distributions remain. Assuming all after-tax earnings are distributed, the combined effective tax rate is 36.8%. Income earned from eligible businesses treated as pass-through entities (see discussion under Qualified Business Income (“QBI”) Deduction section) may be eligible for the §199A Qualified Income deduction. This effectively reduces the tax rate of income from pass through entities from 37% to 29.6%. This is still lower than the effective C corporation tax rate, but the difference between the two types of entities is smaller.
The change to both the corporate rate and the §199A deduction available for pass-through entities may provide tax benefits to entities and their owners. However, further analysis regarding future business environments and other factors should be considered to determine the best entity choice. The type of business and its income level will also be factors in choosing the most appropriate entity form.
Corporate AMT Repealed
Prior to the TCJA, corporations were subject to an alternative minimum tax (“AMT”) regime that imposed a 20% rate on alternative minimum taxable income. The AMT rules also limited the net operating loss (“NOL”) deduction to 90% of alternative minimum taxable income. For tax years starting in 2018 or later, the corporate AMT is repealed. Corporations that paid the AMT in earlier years may carryover an AMT credit to offset tax liabilities in future years. With the corporate AMT repealed, corporations may use their AMT credit carryovers in their 2018–2021 tax years.
This provision can provide additional funds to C corporations in the form of reduced tax liabilities and refundable credits through 2021. In addition, C corporations will no longer be required to track the many AMT-related adjustments required in determining alternative minimum taxable income.
Rules limiting AMT NOL deductions are now incorporated into the regular NOL deduction rules (see discussion under Net Operating Losses below). While the corporate AMT repeal simplifies the tax rules, it effectively subjects all corporations to some level of taxation by not allowing them to reduce their income to zero through NOL deductions.
Dividends Received Deduction
Prior to the TCJA, C corporations that received dividends from corporations that they hold less than 20% ownership of were entitled to deduct 70% of those dividends. For corporations in which a C corporation owned greater than 20% but less than 80%, an 80% deduction applied. For tax years starting in 2018 and later, the TCJA reduces the 70% deduction to 50% and the 80% deduction to 65%. For C corporations owning greater than 80% of another C corporation, the100% deduction remains unchanged.
Accounting Method Changes
Small businesses with average annual gross receipts of $25 million or less in the prior three-year period have the option to use certain simplified tax accounting methods.
The simplified tax accounting methods allow eligible taxpayers to:
– Use the overall cash basis method accounting
– Be exempt from certain accounting rules for inventories
– Be exempt from capitalizing costs related to real and personal property
– Be exempt from long-term contract reporting
In addition, the TCJA modified Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it is recognized for financial reporting purposes. Under Section 451(b), taxpayers that use the accrual method of accounting will meet the “all events test” no later than the taxable year in which the item is considered revenue in a taxpayer’s “applicable financial statement.” Taxpayers wishing to change their current method of tax accounting for the above will be required to file Form 3115 to conform to the new rules.
The tax accounting method changes for small businesses expand eligibility for the use of cash basis accounting methods, as well as simplify the tax compliance burdens in making a method change. In addition, one or more of these method changes can provide planning opportunities for acceleration of expenses or income deferral.
For example, where a business has more receivables than payables, adopting the cash method may result in tax savings in year one because the amount of revenue that will be deferred will exceed the amount of deductions that would have been taken.
Conversely, where a business has more payables than receivables, adopting the cash method in year one may not be advantageous because the amount of income that would be deferred would be less than the amount of deductions that would not be accelerated.
It is important to project business income over a few years and convert results to the cash basis. Business owners must be mindful of cash management and requirements to pay taxes as well as possibly losing eligibility to use any of the above methods and switching back.
Careful consideration and planning are required before adopting an overall change to cash basis tax reporting. Furthermore, taxpayers that previously made a mandatory change from cash to accrual must consider the transition rules outlined in Revenue Procedure 2018-40. The automatic Form 3115 must be attached to the timely filed (including extensions) federal income tax return for the year of change.
Net Operation Losses
Losses incurred for years ending on or before December 31, 2017 will continue to carryforward for 20 years. NOLs incurred in tax years ending after December 31, 2017 generally can no longer be carried back to an earlier tax year but can be carried forward indefinitely. Special attention is required by fiscal year taxpayers as the statutory language regarding the carryback of NOLs is inconsistent with the legislative intent.
For NOLs arising in tax years starting after December 31, 2017, the maximum amount of taxable income that can be offset with NOL deductions is generally reduced from 100% to 80%.
Tracking NOLs is extremely important as completely different rules apply depending on what year the NOL was generated. For companies that have NOL carryovers from tax years after 2017, careful attention to the 80% limitation is necessary, as a company accustomed to eliminating taxable income through NOL deductions could find itself with taxable income and a resulting tax liability. Presumably, the 80% limitation was put in place to offset the repeal of the corporate AMT.
Only post-2017 NOLs are utilized up to the 80% limit. The effective tax rate will be 4.2% on taxable income after NOL utilization. NOLs will be utilized on a first in, first out basis, according to the years they were generated.
In addition, the ability to use an NOL carryforward may be limited where a corporation has experienced a change of stock ownership, for example, because of a merger or acquisition, the issuance of new stock, or the acquisition of outstanding stock by one or more 5% shareholders. Therefore, appropriate planning is needed to preserve and maximize the use of NOLs.
The TCJA temporarily allows 100% expensing for business property acquired and placed in service after September 27, 2017 and before January 1, 2023. Qualified assets include both new and used tangible property with a recovery period of 20 years or less (such as office furniture, computers, equipment, and land improvements), off-the-shelf computer software, water utility property and, depending on when it is placed in service, Qualified Improvement Property (“QIP”).
The 100% allowance generally decreases by 20% per year in taxable years beginning after December 31, 2022 and expires January 1, 2027:
– 80% for 2023
– 60% for 2024
– 40% for 2025
– 20% for 2026.
The law now allows bonus depreciation for certain film, television, and live theatrical productions, and used qualified property with certain restrictions. For certain property with longer production periods, these reductions are delayed by one year. For example, 80% bonus depreciation will apply to long-production-period property placed in service in 2024.
The 100% bonus depreciation deduction begins to phase out after December 31, 2022. Managing the timing of when eligible property is placed in service will help assure maximum depreciation deductions each year. Assets must be placed in service before year-end to claim bonus depreciation.
Bonus depreciation is now permitted for both new and used property acquired by purchase, provided the property was not used by the taxpayer before the taxpayer acquired it. Companies that acquire eligible depreciable assets as part of a business acquisition may also use the favorable bonus depreciation rules to accelerate deductions.
In some cases, a business may not be eligible for bonus depreciation starting in 2018. Examples include real estate businesses that elect to deduct 100% of their business interest, and dealerships with floor-plan financing, if they have average annual gross receipts of more than $25 million for the three previous tax years.
QIP, which generally include most interior improvements to real property, were eligible for bonus depreciation if placed in service before December 31, 2017. Contrary to Congress’s intent, QIP placed in service after this date is no longer eligible for bonus depreciation. Until Congress passes a technical correction to this provision, QIP is depreciated over 39 years. Companies should scrutinize all QIP expenditures to determine if items may be treated as a repairs expense (e.g. drywall or bathroom repairs) or may qualify as an asset eligible for a shorter depreciation life (e.g. electrical upgrades for machinery and equipment).
Companies purchasing new real estate or making renovations to existing property should consider a cost segregation study to maximize the bonus depreciation on land improvements and contents of a building. Typical assets that qualify include decorative fixtures, security equipment, parking lots, landscaping and architectural fees allocated to qualifying property. A cost segregation study will identify personal property and determine optimum depreciable lives for both current and prior acquisitions and construction.
Cost segregation studies can also examine assets placed in service in prior years. If it is determined that the company was entitled to more favorable depreciation methods, it can file Form 3115, Application for Change in Accounting Method, with its tax return and deduct a “catch-up” depreciation adjustment.
Taxpayers should be mindful of the de minimis safe harbor expensing rule that allows for immediate expensing of up to $2,500 or $5,000 where an audited financial statement is prepared. While de minimis expensing vs. bonus depreciation may produce the same result at the federal level, it may reduce state level income taxes, as most states follow the de minimis provisions but disallow bonus depreciation.
Taxpayers purchasing a sport utility vehicle should consider purchasing one which is rated 6,000 pounds or more. This will allow the business to take bonus depreciation up to 100% of the cost of the vehicle. Vehicles rated at 6,000 pounds or less don’t satisfy the SUV definition and thus are subject to the passenger vehicle limits. For passenger vehicles placed in service in 2019, the first-year depreciation limit is $18,100 ($10,000 plus $8,100 bonus depreciation).
Section 179 Election
A taxpayer may elect to expense the cost of any section 179 property and deduct up to $1 million of it in the year the property is placed in service. The section 179 deduction begins to phase out on a dollar-for-dollar basis after $2.5 million of qualifying property is placed into service in the tax year. Thus, the entire deduction is phased out once the business makes $3.5 million in purchases. For later tax years, these amounts will be indexed for inflation. Companies may claim the election only to offset net income, not to reduce it below zero to create a net operating loss.
Section 179 deductions are generally not allowed on real property improvements. The TCJA expanded the list of eligible property to include certain improvements to nonresidential real property, such as roofs, fire alarm and security systems, and HVAC systems.
Profitable companies should evaluate whether to take bonus depreciation or elect section 179 expense on assets placed in service during the year. Both may yield the same overall federal tax deduction, but the decision could impact the amount deductible for state purposes. Many states adopted rules that disallow bonus depreciation and/or the section 179 deduction. Also, certain property may entitle a company to generate additional state tax credits (e.g. equipment used for manufacturing). Tax credits may get reduced if the company elects section 179 expenses on qualifying property. In those cases, a company may be better off taking bonus depreciation instead. Companies expecting to show a net loss for the year will not be able to elect section 179 expense but may still take bonus depreciation to increase the tax losses.
The section 179 deduction offers more flexibility than bonus depreciation in controlling how much the deduction will be. Subject to the annual limitations, companies may choose to expense some, or all of the asset purchased. They can also choose which specific assets to elect section 179 expense on. If a business uses bonus depreciation, it is forced to use bonus depreciation for all assets in that same class life (e.g. all assets in a 5-year class life would consistently use bonus depreciation).
Qualified Opportunity Zones
The TCJA created a new tax incentive program designed to spur economic development and job creation in distressed communities by providing a tax benefit to those that invest realized capital gains in specified areas known as Qualified Opportunity Zones. Funds established to invest in these zones are Qualified Opportunity Funds (“QOF”). Individuals, partnerships, corporations, and other pass-through entities can all take advantage of these tax benefits. If a taxpayer realizes gains from the sale or exchange of property and invests some or all the realized gain into a QOF within 180 days, the QOF investment allows them to:
- Defer those gains from taxable income until the earlier of (a) selling the investment in the QOF or (b) December 31, 2026.
- Permanently exclude 10% of the originally-invested gain from taxable income if the investment in the QOF is held for at least 5 years (5-year period must be met prior to December 31, 2026).
- Permanently exclude an additional 5% for a total exclusion of 15% of the originally invested gain from taxable income if the investment is held for at least 7 years (7-year period must be met prior to December 31, 2026).
- Permanently exclude post-acquisition appreciation in the investment in the QOF if the taxpayer holds the investment for a minimum of 10 years.
The 180-day requirement for pass-through entities starts on the last day of the entity’s tax year. Thus, if a capital transaction happens in the first month of the tax year, the 180-day clock doesn’t start until the last day of the tax year.
Pass-through entities that will report capital gains to their owners in 2019 should consider communicating these amounts shortly after year-end to allow the investors time to consider investing in a Qualified Opportunity Fund. Passthrough entities that use extensions to file their tax returns and that wait until then to pass along this information may not give their investors sufficient time to make such investments before the 180-day requirement lapses.
Initially the taxpayer’s basis in the fund is zero. The exclusion described in items #2 and #3 above is accomplished through an increase to the basis of the investment. If the investment is held for at least 5 years, the taxpayer’s basis is increased by 10% of the deferred gain.
If the investment is held for at least 7 years, the taxpayer’s basis is increased by another 5% of the deferred gain, totaling 15%.
Investing in a Qualified Opportunity Fund could provide significant tax benefits if done at the right time and in the right investment vehicle. To maximize all benefits available, taxpayers need to invest their gains no later than December 31, 2019 to meet all holding period requirements. Taxpayers that invest after December 31, 2019 can still realize substantial tax benefits but will not qualify for the additional 5% basis adjustment discussed in #3 above. All appreciation in the QOF over and above the original investment is still 100% tax free if the ten-year holding duration is met.
Taxpayers may choose to form their own QOF but must weigh the cost/benefit for doing so. The additional burden and costs to qualify and administer the QOF may significantly reduce the benefits. Taxpayers can also consider investing with a managed QOF through banks or brokerage firms instead.
Taxpayers should also keep in mind that capital gains tax rates may increase between now and when the QOF investment is ultimately sold (or 2026, whichever comes first). Therefore, it’s possible the capital gains tax on the same investment may ultimately cost more if the capital gain rates increase.
The tax deferral benefits of investing in QOFs are comparable, and in some cases better, than those available in Like Kind Exchanges (“LKE”) (see discussion below). Taxpayers not only defer the gain but can reduce the amount of gain deferred by meeting the holding period requirements. Also, appreciation on the eventual sale of the investment is tax-free when the 10-year holding period is met. This is not the case with replacement property in an LKE and an investor does not have to purchase like-kind property to qualify for gain deferral. Taxpayers can invest proceeds from the sale of marketable securities, or a sale of a business, and invest in a QOF. This is not possible with LKEs.
For a list or visual map of the designated Qualified Opportunity Zones please click on the website listed below:
Companies with publicly traded stock or registered debt may not be allowed to deduct compensation in excess of $1million paid to certain covered employees. Prior to 2018, there were two exceptions to the deduction limit – the exception for performance-based pay (including stock options) and the exception for commission-based pay. However, the TCJA repealed these exceptions, placing an effective cap on the amount a company can deduct for executive compensation at $1 million for a company’s CEO, CFO, and the three other most highly paid executives.
TCJA changes to Section 162(m) do not apply to compensation paid under a “written binding contract” in effect on November 2, 2017, provided the contract is not “materially modified” after such date.
The TCJA limits deductions for business interest incurred by certain large businesses – generally businesses with $25 million or more in average annual gross receipts. The $25 million limit is subject to aggregation rules that may require combining different businesses for purposes of this limitation. Business interest expense is limited to business interest income plus 30% of the business’s adjusted taxable income and floor-plan financing interest. There are some exceptions to the limit, and some businesses can elect out. Disallowed interest expense may be carried forward indefinitely, with special rules for partnerships. Taxpayers will use Form 8990 to calculate any limitation on business interest expense and to track any disallowed interest being carried forward.
This limit does not apply to taxpayers whose average annual gross receipts are $25 million or less for the three prior tax years. This amount will be adjusted annually for inflation starting in 2019.
Other exclusions from the limit are certain trades or businesses, including performing services as an employee, electing real property trades or businesses, electing farming businesses and certain regulated public utilities. Taxpayers must elect to exempt a real property trade or business or a farming business from this limit.
Real estate entities should consider making a real property trade or business election. The interest deduction is potentially more valuable than the slightly shorter life available for depreciation of real estate assets. In addition, entities that are required to use ADS, such as partnerships with tax-exempt partners, or REITs that use ADS in connection with earnings and profits calculations, should not suffer adverse tax consequences by making the election.
Further, the taxpayer can elect out of the interest deductibility limitation in any tax year, bearing in mind that once made, the election is irrevocable. Thus, a taxpayer can decide not to elect out in 2019, allow the interest deduction to be suspended, and then elect out in 2020 when the freed-up deductions are available to offset other income. In addition, it may be possible to claim bonus depreciation in one year and elect out of the deduction limitation the next year without recapturing the bonus depreciation claimed.
Meals and Entertainment
Companies can no longer deduct expenses related to activities considered entertainment, amusement or recreation. However, taxpayers can continue to deduct 50% of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages are not considered lavish or extravagant. The meals may be provided to a current or potential business customer, clients, consultants, or other business contacts. If food and beverages are provided during, or at, an entertainment activity, they must be purchased separately from the entertainment, or the cost of the food or beverages must be stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.
De minimis employer-provided meals will be 50% tax deductible and 100% non-deductible for expenses incurred after December 31, 2025. Businesses generally co-mingle meals and entertainment expenses in their books and records, since the tax treatment used to be the same before TCJA. Companies are beginning to revise their bookkeeping practices to better track these expenditures to preserve any tax deductible amounts.
Commuting Costs and Transportation Fringe Benefits
Employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service) are no longer allowed, unless the transportation is necessary for the employee’s safety. Also eliminated are employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking allowances, mass transit passes and van pooling). However, those benefits remain tax-free to recipient employees.
Employers now must choose to either include these amounts in employee taxable income and take a 100% tax deduction or exclude the amounts from employee income and take a lesser deduction.
A like-kind exchange is a tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a tax liability on the sale of the first asset. This deferral provision applies only to exchanges of real property and not to exchanges of personal or intangible property.
Real property must still be held for productive use in a trade or business or for investment to be eligible for like-kind exchange treatment. This applies to exchanges completed after December 31, 2017. Real property located in the U.S. is not considered like-kind to real property located outside the U.S.
Tax credits are incentives to encourage taxpayers to engage in certain activities such as hiring more employees or investing in new technology or capital expenditures. Tax credits are better than tax deductions since they reduce tax liabilities on a dollar-for-dollar basis. They help reduce the overall effective tax rate for the business and will generally carryover to future years if a company is unable to use all credits in one year. In some cases, companies may claim unrecognized credits in prior year returns. Credits generated by pass-through entities will pass on to their owners and are used to reduce their tax liabilities. Below is a brief description of some available credits to consider:
- Research Credit (“R&D Credit”). This credit is based on wages and certain other costs to develop new products, make improvements to existing products, and develop or improve a process. It provides a great opportunity for many companies across several industries to reduce their tax liabilities. Certain start-ups (in general, those with less than $5 million in gross receipts) that haven’t yet incurred any income tax liability can use the R&D credit against their payroll tax for the first five years generating revenue.
The R&D credit is not just for companies that invent new products. In fact, many companies have qualifying expenses, but may erroneously conclude the credit does not apply to them. The credit is also available to companies expending resources to develop a new process or improve existing processes using technology and science.
- Work Opportunity Credit. This credit is designed to encourage hiring from certain disadvantaged groups, such as certain veterans, ex-felons, individuals who’ve been unemployed for 27 weeks or more and food stamp recipients. The credit is available for employees hired by December 31, 2019. The size of the tax credit depends on the hired person’s target group, the wages paid to that person and the number of hours that person worked during the first year of employment. The maximum tax credit that can be earned for each member of a target group is generally $2,400 per adult employee. But the credit can be higher for members of certain target groups, up to as much as $9,600 for certain veterans.
An employer must obtain certification that an individual is a member of the targeted group before the employer can claim the credit. Employers should revisit their employment application process to ensure they identify qualifying employees.
- Retirement Plan Credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for 3 years. The credit is limited to 50% of qualified startup costs.
- Small-Business Health Care Credit. The maximum credit is 50% of group health coverage premiums paid by the employer, provided it contributes at least 50% of the total premium or of a benchmark premium. The full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $27,100 per employee. To qualify for the credit, online enrollment in the Small Business Health Options Program (SHOP) is generally required. In addition, the credit can be taken for only 2 years, and they must be consecutive.
- Family Medical Leave Credit. The credit applies to wages paid in taxable years beginning after December 31, 2017, and before January 1, 2020. The credit is a percentage of wages (as determined for Federal Unemployment Tax Act (FUTA) purposes and without regard to the $7,000 FUTA wage limitation) paid to a qualifying employee while on family and medical leave for up to 12 weeks per taxable year. The percentage can range from 12.5% to 25%, depending on the percentage of wages paid during the leave.
- Business Energy Credit. Commercial and industrial property owners are eligible for a tax credit of 30% of the installation costs of solar panels, if the property is placed in service by the end of 2019. In 2020, the credit is scheduled to go down to 26%. Utility companies often have additional rebates and incentives for installing solar panels.
International Tax Planning
The passage of the TCJA left us with many more questions than answers and this year has been a busy one for Treasury guidance as the lay of the international tax landscape continues to settle. What follows below is a summary of some of the salient international tax changes.
Section 965 Transition Tax
One of the hot button issues in the tax reform discussions was the repatriation tax under Internal Revenue Code (IRC) Section 965. This moved the US international tax system from a global regime to a territorial regime, requiring taxpayers to include their foreign corporate untaxed income in their subpart F income calculation for their latest tax year beginning on, or before, December 31, 2017. The result was a tax holiday where previously untaxed foreign income was repatriated, but taxed at relatively low rates. While the 2017 tax year was used to give all foreign businesses a clean slate from which to begin operating under the new territorial system, the reporting and accounting requirements extended into the 2018 reporting year as the IRS made changes after most taxpayers had filed their 2017 tax returns.
Taxpayers could include the repatriation tax in their 2017 returns or elect to make payments in installments over the course of 8 tax years, beginning with the 2017 tax year.
Throughout 2019, the Treasury provided guidance and released new Form 965 and its long list of schedules to be filed with 2018 tax returns by taxpayers reporting a section 965 inclusion.
By the end of 2019, all taxpayers, including those with fiscal years ending in 2018, will have filed all returns that require them to calculate their tax under section 965. All US shareholders of specified foreign corporations will have to continue to file form 965 in future tax years if they elect deferral or the 8-year installment option.
Base Erosion Anti-Abuse Tax (BEAT): Final and Proposed “BEAT” Regulations under Section 59A
On December 2, 2019, Treasury and IRS issued proposed and final regulations relating to the base erosion and anti-abuse tax (BEAT) under tax code Section 59A following the enactment of the TCJA. Mazars USA is in the process of reviewing these regulations in detail. The below discussion provides a summary of some of the key highlights and is not an exhaustive list of the provisions.
BEAT, which is designed to deter US multinationals from moving profits offshore and prevent the erosion of the US tax base, applies to a company when 3% or more of its deductible payments are considered base-erosion payments. When a company becomes subject to BEAT, under tax code Section 59A, the company is subject to an additional 10% “BEAT” tax, which increases to 12.5% after 2025.
The final regulations take into account comments received on the proposed regulations released in December 2018 and provide guidance regarding which taxpayers will be subject to BEAT, how to determine base erosion payments, and the calculation of the base erosion minimum tax amount.
The new proposed regulations provide further guidance on how to apply BEAT when taxpayers elect to waive certain deductions and provide additional guidance for applying the BEAT with respect to partnerships.
The above-mentioned highlights are not exhaustive. Taxpayers are encouraged to review the guidance carefully and discuss with their advisors how the provisions in the final and proposed regulations may affect their businesses as well as, consider commenting on the BEAT issues that Treasury should address.
Foreign Tax Credits (FTC): Final and Temporary Regulations along with Proposed Regulations
On December 2, 2019, Treasury and IRS released both final and temporary regulations along with proposed regulations under Sections 704, 861, 901, 904, 905, 954, 960, 965 and 986, providing guidance with respect to the foreign tax credit (FTC) regime following the enactment of the TCJA. Mazars USA is in the process of reviewing the final, temporary, and new proposed FTC regulations in detail. The below discussion provides a summary of some of the key highlights and is not an exhaustive list of the provisions.
The final regulations finalize certain provisions of the proposed regulations issued in December 2018, which include a rule treating certain assets as 50% exempt for expense allocation purposes, rules on applying the new FTC limitation categories, and a taxpayer-favorable elective transition rule for carryovers of FTCs. They also clarify, modify and amend several notable provisions of the December 2018 proposed regulations.
The new proposed regulations include rules on the allocation and apportionment of research and experimental deductions, which will generally allow taxpayers subject to the GILTI regime to increase their use of foreign tax credits, and provide guidance related to the allocation and apportionment of stewardship expenses, as well as other FTC issues.
The final regulations are generally effective on the date of publication in the Federal Register with various effective dates that apply to provisions under the final and proposed regulations.
Taxpayers and their advisors are encouraged to review the guidance carefully and discuss with their advisors how the provisions in the final, temporary, and new proposed regulations may affect their businesses, as well as, consider commenting on the FTC issues that Treasury should address.
Global Intangible Low-Taxed Income (GILTI): Final and Proposed “GILTI” Regulations under Section 951A
On June 14, 2019, Treasury and the IRS released final regulations and proposed regulations concerning global intangible low-taxed income (GILTI) under section 951A.
GILTI is a new type of Subpart F income created under the TCJA. The basic premise is that a tangible asset owned by a controlled foreign corporation should only produce a 10% return. Any return above 10% (the “excess return”) is thought to be the product of intangibles, rather than the tangible asset. This excess return is taxed to the US shareholder as subpart F income, subject to special rules that reduce the effective tax rate to the shareholder. The GILTI rules under section 951A became effective for tax years beginning after December 31, 2017.
Although the GILTI rules require an income inclusion, a 50% deduction against the GILTI inclusion is available to US shareholders that are C-corporations. This deduction brings the effective tax rate on GILTI for corporations down to 10.5% until 2026, when the deduction is reduced to 37.5%.
Additionally, indirect foreign tax credits are allowed for corporate shareholders under section 960 for 80% of the pro rata share of aggregate deemed paid foreign taxes allocable to GILTI income, but, in contrast, are generally not available to individuals.
However, individual shareholders can make an election that allows them to take the same 50% deduction and use the same foreign tax credits as a corporate taxpayer. Thanks to this election, many individual taxpayers were able to avoid the hassle of adding a C-corporation to their business structures and were instead able to make the election.
With a year of GILTI planning and form filings under their belts, taxpayers and tax preparers have now gone through the experience of calculating and reporting GILTI. Many of the forms and rules used for 2018 filings were incomplete or in draft form. Taxpayers, especially those that filed before the extended deadline, should plan to spend time reviewing their 2018 filings to ensure that their GILTI was calculated in accordance with the most recent Treasury guidance available.
The final regulations released in June 2019 provide guidance to determine the amount of GILTI included in the gross income of certain United States shareholders of foreign corporations, including United States shareholders that are members of a consolidated group and final regulations relating to the determination of a United States shareholder’s pro rata share of a controlled foreign corporation’s subpart F income included in the shareholder’s gross income, as well as certain reporting requirements relating to inclusions of subpart F income and GILTI. The final regulations revise the domestic partnership provisions that were included in the proposed regulations released in September 2018 to adopt an aggregate approach for purposes of determining the amount of GILTI included in the gross income of a partnership’s partners under section 951A with respect to controlled foreign corporations owned by the partnership.
Generally, the final GILTI regulations, with some exceptions, are effective for tax years of foreign corporations beginning after December 31, 2017, and to tax years of US shareholders in which, or with which, those foreign corporations’ tax years end.
A key revision in the final regulations from the 2018 proposed regulations relates to the treatment and determination of GILTI with respect to a domestic partnership and their partners that directly or indirectly own stock of controlled foreign corporations (“CFCs”). Under the 2018 proposed regulations, a hybrid approach is adopted, whereby a domestic partnership that is a US shareholder of a CFC is required to determine its GILTI inclusion amount (i.e., entity approach) and then provides that partners of the partnership that are not separately US shareholders of the CFC take into account their distributive share of the partnership’s GILTI inclusion amount (i.e., aggregate approach with respect to partners that are themselves US shareholders of the CFC).
The June 2019 final regulations depart from this hybrid approach and instead apply an aggregate approach for purposes of the GILTI regime. The final regulations provide that for GILTI purposes “a domestic partnership is not treated as owning stock of a foreign corporation within the meaning of section 958(a),” but rather its partners are treated as the section 958(a) owners in the same manner as the partners of a foreign partnership are treated under IRC Section 958(a), while providing that this aggregate approach does not apply for purposes of determining whether a US person is a US shareholder or whether a foreign corporation is a controlled foreign corporation.
Under the 2018 proposed regulations, a hybrid approach was applied with respect to the determination of GILTI with respect to a domestic partnership and their partners that directly or indirectly own stock of CFCs. Under the prior hybrid approach to treatment of partnerships in the determination of GILTI, a partner of a domestic partnership would have been required to include in gross income his/her distributive share of the partnership’s section 951 inclusion and to take into account his/her distributive share of the partnership’s GILTI items.
Under the new regulations, since domestic partnerships that own shares in foreign corporations are no longer treated as section 958(a) owners of the shares (under the new rules, the partner rather than partnership is considered the section 958(a) owner of a foreign corporation’s shares), any less-than-10% partners, who do not also own additional shares, are no longer subject to section 951 and GILTI inclusions in respect to such foreign corporations. However, careful consideration should be given for less-than-10% partners of a domestic partnership owning stock of a CFC, who may now be excluded from Subpart F and GILTI, but also subject to the PFIC regime under these new rules.
Treasury and the IRS also issued proposed regulations in June 2019 regarding the treatment of domestic partnerships for purposes of determining the subpart F income included in the gross income of their partners under section 951 with respect to controlled foreign corporations owned by the partnership and the treatment of income of a controlled foreign corporation that is subject to a high rate of foreign tax under section 951A.
The proposed GILTI and subpart F income regulations will be effective for tax years of foreign corporations beginning after the date the final regulations are published, and to tax years of US shareholders in which, or with which, those foreign corporations’ tax years end. The treatment of a domestic corporation as foreign for subpart F income purposes can, however, be applied for a foreign corporation’s tax years beginning after December 31, 2017, and for tax years of a domestic partnership in which, or with which, the foreign corporation’s tax years end, provided that certain related parties also apply the regulations.
Passive Foreign Investment Companies (PFICs)
Treasury issued proposed regulations in the middle of 2019 that significantly revised some of the core rules related to passive foreign investment companies (PFICs). The two most significant revisions involve changes to the look-through rules for 25%-owned corporations and subsidiaries, and the ownership and attribution rules for foreign stock owned through partnerships. As is often the case, these proposed regulations brought with them the advent of a slew of new terms and definitions.
In addition to the general rules, the proposed regulations also included rules applicable specifically to the insurance industry. The proposed regulations offered guidance on the insurance exception to the PFIC rules, creating the need for a fresh analysis of global insurance operations with minority US owners. The insurance exception rules are in addition to the insurance exception rules applicable to foreign majority US-owned insurance businesses treated as CFCs.
The proposed regulations also changed the rules used in determining PFIC status, and the asset and income tests, as well as a useful exception, the change of business exception. Taken together, the proposed PFIC regulations are a significant set of rules that create new opportunities, but also leave ambiguity, especially where the dust is still settling on new legislation under the TCJA.
With the global economy bullish and equity values at an all-time high, 2020 will open amid likely near record high cross-border investment activity. Much of this activity will be through private equity and venture capital, with new investment vehicles being organized every day. A core component of this landscape will be US offshore investment through partnerships holding foreign entities classified as corporations for US tax purposes. Many, if not most, of these foreign entities will be PFICs or will at least implicate the PFIC rules. Investors and fund managers alike are well advised to take a fresh look at the PFIC rules under the proposed regulations and watch for final rules sometime in 2020.
Mitigation of Repeal of Rule Against Downward Attribution
The TCJA repealed one short sentence from the CFC ownership rules that produced upheaval through the first half of 2019. Prior to the TCJA, section 958(b)(4) prevented foreign company stock owned by a foreign person from being attributed to a US person to consider the US person the owner of the stock. Wary of inversion transactions, the TCJA repealed this rule with the aim of subjecting foreign entities held in inverted structures to the CFC rules. However, the law of unintended consequences dramatically itself in the new world of downward attribution.
Taxpayers with holdings through complex structures suddenly found themselves owning shares in CFCs that were never CFCs before. Problematically, these CFCs were controlled by non-US persons, leaving the US shareholders with potential filing obligations, but without the voting power necessary to obtain the records necessary to satisfy those obligations.
Fortunately, on October 1, 2019, Treasury and the IRS released proposed regulations limiting application of the Downward Attribution Rules under various provisions of the Code, which were impacted by the repeal of section 958(b)(4) as part of the 2017 tax reform legislation, along with a revenue procedure that provides safe harbors for complying with provisions relevant to controlled foreign corporations (CFCs) in light of the Downward Attribution Rules. The proposed regulations directly address certain unintended consequences caused by application of the Downward Attribution Rules and provide that such rules are disregarded for purposes of determining CFC status and US shareholder determination under certain provisions of the Code.
Rev. Proc. 2019-40 provides targeted relief related to the repeal of section 958(b)(4) to certain United States persons that own stock in certain foreign corporations, including providing for the following safe harbors, penalty relief, and modifications to filing requirements:
- Provides a safe harbor for determining whether a foreign corporation is a CFC within the meaning of section 957.
- Provides a safe harbor for determining certain items, including taxable income and earnings and profits (“E&P”), of a CFC based on alternative information.
- Provides a safe harbor for determining certain items of a specified foreign corporation within the meaning of section 965 based on alternative information.
- Provides relief from accuracy-related penalties and penalties related to the failure to furnish information on Form 5471.
- Provides modifications to be made with respect to filing requirements for Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations.
Unless otherwise provided in future guidance, taxpayers may apply and rely on this revenue procedure with respect to the last taxable year of a foreign corporation beginning before January 1, 2018, and each subsequent taxable year of such foreign corporation, and with respect to the taxable years of United States shareholders in which or with which such taxable years of such foreign corporation end.
Many US persons treated as US Shareholders based on downward attribution filed their tax returns before the proposed regulations and revenue procedure were released. These taxpayers may have filed “protective” filings for foreign entities they did not control. Some may have simply not filed with respect to the foreign corporations, risking assessment if CFC status is determined in the future. Going forward, these taxpayers may benefit from the relief provided in this revenue procedure with respect to foreign-controlled CFCs.
Investment in US Property and the Participation Exemption
On May 22, 2019, Treasury and IRS released final regulations under section 956 that affect certain domestic corporations (i.e., corporate US shareholders) that own (or are treated as owning) stock in controlled foreign corporations. Consistent with the proposed regulations released in November 2018, these final regulations would generally reduce a corporate US shareholder’s Section 956 amount with respect to a CFC by the section 245A deduction that would be allowed if the US shareholder received a dividend from the CFC (the “hypothetical distribution”).
In addition, the final regulations revise the ordering rules under section 959(c) for purposes of attributing the hypothetical distribution first to E&P described in section 959(c)(2), then to E&P described in section 959(c)(3). The final regulations also extend application of these rules to domestic partnerships with corporate US shareholders.
The final regulations apply to a CFC’s tax years beginning on or after July 22 2019; however, taxpayers may apply the final regulations to tax years beginning after December 31 2017, provided that the taxpayer and its related US persons consistently apply the final regulations across all CFCs in which they are US shareholders for taxable years of the CFCs beginning after December 31, 2017.
The IRS has paid a lot of attention to the functioning of the participation exemption. The IRS acted quickly to address perceived abuses and then to reverse the disincentive to US investment transactions. Going forward, corporate taxpayers should be able to apply some traditional planning to their use of previously untaxed E&P.
In general, under section 245A and the final 956 regulations, respectively, neither an actual foreign-sourced dividend to a corporate US shareholder, nor such a shareholder’s tentative section 956 amount (i.e., corporate US shareholder of CFCs with investments in US property), will result in additional US tax. However, these regulations do not apply to taxpayers who are not domestic corporations. Therefore, individual and non-corporate entities that are US shareholders in CFCs may still be subject to US tax on foreign dividends received as well as potential income inclusion under section 956.
New and Revised Tax Forms
Many new and heavily revised tax forms were released by the IRS in 2019.
Forms 5471 and 8858, used to report CFCs and foreign branches, respectively, were heavily revised. The Form 5471 doubled from 8 pages to 16 pages. Form 8992 is a new form required by taxpayers that are US shareholders of CFCs and is used to report a summary of GILTI income from the CFCs that the taxpayer owns. New Form 8993 is also required for CFC owners that calculate a GILTI deduction and US business owners calculating a FDII deduction.
Although most of the calculations and inclusions under the repatriation tax, section 965, have been completed, some are being paid in installments and some are being deferred. The IRS finally published forms used to report the 2017 transition tax in 2018 and future tax years. Form 965 goes through the same calculation taxpayers carried out in filing their section 965 tax statements with their 2017 tax returns but requires significantly more information to fill out its eight schedules and two sub-forms.
Key international provisions of the TCJA required the development of new tax forms and instructions as well as significant revisions to existing tax forms that increased the reporting burden for affected taxpayers. Further, the Large Business and International (LB&I) division of the IRS encountered significant challenges related to the processing of certain electronically filed tax returns for 2018. Taxpayers are strongly encouraged to review the revisions to tax forms and instructions, as well as implementation changes to tax preparation software, especially in light of recently issued final regulations and ongoing issuance of additional guidance.
Taxpayers should take steps now to plan for how to obtain and track additional information required to be reported on the revised and/or new US foreign information reporting forms. In particular, taxpayers should consider application and interplay of reporting requirements with respect to partnerships and their partners under the GILTI and PFIC regimes (see discussion under the GILTI section above), as well as, potential application of safe harbor relief and/or alternative information afforded under the recently released revenue procedure with respect to foreign-controlled CFCs (see discussion under the Mitigation of Repeal of Rule Against Downward Attribution section above).
2019-2020 Priority Guidance Plan: Summary of Guidance, Released Through September 30, 2019, on Implementing Key International Tax Provisions of the Tax Acts and Jobs Act (TCJA)
Each year, the Treasury Department’s Office of Tax Policy and the IRS release the Guidance Priority List to identify and prioritize the tax issues that should be addressed through regulations, revenue rulings, revenue procedures, notices, and other published administrative guidance. This plan focuses resources on guidance items that are most important to taxpayers and tax administration.
On October 8, 2019, Treasury and the IRS released the 2019-2020 Priority Guidance Plan. This plan continues to prioritize implementation of the TCJA and is based on public input from solicited comments as well as Treasury and the IRS’s continued engagement with taxpayers since the enactment of the tax reform.
Below is a summary from the 2019-2020 Guidance Plan that includes key guidance that has been published and released through September 30, 2019 with respect to the implementation of certain international tax provisions under the TCJA. The list below also provides a summary of other key projects/guidance in the international tax area including Subpart F and sourcing and expense allocation.
- Final regulations and other guidance under §59A concerning the base-erosion and anti-abuse tax. Proposed regulations were published on December 21, 2018.
- Final regulations and other guidance concerning the participation exemption system for the taxation of foreign source income under §§245A, 1248(j) and (k), and 91. Temporary and proposed regulations were published on June 18, 2019.
- Final regulations and other guidance under §250 regarding the deduction for foreign derived intangible income and global intangible low-taxed income. Proposed regulations were published on March 6, 2019.
- Final regulations and other guidance under §267A addressing certain related- party amounts paid or accrued in hybrid transactions or by or to hybrid entities. Proposed regulations were published on December 28, 2018.
- Regulations under §§863(b) and 865(e)(2) regarding the source of sales of personal property.
- Final regulations under §§864(c)(8) and 1446(f) on the treatment of gain or loss of foreign persons from the sale or exchange of an interest in a partnership engaged in a trade or business within the US. Proposed regulations under §864(c)(8) were published on December 27, 2018. Proposed regulations under §1446(f) were published on May 13, 2019.
- Final regulations and other guidance on certain foreign tax credit issues arising under the TCJA under §§901 and 960, and related provisions, including §§78, 861, 904, and 905. Proposed regulations were published on December 7, 2018.
- Regulations under §861, including on the character and source of income arising in transactions involving intellectual property and the provision of digital goods and services.
- Final regulations and other guidance under §951A regarding the inclusion of global intangible low-taxed income by United States shareholders. Proposed regulations were published on June 21, 2019 and Notice 2019-46 on September 9, 2019.
- Regulations and other guidance addressing modifications to subpart F, including coordination with the enactment of §951A, the repeal of §958(b)(4) and the modification of § 951(b). Proposed regulations were published on June 21, 2019.
- Regulations under §§959 and 961 concerning previously taxed earnings and profits under subpart F. Notice 2019-01 was published on January 7, 2019.
- Final regulations under §954 concerning the definition of related person and the active rents exception to foreign personal holding company income. Proposed regulations were published on May 20, 2019.
The above list provides a summary of some of the key highlights from the 2019-2020 Guidance Plan, including guidance that has been published and released through September 30, 2019. Taxpayers are encouraged to work with their advisors to monitor and assess the effect of future guidance to be released by Treasury and the IRS.
Although tax planning occurs throughout the year, as we move towards the end of 2019 and into 2020, now is an opportune time to review your tax situation and make adjustments accordingly.
Because the different areas of tax law are often interconnected, it is important to take into consideration the direct and indirect implications of tax strategies. Your advisors at Mazars USA LLP have expertise across the many disciplines of tax law and are available to help you refine your approach, learn more about the strategies mentioned, and meet your objectives.