Reducing the high U.S. corporate tax rate was a key driver for enacting the Tax Cuts and Jobs Act (TCJA), Public Law 115-97. The most significant change is the reduction in the corporate tax rate to 21% from 35% and changing the U.S. international tax system to a territorial model. These reforms increase the U.S.’s competitive position by switching the U.S. corporate tax rate from close to the highest in the industrialized world to a rate below the worldwide average.
The new rate took effect on January 1, 2018, so corporations need to act quickly to bring their business practices in line with the new corporate tax regime. The corporate rate reduction is permanent, unlike the individual rate reductions, which expire in 10 years. Some other business changes such as increased expensing limits, however, will expire within the next few years.
A complete description of the bill is contained in the 708-page official Conference Report. We have described the major corporate provisions below, along with a discussion of other key business provisions.
An analysis of the changes for other types of businesses, including passthroughs (partnerships, LLCs, and S Corporations) is available in FD Insights.
Highlights and Implications
The immediate reduction in the corporate tax rate will put the U.S. on a more competitive footing in the global business market. The new rate of 21% is slightly below the worldwide average of approximately 22.96%. The lower rate also reduces the tax burden of operating in the corporate form, making it a more attractive option in business formations.
The immediate 100% bonus depreciation for business assets will reduce the cost of capital investment, but this benefit starts phasing down after five years. Companies will need to reconsider their investment plans to capture these early year tax benefits. Used property now is eligible for bonus depreciation, so the market for used business assets may get a boost.
Net Operating Losses
Companies in a loss position will benefit less from net operating loss (NOL) deductions going forward. NOLs can no longer be carried back, and they can offset only 80% of tax liability when carried forward. This change only applies to NOLs incurred after 2017, so companies will need to track pre-2018 and 2018-forward NOLs separately.
Limitation on Deductible Interest
The new 30% corporate interest deduction limit on adjusted taxable income will increase the after-tax cost of interest expense, except for small businesses, which are exempt, and real estate companies, that can elect out of the interest limitation. If a real estate company opts out of the interest limitation, it will be required to depreciate its buildings and improvements over a longer period and also will not be able to claim the 100% bonus depreciation on an expanded class of building improvements.
Business entertainment deductions are curtailed. Tickets to sporting events, concerts, and golf club dues to entertain clients are no longer deductible at all.
Key Corporate Provisions (see International and Compensation/Benefits below)
|Corporate Tax Rate||Reduced from 35% to 21%, effective in 2018.
The 21% is a flat rate with no brackets.
|Dividends Received Deduction||The corporate dividends received deduction is reduced from 70% to 50% and
from 80% to 65% for dividends received from corporations 20% or more owned by the dividend recipient.
|Interest Deduction||The TCJA limits the corporate net interest deduction to 30% of adjusted taxable income. The exact calculation is more involved. The deduction for any tax year cannot exceed the sum of:
(1) the taxpayer’s interest income;
(2) 30% of the taxpayer’s adjusted taxable income;
(3) the taxpayer’s floor plan financing interest.
Example: Corporation XYZ has $100,000 in adjusted taxable income, $4,000 of interest income, and $10,000 of business interest expense. The Corporation would be able to deduct all of the $10,000 in business interest expense because it is less than the limitation of $34,000, calculated as 30% of its adjusted taxable income of $100,000 ($30,000) plus the $4,000 in interest income.
Floor Plan Interest: Floor plan financing refers to the interest incurred on floor inventory, such as car dealer’s costs for automobiles. This type of interest is exempt from the interest cap and remains fully deductible.
Any business interest that is not deductible because of the interest limitation may be carried forward indefinitely. This benefits taxpayers who have low taxable income for a year and, as a result, have a very low interest deduction limit.
Adjusted Taxable Income: For tax years 2018-2021, adjusted taxable income is calculated by adding back deductions for depreciation, amortization, and depletion. After that, these amounts are not added back. The effect of this change is to increase the business interest deductible in the first four years.
Small Business Exemption: Taxpayers with average annual gross receipts of $25 million or less for the three previous years are not subject to the interest limitation.
Real Estate Exception: A real property trade or business can elect out of the limitation, but if it does, it must use the ADS slower depreciation system. This exception applies to any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Farming Election: Farming businesses can elect out of the net interest limitation.
|Net Operating Losses||The new Act restricts net operating loss (NOL) deductions to 80% of taxable income starting in 2018. This means that NOLs can no longer completely offset taxable income.
Carryback of NOLs is no longer allowed, but they can be carried forward indefinitely. Farming losses can continue to be carried back two years, while property and casualty insurance losses keep the old rules, with a two-year carryback and a 20-year carry forward.
In 2018, a calendar-year taxpayer has a $95,000 NOL. In 2019, the taxpayer has taxable income of $100,000. The 2018 NOL can be carried forward to offset the 2019 income, but can only offset $80,000. The $15,000 unused NOL is carried forward.
|Corporate Alternative Minimum Tax (AMT)||The new law repeals the corporate AMT. Taxpayers with AMT credit carryforwards can claim a refund of 50% of the remaining credits in tax years beginning in 2018, 2019, and 2020. For a tax year beginning in 2021, taxpayers may claim their remaining AMT credits.|
|Depreciation and Capital Investment||100% Bonus Depreciation: The new law expands bonus depreciation by allowing a 100% write-off of business assets for five years, through 2022. This rule is retroactive to September 28, 2017, so assets placed in service from that date forward qualify.
Purchases of both new and used property qualify. Prior law only allowed bonus depreciation for purchases of new property.
Film, TV, and Live Theater: The new law allows 100% bonus depreciation for film, television and live theatrical productions. Productions are considered placed in service at the time of the initial release, broadcast, or live commercial performance.
Phase-down and Expiration: Beginning in 2023, bonus depreciation is reduced 20% each year to:
After 2026, bonus depreciation expires.
Longer Production Period Property: The phase-down and expiration of bonus depreciation for property with longer production periods is pushed out for another year, until after 2023 for the phase-down and after 2027 for the expiration.
Section 179 Expensing: The new law raises the expensing limit to $1 million of business assets, with a $2.5 million purchase limitation. The purchase limitation means that for every dollar a taxpayer spends over the purchase limit, the expensing deduction is reduced by one dollar. These higher expensing limits expire after five years.
Also, depreciable personal property used to furnish lodging such as beds, other furniture, stoves, and refrigerators is now eligible for Section 179 expensing.
Qualified Improvements Expanded: The Tax Cuts and Jobs Act allows a 15-year recovery period for an expanded class of property improvements. Prior law only allowed the 15-year write-off for leasehold and retail improvements and restaurant property.
Shorter recovery periods are now allowed for “qualified improvement property.” The improvement must be made to an interior part of a building and be placed in service after the date the building is first placed in service. Only nonresidential real property qualifies. Improvements such as roofs, ventilation, heating and air conditioning systems, fire protection, alarm systems, and security systems now qualify as 15-year property.
Expenses that do not qualify for the 15-year recovery period include expenses for enlargement of a building, an elevator or escalator, or the internal structural framework of the building.
The effect of this change is to make more types of building improvements qualified for both bonus depreciation and Section 179 expensing.
Qualified improvement property will have a 20-year recovery period going forward for taxpayers who use the slower alternative depreciation system.
Note: Congress actually left this provision out of the bill, but the tax committees have indicated it was an oversight that will be fixed in a forthcoming technical corrections bill.
Farm Property: A faster recovery period is allowed for some farming equipment, along with more accelerated deductions.
Real Estate Depreciation and the Interest Deduction: The TCJA shortens the write-off period for residential property under the alternative depreciation system (ADS) from 39 years to 30 years. Nonresidential property remains at 40 years. The ADS depreciation system requires use of the straight-line method over a longer life.
Under the new law, the ADS system is required if a real estate business opts out of the new 30% interest expense limitation (see above).
|Computers and Peripheral Equipment||The Act removes computers and peripheral equipment from the “listed property” designation.
Listed property has reduced tax benefits and stricter substantiation requirements because of the potential for personal use. This change makes it easier to prove a taxpayer’s entitlement to a business deduction for computer equipment.
|Cash Accounting Method||Use of the cash accounting method is expanded for small businesses. The Act increases the limitation for cash accounting from $5 million in gross receipts to $25 million. Gross receipts are calculated using an average for the business’ past 3 years.|
|Like-Kind Exchanges||The new Act abolishes like-kind exchange treatment for personal property but retains it for real property.|
|Research and Experimental Expenditures||Beginning in 2022, taxpayers may no longer choose to expense research and experimentation costs but instead must capitalize and amortize them over five years.|
|Section 199 Domestic Production Deduction||The Act repeals the Sec. 199 domestic production deduction, effective in 2018.|
|Orphan Drug Credit||The Act modifies and reduces the business tax credit for clinical testing expenses for orphan drugs, which are drugs for rare diseases or conditions. The credit is reduced from 50% to 25% of clinical testing expenses for tax years beginning in 2018.|
|Other Business Credits and Deductions
|The Act modifies the rehabilitation credit to eliminate the 10% credit for pre-1936 buildings and to require that the 20% credit for certified historic structures be taken over five years instead of allowing the full credit in the year the building is placed in service, as under prior law.
The TCJA retains many special tax breaks, including the R&D credit and the low-income housing credit.
|Key International Provisions|
|International Taxation and Deemed Repatriation
|Participation Exemption: The new tax law moves the U.S. to a modified territorial system of international taxation. Multinational corporations that own 10% or more of a foreign corporation would receive a 100% exemption on the foreign-sourced dividends paid by the foreign corporation to the U.S. shareholder.
Deemed Repatriation of Offshore Profits: As a transition to the lower corporate tax rate and the territorial tax system, profits now held offshore will face a one-time tax of 15.5% for liquid assets and 8% for illiquid assets. The tax may be paid over an 8-year period, with 8% paid in each of the first five years, 15% in the 6th year, 20% in the 7th year, and 25% in the 8th year.
Base Erosion Minimum Tax: The new law includes a base erosion minimum tax calculated as the excess of (a) 10% of the taxpayer’s “modified taxable income” over (b) the taxpayer’s regular tax liability reduced by credits allowed. This “Base Erosion Anti-Abuse Tax (BEAT)” applies to corporations (1) with average annual gross receipts of $500 million or more for the past three years and (2) that made deductible payments to foreign affiliates that are at least 3% of the corporation’s total deductions for the year.
Global Intangible Low-taxed Income (GILTI): The new law makes shareholders of a controlled foreign corporation (CFC) subject to current U.S. tax on GILTI. GILTI is the excess of CFC net income over 10% of its share of depreciable tangible property basis and interest. Corporations may deduct 50% of GILTI. After 2025, 62.5% of GILTI will be taxed.
Given the 21% corporate tax rate, the effective tax rate on GILTI is an effective 10.5% minimum tax (13.125% after 2025), after foreign tax credits. No residual U.S. tax if the foreign tax rate equals or exceeds 13.125% (16.406% after 2025). Certain U.S. individual shareholders of a CFC will be subject to tax on GILTI at regular individual marginal rates (up to 37%).
Foreign Derived Intangible Income (FDII): For tax years 2018-2025 U.S. corporations are allowed a deduction of 37.5% of FDII, which is reduced to 21.875% after 2025. Taking into account the 21% corporate income tax rate, the effective tax rate is 13.125% for income earned from sales, leases, licenses or services provided by a U.S. person to an unrelated foreign person. The rate increases beginning in 2026.
|Key Provisions: Compensation & Benefits|
|Executive Compensation Deduction||The TCJA changes the rules for the $1 million deduction limit for compensation paid to officers of large publicly held corporations in several ways. First, the deduction limit applies to the five top employees, including the principal executive officer (PEO), the principal financial officer (PFO), and the three other highest paid employees.
Any person who holds the position of PEO or PFO at any time during the tax year is a covered employee subject to the limitations as are former officers who still receive compensation. Once an employee is a covered person for a tax year beginning after 2016, the employee remains subject to the limit for all future years.
The most far-reaching change is that the new Act removes the exemption for commissions and performance-based compensation, so corporations will lose their business expense deduction for these types of remuneration. Going forward, stock options, cash bonuses, and some types of deferred compensation will not be deductible by corporations.
Example: In 2018, Corporation XYZ, a publicly held corporation, pays its principal executive officer a salary of $800,000 and a bonus of $3 million. XYZ can deduct a total of $1 million of the compensation, but the $2.8 million balance is nondeductible.
Finally, the deduction limit is extended to foreign companies publicly traded through American depositary receipts (ADRs) and to companies that are required to file SEC reports due to public debt, such as many private equity firms.
Effective Date: The new rules do not apply to compensation that is provided under a written binding contract that was in effect on November 2, 2017, if the contract is not modified in any material way on or after that date.
|Passenger Auto Depreciation Limits and
|The deduction limitations on passenger automobiles are significantly increased from approximately $5,000 per year under current law to:
If bonus depreciation is also claimed, another $8,000 would be deductible in the first year.
These changes significantly increase the write-off for luxury vehicles.
The Act also extended the placed in service deadline to December 31, 2016 for the $8,000 additional bonus depreciation amount for passenger automobiles, trucks, and vans.
Going forward, the $25,000 heavy SUV expensing limitation will be indexed for inflation.
|Meals and Entertainment Deductions
|The new law repeals the deduction for business entertainment expenses. Deductions also are no longer allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes, or facilities used for entertainment.
Business meals are still deductible; however, the new law reduces the deduction for employer-operated eating facilities to 50% and repeals it completely in 2026.