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Updated: 5 hours 27 min ago

Treasury Suspends Withholding Requirements on Disposition of Certain Publicly Traded Partnership Interests

Wed, 01/17/2018 - 12:00am
Summary On January 2, 2018, the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”) issued Notice 2018-8 (the “Notice”).  In the Notice, Treasury announced the suspension of the application of new Section 1446(f) in the case of a disposition of certain publicly traded partnership interests. New section 1446(f) was added by Section 13501 of “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97 (the “Act”), which was enacted on December 22, 2017. Section 13501 of the Act also added new Section 864(c)(8).
  Details In general, Section 864(c)(8) provides that a nonresident alien individual’s or foreign corporation’s gain or loss from the sale, exchange, or other disposition of a partnership interest is effectively connected with the conduct of a trade or business in the United States to the extent that the person would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value. New section 864(c)(8) applies to sales, exchanges, or other dispositions occurring on or after November 27, 2017. New Section 864(c)(3) essentially overrides the holding in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Comm’r.[1] For a discussion of the Tax Court’s holding in Grecian, see our July Tax Alert and see Revenue Ruling 91-32, 1991-1 C.B. 107, for the IRS’s position with respect to sales, exchanges or other dispositions of an interest in a partnership occurring before November 27, 2017.
 
In general, new Section 1446(f)(1) provides that if any portion of the gain on any disposition of an interest in a partnership would be treated under new Section 864(c)(8) as effectively connected with the conduct of a trade or business within the United States, then the transferee must withhold a tax equal to 10 percent of the amount realized on the disposition. Under an exception in new Section 1446(f)(2), however, withholding is generally not required if the transferor furnishes an affidavit to the transferee stating, among other things, that the transferor is not a foreign person.
 
New Section 1446(f)(6) authorizes the Secretary to issue such regulations or other guidance as may be necessary to carry out the purposes of new Section 1446(f), including regulations providing for exceptions from the provisions of new  Section 1446(f). Furthermore, new Section 1446(g) authorizes regulations that are necessary to carry out the purposes of new Section 1446 generally, including regulations providing for the application of new Section 1446 in the case of publicly traded partnerships. New Section 1446(f) applies to sales, exchanges, or other dispositions occurring after December 31, 2017.
 
Given certain practical concerns raised by stakeholders in publicly traded partnerships, and to allow for an orderly implementation of the requirements of new Section 1446(f), the Notice states that withholding under new Section 1446(f) is not required with respect to any disposition of an interest in a publicly traded partnership (within the meaning of Section 7704(b)) until regulations or other guidance have been issued under new Section 1446(f). This temporary suspension is limited to dispositions of interests that are publicly traded and does not extend to non-publicly traded interests.
 
The Notice also states that Treasury intends to issue future regulations or other guidance on how to withhold, deposit, and report the tax withheld under new Section 1446(f) with respect to a disposition of an interest in a publicly traded partnership. The Notice further provides that guidance under Section 1446(f) with respect to a disposition of an interest in a publicly traded partnership will be prospective and will include transition rules to allow sufficient time to prepare systems and processes for compliance.
 
The rules suspending withholding under new Section 1446(f) does not extend to new Section 864(c)(8), which remains applicable. Lastly, in the Notice, Treasury also requested comments on the rules to be issued under new Section 1446(f).
  BDO Insights The temporary suspension of the application of Section 1446(f) to dispositions of certain publicly traded partnership interests should provide relief for withholding agents facing practical difficulties in determining whether to withhold under new Section 1446(f) on dispositions of certain publicly traded partnership interests.  
For more information, please contact one of the following practice leaders:
  Joe Calianno
Partner and International Tax Technical Practice Leader
National Tax Office       Monika Loving
International Tax Practice Leader   Natallia Shapel
Partner    Annie Lee
Partner   Chip Morgan
Partner   Robert Pedersen
Partner   William F. Roth III
Partner
National Tax Office   Jerry Seade
Principal   Sean Dokko
Senior Manager
National Tax Office   [1] 149 T.C. No. 3 (2017)

State and Local Tax Issues Presented By Federal Tax Reform

Wed, 01/17/2018 - 12:00am
Summary The Conference Report to H.R. 1, the “Tax Cuts and Jobs Act” (the “Act”), which was agreed to by House and Senate conferees on December 15, 2017, passed the Senate on December 19, 2017, and passed the House on December 20, 2017.  The Act enacts the most sweeping federal tax reform since 1986.  President Trump signed the bill into law on December 22, 2017.  This Alert discusses some of the state and local tax issues that could be presented by key features of the Act.  For BDO’s Alert that provides a comprehensive review of all the major provisions contained in the Act, please click here.
  Details Background
For corporate income tax purposes, most states will begin the calculation of state taxable income with either “line 28” or “line 30” federal taxable income.  To this federal taxable income starting point, states provide various addition and subtraction modifications applicable to particular income, gain, loss, and deduction items that enter into the calculation of federal taxable income.  However, in addition to federal taxable income either before (“line 28”) or after (“line 30”) net operating losses and special deductions, the federal taxable income starting point may mean different things in different states depending on the method of state conformity to the Internal Revenue Code (the “IRC”).
 
For example, a state may adopt “rolling” conformity, which means it will adopt a definition of federal taxable income (as well as addition and subtraction modifications) on the basis of the IRC “as amended.”  Such states could automatically conform to the federal tax reform changes contained in the Act unless they enact legislation to expressly decouple from the particular aspects of the Act (most of which will be effective for taxable years beginning after December 31, 2017).  Other states conform to the IRC on a “fixed date” basis.  For example, if a state’s definition of federal taxable income (as well as addition and subtraction modifications) is to the IRC “in effect on” or “as amended through” December 31, 2016, that state will not conform to any of the federal tax reform changes in the Act unless or until the state updates its conformity date or enacts specific legislation adopting a federal change.  Other states only adopt or conform to specific IRC sections on a rolling or fixed date conformity basis.  For example, California adopts specific IRC sections only and they are such sections “as amended through” January 1, 2015.  Some states simply start the calculation of state taxable income with federal taxable income without any IRC reference.  A few states provide their own definition of taxable income or “net income.” 
 
Whether any change in the Act will have an impact on a state corporate income taxpayer will initially be determined on the basis in which the states, where the taxpayer does business and has a corporate income tax return filing obligation, conform to the IRC.  Similarly, the Act’s affect on individuals, pass-through entities, and other business entities begins with a state’s method of IRC conformity.
 
Corporate Rate Reduction
Effective for taxable years beginning after December 31, 2017, the federal corporate rate is reduced to 21 percent from 35 percent.  Since state taxes and rates are not a percentage of the federal rate, the federal corporate rate reduction has no direct impact on state rates.  Nonetheless, with such a substantial federal rate reduction, state corporate income tax will proportionally be a more significant part of a company’s overall effective tax rate.  The effect could be magnified to the extent states adopt a number of the federal base-broadening measures contained in the Act.  As a result, the state effective tax rate, utilization of state tax credits, and possibly tax planning will likely demand increased attention.  In addition, with the federal corporate rate reduction, a company’s state tax deferred positions will be materially impacted since its state tax deferred balances are recorded after-federal tax effect.  
 
Expensing Provisions
A number of states decoupled from federal bonus depreciation under prior law or provided a modified state-only bonus depreciation calculation.  Likewise, many states limited or did not conform to IRC § 179.  It is unlikely that such states will conform to the new federal fully expensing capital expenditure regime,  but a state’s conformity to or modification of IRC § 168(k)(1)(A) will need to beevaluated.  Further, depending on the wording of a state’s statute decoupling from prior law, since full expensing will enter into the calculation of a federal taxable income starting point, a state may need to enact legislation in 2018 to further decouple from federal full expensing.  As a result, state legislative responses to amended IRC § 168(k)(1)(A) during their 2018 legislative sessions will need monitoring. 
 
Net Operating Loss (NOL) Deduction Limitation
The Act amends IRC § 172 to limit the NOL deduction to 80 percent of taxable income (determined without regard to the NOL deduction) for losses arising in taxable years beginning after December 31, 2017.  The Act eliminates NOL carrybacks, but permits NOLs to be carried forward indefinitely.  While most states could be assumed to adopt most of the base-broadening measures in the Act, a number of states provide their own NOL deduction, as well as their own limitations.  Thus, states may not be impacted by this federal change.  However, states without NOL limitations of their own may be encouraged to adopt new IRC § 172 or similar NOL limitations.  For the handful of states that currently allow NOL carrybacks, amended IRC § 172 could also encourage them to eliminate their NOL carryback as well.  And, it is unlikely that states will adopt the new federal indefinite NOL carryforward provision.  It is anticipated that there will continue to be inconsistency between federal and state NOLs, which will create additional complexity for corporate taxpayers.
 
Revised Treatment of Contributions to Capital
One of the most far-reaching and negative changes in the Act (for states, localities, and taxpayers alike) is amended IRC § 118.  Under prior law and the Act, contributions to capital of a corporation are not included in the corporation’s gross income.  However, under the Act’s amendment to section 118, a “contribution to capital” does not include (1) any contribution in aid of construction or any other contribution as a customer or potential customer, or (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
 
Tax incentives, including grants and reimbursements by state and/or local governments to businesses that promote economic development in the state, may be non-shareholder contributions to capital under Detroit Edison Co., 319 U.S. 98 (1943), Chicago, Burlington, & Quincy R.R. Co., 412 U.S. 401 (1973), and other cases.  After the Act’s amendment of IRC § 118, such tax incentives are includible in gross income.  The amendment is effective for contributions made after the date of enactment, but does not apply to contributions made by a governmental entity after the date of enactment pursuant to a master development plan that was approved prior to the date of enactment.  As a result, state and local incentives, grants, and reimbursements after December 22, 2017, will have to be evaluated to determine if there are included in federal gross income.  While it would seem unlikely that a state would conform to amended IRC § 118, as that runs counter to a state’s economic development programs, a state would likely have to decouple from this new federal provision.  However, if a state only decouples with respect to its incentives, grants, and reimbursements, this could discriminate against interstate commerce by arguably favoring in-state incentives over out-of-state incentives.
 
Business Interest Deduction Limitation
The Act amended the IRC § 163(j) net business interest deduction limitation to (1) change the limitation to 30 percent of “adjusted taxable income”, (2) apply the limitation to related and unrelated party debt (as well as existing debt), and (3) added an indefinite carryforward provision for excess net interest expense subject to limitation in a taxable year.  Until 2022, “adjusted taxable income” will generally mean taxable income computed without regard to depreciation, amortization, or depletion.  Beginning in 2022, adjusted taxable income will generally mean income before interest and taxes.  Since the limitation will enter into the determination of federal taxable income, “rolling” conformity states will automatically conform unless such a state specifically decouples.  However, a “fixed-date” conformity state will not conform unless or until the state updates its IRC conformity date. 
 
Because the new limitation applies to unrelated and related party interest expenses, a state’s related party interest expense add-back statute could further disallow excess carryforward net interest expense at the state level.  In addition, it is uncertain whether states will conform to the indefinite carryforward period for excess interest expense, as well as whether states will require the apportionment of any excess interest expense.  Last, the determination of “adjusted taxable income” is done at the federal filer level (i.e., federal consolidated group, partnership, etc.)  Again, after determining their method of IRC conformity and whether specific state legislation is required, separate return states (and a number of combined reporting states) could require the determination of “adjusted taxable income” be made on a separate entity basis.  Moreover, the calculation of the amended IRC § 163(j) net business interest expense limitation at the filer or entity level for federal purposes could add another level of complexity (and increased tax cost) for pass-through entities in states that tax pass-through entities at the entity level.  The interaction of amended IRC § 163(j) between the federal level and state level is likely to increase complexity for state compliance.   
 
Deduction for Qualified Business Income
While the state and local tax deduction got most of the press coverage, one of the most pressing state personal income tax issues presented by the Act is whether states will conform to the deduction for qualified business income (QBI) from pass-through entities and sole proprietorships.  Subject to certain thresholds and limitations, for taxable years beginning after December 31, 2017, individual taxpayers will be allowed to deduct 20 percent of QBI passed through from partnerships, limited liability companies taxed as partnerships, S corporations, and sole proprietorships (as well as qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.) 
 
The Conference Report clarifies, however, that the deduction is not allowed in computing adjusted gross income.  Rather, it is a below-the-line deduction reducing federal taxable income.  This is a key distinction for state personal income tax purposes.  While most states begin the calculation of state taxable income of a corporation with federal taxable income, however defined, most states begin the calculation for individuals with federal adjusted gross income.  As a result, even for “rolling” conformity states, the federal deduction for QBI may not enter into the calculation of an individual’s state taxable income unless a state decides to amend its statute to allow the deduction.  For the handful of states that do start the calculation with an individual’s federal taxable income, the QBI deduction will apply only to “rolling” conformity states, unless they decouple, and only for fixed-dated conformity states after they update their conformity (assuming they do not also decouple.)  If the QBI deduction does apply in a state, other questions could be presented, such as whether a resident or non-resident state will subject the deduction to apportionment, whether the deduction could affect withholding tax calculations, and whether the deduction enters into a pass-through entity’s composite return calculation of income of non-resident investors.  For the handful of states that tax pass-through entities at the entity level, the federal QBI deduction may not reduce entity level income or earnings for state tax purposes 
 
Federal Change to a “Territorial/Dividend-Exemption” System
There are a number of complex new federal international tax provisions enacted as part of the Act for which state conformity evaluations will be required, including for impact on apportionment calculations and possibly water’s-edge unitary combined reporting purposes.  This Alert focuses on only three:  (1) the new federal dividends received deduction (DRD); (2) the deemed repatriation transition tax; and (3) the Global Intangible Low-Taxed Income tax. 
 
The Act adopts a new IRC § 245A that will provide a 100 percent DRD for the foreign source portion of dividends received by a domestic corporation that is a 10 percent shareholder in a distributing foreign corporation.  After the U.S. Supreme Court’s decision in Kraft General Foods, Inc. v. Iowa Dept. of Revenue and Finance, 505 U.S. 71 (1992), so-called separate return states are required to provide a DRD for foreign source dividends equivalent to any DRD provided for dividends received from domestic U.S. corporations.  Failure to do so constitutes discrimination by a state against foreign commerce in violation of the foreign Commerce Clause of the U.S. Constitution.  Separate return states that already provide a full DRD for foreign source dividends may see no need to adopt IRC § 245A.  A failure to do so by such states may lead to federal/state stock basis differences (see below).  However, in an odd twist, some of these separate return state foreign source DRDs may be operative on the inclusion of such foreign source dividends in federal taxable income.  As a result, such states will be required to amend their foreign source DRDs, as the foreign source dividend will no longer be included in federal taxable income.
 
Based on footnote 23 in the Court’s Kraft decision and the mechanics of state “water’s-edge” unitary combined reporting systems, such states are not required to provide a similar DRD for foreign source dividends and a number do not.  While separate return states likely will, and are required to, conform to new IRC § 245A, water’s-edge combined reporting states may not conform or may only provide a partial DRD for foreign source dividends.  Again, for those combined reporting states that provide a whole or partial foreign source DRD, such DRD may be operative only if the dividends were included in federal taxable income.
 
As a result, U.S. corporate taxpayers receiving foreign source dividends that will be deductible under new IRC § 245A will need to address (a) whether such dividends are deductible from or includible in state taxable income for state purposes, (b) if, or to the extent, includible, whether such dividends should be treated as business or nonbusiness income under state rules and case law, and (c) if treated as business income whether the dividends are included in the sales factor of the apportionment formula and, if so, the sourcing of the dividends.  For states that conform to new IRC § 245A or that already provide a full or partial DRD for foreign source dividends, corporate taxpayers will still need to determine whether any expenses directly or indirectly related to the deductible dividend income are disallowed as deductions for state purposes. 
 
In addition, several water’s-edge combined reporting states will include the income and apportionment factors of certain foreign corporations in the state’s combined report.  These may include foreign “tax haven” corporations, foreign corporations that have a certain amount of apportionment factors assigned to U.S. locations (e.g., 20 percent or more), or controlled foreign corporations with Subpart F income.  With the federal move to a territorial system while some states retain their existing “water’s-edge” combined reporting systems, there will undoubtedly be increased complexity in tax reporting for U.S. based multinationals. 
 
Further, solely for purposes of determining loss on the disposition of stock in a 10-percent owned foreign corporation, a U.S. corporate shareholder is required to reduce its basis in its foreign corporation stock in an amount equal to the IRC § 245A DRD.  As noted, if a separate return state believes there is no need to adopt IRC § 245A because it already provides a full foreign source DRD, then federal and state stock basis will likely be different.  Likewise, water’s-edge combined reporting states that have not conformed to IRC § 245A, and are not compelled by Kraft to do so, may also present federal and state stock basis differences. 
 
A question that could arise, however, is whether Kraft prohibits separate return states from conforming to the federal foreign corporation stock basis adjustment when stock basis in a similarly situated U.S. corporation is not reduced for a state DRD. 
 
Deemed Repatriation Transition Tax
The Act enacts a transition tax that generally requires U.S. shareholders of “specified foreign corporations” (as specifically defined in IRC § 965(e)) to increase Subpart F income, as otherwise determined under IRC § 952, and include in federal taxable income under IRC § 951(a)(1)(A) their pro rata shares of such foreign corporation’s accumulated post-1986 foreign earnings.  The transition tax is imposed at rates of 15.5 percent on foreign earnings held in cash or cash equivalents and eight percent on all other foreign earnings.  Because the deemed repatriation amount is included as Subpart F income under IRC § 951(a)(1)(A), it will be necessary to address how a state currently treats such Subpart F income.  However, the individual mechanics of calculating the deemed repatriation transition tax must be individually understood from a state perspective.
 
In brief, under new IRC § 965(a), a “U.S. shareholder” first increases its federal gross income under IRC § 951 equal to its share of deferred foreign income of a specified foreign corporation or “deferred foreign income corporation” (“DFIC”).  The “inclusion amount” is treated as an increase to Subpart F income under IRC § 952 and included in federal taxable income of the shareholder under IRC §951.  Next, to arrive at the effective 15.5 percent or eight percent tax rates, the shareholder is allowed a deduction under new IRC § 965(c) based on a calculation referenced to the shareholder’s aggregate foreign cash position equal to an amount that results in an effective tax rate of 15.5 percent on foreign earnings held in cash or cash equivalents and/or eight percent on foreign earnings held in other property.  Lastly, the shareholder may elect to pay the transition tax currently or in eight equal annual installments.
 
The “inclusion year” for the deemed repatriation amount that is included in a U.S. shareholder’s Subpart F income is the last taxable year of a DFIC that begins before January 1, 2018.  The Subpart F income of the corporation is increased by the greater of (1) the accumulated post-1986 deferred foreign income of the DFIC as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of the DFIC determined as of December 31, 2017.  Further, new IRC § 965 is effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders for taxable years in which or with which such taxable years of the foreign corporations end.  As a result, the inclusion year for the deemed repatriation is 2017 (although a U.S. shareholder could have an inclusion in more than one taxable year.)  Thus, a state’s method of conformity (“rolling,” “fixed-date,” or other) takes on added significance for determining whether, as an initial matter, the deemed repatriation could be included in state taxable income for a U.S. corporation’s 2017 state taxable year.  
 
Initially, after evaluating a state’s method of IRC conformity, taxpayers will need to evaluate how states treat Subpart F income for purposes of whether the deemed repatriation is included or excluded from state taxable income.  While most separate return and combined reporting states will exclude Subpart F income, some states may include all or a portion of Subpart F income in state taxable income.  For example, California includes the income and apportionment factors of a “controlled foreign corporation” in a water’s-edge combined report based on the ratio of the CFC’s total Subpart F income for the taxable year to the CFC’s current earnings.  Some other water’s-edge and separate return states will only exclude a portion of Subpart F income from state taxable income or treat Subpart F income as a foreign source dividend eligible for a less than 100 percent DRD.  Further, even if a state excludes all or a portion of Subpart F income, taxpayers will also need to evaluate whether the state disallows deductions for expenses directly or indirectly related to the excluded Subpart F income.
 
With regard to the deduction, taxpayers will need to evaluate state federal taxable income starting points (i.e., line 28 or line 30) and whether this IRC § 965 deduction is a special deduction or whether a state decouples from IRC § 965. 
 
If the deemed repatriation is included in state taxable income, it is unlikely that a state, without specific legislation allowing taxpayers to do so, will conform to the election permitting a taxpayer to pay the transition tax over eight annual installments.  Rather than being a deferral from inclusion in federal taxable income, the election defers the payment of a federal tax liability.
 
Finally, for federal tax purposes, a subsequent actual repatriation of DFIC earnings that were previously subject to transition tax are not subject to federal income tax, because the earnings are “PTI” under IRC § 959.  If a state previously excluded the deemed repatriation “inclusion amount” either based on its method of IRC conformity or based on a whole or partial Subpart F income exclusion, the actual distribution, wholly or partially, could be subject to state income tax (see discussion above regarding new IRC § 245A).
 
Global Intangible Low-Taxed Income
The Act also imposes another special tax on global intangible low-taxed income (GILTI).  Generally, the tax is at a 10.5 percent rate on a U.S. shareholder’s share of a CFC’s GILTI and, while similar to Subpart F income provisions, GILTI is “active” income, not Subpart F.  The amount of GILTI and corresponding federal tax is a complicated calculation, but generally impacts U.S. shareholders of CFC’s that have a heavy concentration of intangible assets compared to fixed/tangible assets (or high income relative to low depreciable assets.)  Like the deemed repatriation transition tax, GILTI is included in the U.S. shareholder’s federal taxable income under new IRC § 951A, and then a new deduction is provided under new IRC § 250 in an amount under a calculation that arrives at the 10.5 percent effective rate of tax on the GILTI.  Unlike the deemed repatriation transition tax, the GILTI tax is effective for taxable years beginning after December 31, 2017. 
 
For states that exclude Subpart F income and/or provide a foreign source DRD (or qualify Subpart F income for such DRD), it is uncertain whether the GILTI inclusion in federal taxable income would be deductible or excludible.  For example, if a state only excludes Subpart F income “as defined under IRC § 952” or included under IRC § 951, then GILTI could be included in the state tax base.  Further, it is uncertain whether GILTI would qualify as a foreign source dividend for state tax purposes.  Without the enactment of specific state legislation, it is uncertain whether existing state Subpart F or foreign source dividend exclusions apply to GILTI.  Similar state evaluations applicable to the deemed repatriation transition tax will need to be applied by taxpayers that are subject to the new GILTI tax.       
 
State and Local Tax Deduction
Effective for taxable years beginning after December 31, 2017, and before January 1, 2026, the only state and local taxes that will be deductible for an individual are those incurred in the carrying on of a trade or business, or in an activity described in IRC § 212.  Thus, only state and local taxes entered on an individual taxpayer’s Schedule C, Schedule E, or Schedule F will be eligible for a deduction under IRC § 164.  This also impacts owners of pass-through entities with respect to their state income taxes on distributive shares of income. 
 
The Act provides an exception for taxpayers that itemize deductions and allows the deduction of state and local property taxes and/or income taxes (or sales taxes in lieu thereof) that are not incurred in a trade or business, or in an activity related to the production of income, in the aggregate amount up to $10,000 ($5,000 for married filing separate). 
 
While the new federal “SALT cap” has no direct state impact, as states already add-back other state taxes to federal taxable income when determining state taxable income, it could encourage a number of different reactions on the part of states and individuals.  States could replace their pass-through entity tax structures with entity-level taxes, such as Tennessee and Texas have done for years.  Recent reports indicate that some states are considering charitable contribution funds that would allow taxpayers the option to contribute what otherwise would be a personal income tax payment to these funds as ostensible charitable contributions in exchange for an income tax credit.  For example, Senate Bill 227 was introduced in the California Senate on January 3, 2018.  The bill would create the California Excellence Fund to accept contributions from individuals (and corporations) for public purposes in exchange for a California income tax credit.  It is uncertain whether the IRS would view these contributions as qualifying for a federal charitable contribution deduction, which is not subject to the same $10,000 cap.  Other states are considering other options (e.g., New York’s consideration of an employer-side payroll tax.)  Given the federal corporate rate reduction, individual owners of pass-through entities may consider converting to C corporations whose state tax deductions will not be limited for federal purposes. 
  BDO Insights
  • Obviously, the federal tax reform changes enacted by the “Tax Cuts and Jobs Act” will impact all federal taxpayers immediately.  However, taxpayers should also account for the impact of the federal changes on their state corporate and personal income taxes, and state tax treatment of pass-through entities and foreign corporations, including foreign source dividends and Subpart F income. 
  • Despite the differences in how rolling conformity, fixed date conformity, and other states conform or decouple from the IRC, it is expected that state legislatures, most of which will be convening new legislation sessions starting in January 2018, will have an active legislative season as states address their conformity to or decoupling from the myriad federal tax reform changes.
  • We anticipate that state economic development efforts will increase reliance on statutory tax credits and other incentives that are not contributions of money or other property, such as favorable filing options, alternative apportionment formulas, and other non-capital incentives.
       
Taxpayers should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures, of state conformity or non-conformity to the Act.  
For more information, please contact one of the following practice leaders: 
  West:     Atlantic: Rocky Cummings
Tax Partner
      Jonathan Liss
Tax Managing Director
  Paul McGovern
Tax Managing Director
      Angela Acosta
Tax Managing Director
      Northeast:     Southwest: Janet Bernier
Tax Principal
      Laura Holmes
Tax Managing Director
  Matthew Dyment
Tax Principal
      Gene Heatly
Tax Managing Director
      Central:     Southeast Deborah Kovachick
Tax Partner
      Scott Smith
Tax Managing Director
  Richard Spengler
Tax Managing Director
      Tony Manners
Tax Managing Director
  Mariano Sori
Tax Partner     Taryn Goldstein
Tax Managing Director

BDO’s Tax Reform Resolutions

Wed, 01/17/2018 - 12:00am
After months of will-it-or-won’t-it suspense, on December 22, the biggest overhaul of the U.S. tax system since the Reagan administration was signed into law. Now that the holiday dust has settled, it’s time to shift into full gear and take tax reform by the horns.
 
The problem with New Year’s resolutions is that too often we bite off more than we can chew. Tax reform is no different. Companies should tackle the new tax law in three phases: determining and addressing the to-dos that require immediate attention, navigating the early stages of implementation, and finally, strategizing for the long-term.
 
To help you prioritize, we’ve put together a checklist of tax reform resolutions that will set you up for success in 2018 and beyond.
 
  1. Bump tax reform to the top of your reading list. The new legislation includes over 1,000 pages of provisions and explanatory statements, most of which are already effective. The changes it introduces are significant, and yes, you will need to read it. Every company must parse through the new legislation to identify which provisions are most relevant and analyze whether the impact will be favorable or unfavorable to their business as it currently operates.  
 
  1. Whip your data into shape. Assessing the impact of tax reform requires a substantial amount of readily-available data. Companies need to immediately shift their focus from modeling the impact of tax reform to data collection and computations. Businesses with international operations will likely need more time to collect necessary data, as some of the information needed for the transition tax calculation may not be at their fingertips, and could date back to 1987.
 
  1. Prioritize the most important changes. Focus on the areas that have the greatest impact and urgency. For most companies, the three main areas requiring immediate attention are potential changes to income tax accounting implications, deduction acceleration, and entity classification. Multinational companies will need to pay special attention to historic U.S. and foreign tax attributes, such as earnings and profits, net operating losses, and credits, among others, to determine tax reform impacts.
 
  1. Don’t let the ball drop when it comes to Q4 reporting. Under existing accounting rules, companies are required to account for these legislative changes in their Q4 2017 financial statements, which will require recalculating deferred tax assets under the new corporate rate—a process that should be kicked off as soon as possible. You also may want to consider accelerating deductions into 2017 or delaying income into future years where it will be taxed at a lower rate.
 
  1. Be flexible. Analyze how the new tax laws will impact your choice of entity and whether you need to consider changing entity type. If you’re thinking about changing the way your business is structured, whether to obtain favorable tax treatment or for other reasons, you’ll need to look closely at qualified business income, assets, products, and more, to determine the right move for your bottom line. 
 
  1. Think about the big picture. Tax reform isn’t just a big deal for the finance and accounting department; it’s potentially transformational for your entire business. Companies on the verge of major strategic business decisions such as mergers, acquisitions, or restructurings, all need to seriously examine these moves in light of tax reform. 
 
  1. Don’t go it alone. Tax reform of this magnitude is the biggest change we’ve seen in a generation. It will require intense focus to understand how the changes apply at a federal level and how to navigate the ripple effects this is likely to have on state taxation as well.
   
For additional questions related to tax reform, please contact:

Compensation and Benefits Tax:
Peter Klinger, Compensation and Benefits Principal, National Tax Office
415-490-3214 / pklinger@bdo.com

Corporate Tax:
Ben Willis, Corporate Tax Partner and Technical Practice Leader, National Tax Office
202-644-5433 / bwillis@bdo.com

International Tax:
Joe Calianno, International Tax Partner and Technical Practice Leader, National Tax Office
202-644-5415 / jcalianno@bdo.com

Legislative & Procedure:
Todd Simmens, Controversy and Procedure Technical Practice Leader
732-491-4170 / tsimmens@bdo.com

Partnership Taxation:
Jeffrey Bilsky, Partnership Taxation Partner and Technical Practice Leader, National Tax Office
404-979-7193 / jbilsky@bdo.com

Section 199:
Chris Bard, R&D Tax Credit Partner and National Practice Leader
310-557-7525 / cbard@bdo.com

Connie Cunningham, Tax Managing Director
310-557-8544 / ccunningham@bdo.com

Tax Accounting Methods:
David Hammond, Tax Partner
616-802-3433 / dhammond@bdo.com

Highly Anticipated Income Tax Withholding Tables Released - Refinements to Follow

Tue, 01/16/2018 - 12:00am
Summary
  1. Early release of withholding tables to reflect changes made by tax reform legislation last month (increase in standard deduction, repeal of personal exemptions, changes in tax rates and brackets).
  2. New withholding tables should be implemented as soon as possible, but no later than February 15, 2018.
  3. 2017 and earlier Form W-4s should be used to calculate withholding until employee files a 2018 Form W-4 (not yet available) that will more accurately reflect the new law changes.    
  4. Employer must reduce the employee’s actual wages by the amount specified in the guidance for the pay period times each exemption on the employee’s  Form W-4.
  5. Flat rate for withholding on an employee’s supplemental wages is 22 percent for supplemental wages up to $1 million during a calendar year, and 37 percent on such wages above $1 million.
  6. Backup withholding rate is 24 percent.
  Discussion The Tax Cuts and Jobs Act made a number of changes for 2018 that affect individual taxpayers (i.e., increase in the standard deduction, repeal of personal exemptions, and changes in tax rates and brackets). 

On January 11, 2018, the Internal Revenue Service released Notice 1036, which provides updated withholding information for 2018 that reflects changes made by the new tax law.

Withholding taxes are designed to be approximately equal to an individual’s tax liability for the year.  The 2018 revisions to the Percentage Method Tables are aimed at avoiding over- and under-withholding on employee wages.  Employers should implement the 2018 withholding tables as soon as possible, but not later than February 15, 2018.  In the meantime, employers should continue using the 2017 withholding tables.

In an attempt to reduce the burden on employers and their employees, the new withholding tables work with the Forms W-4 that employers already have on file for existing employees.  Employers should not collect new Forms W-4 from existing employees at this time and should continue to use the 2017 Form W-4 for new hires until a revised form is available.  The IRS is working on a revised Form W-4 for use by new hires and existing employees who wish to update their withholding in response to the new law or changes to their personal circumstances in 2018.
 
Notice 1036 also provides the new flat rates that may be applied to supplemental wages.   Upon the elimination of the 25 percent tax rate effective 2018, many employers processing prior year bonuses were uncertain about the correct withholding rate to use for supplemental wages. According to the Notice, employers using the optional flat rate method must withhold 22 percent of the supplemental wages paid to an employee during a calendar year (up to $1 million); and 37 percent on supplemental wages in excess of $1 million.

The rate for backup withholding when the payee fails to furnish a correct taxpayer identification number is 24 percent. 
 
For more information, please contact one of the following practice leaders:
  Joan Vines
Managing Director   Carlisle Toppin
Managing Director   Paul Cheung
Managing Director   Thomas LeClair
Senior Manager

Treasury Releases Notice Providing Guidance on Deferred Foreign Earnings and the Transition Tax (Code Section 965)

Wed, 01/10/2018 - 12:00am
Summary On December 29, 2017, the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”) issued Notice 2018-07 (the “Notice”).  The Notice provides guidance on new Section 965, Treatment of deferred foreign income upon transition to participation exemption system of taxation, which was enacted on December 22, 2017.  The Notice states that Treasury intends to issue regulations for determining amounts included in gross income by a U.S. shareholder under Section 951(a)(1) by reason of Section 965.  Additionally, Treasury also requested comments on the rules described in the Notice as well as comments regarding what additional guidance should be issued to assist taxpayers in applying Section 965.
  Details In general, Section 965(a) provides that for the last taxable year of a deferred foreign income corporation (“DFIC”)[1] that begins before January 1, 2018 (such year of the DFIC, the “inclusion year”), the subpart F income of the corporation (as otherwise determined for such taxable year under Section 952) shall be increased by the greater of (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 (each such date, a “measurement date,” and the greater of the accumulated post-1986 deferred foreign income of the corporation as of the measurement dates, the “Section 965(a) earnings amount”).
 
Section 965 contains various rules including, but not limited to, rules for determining earnings and profits of DFICs, determining the aggregate foreign cash position of U.S. shareholders in specified foreign corporations, netting among U.S. shareholders in the same affiliated group, and applying the participation exemption to the income included under Section 965.[2]
 
The Notice provides that Treasury plans to issue regulations addressing the application of Section 965 including regulations to provide guidance on (1) determining aggregate foreign cash positions of U.S. shareholders in specified foreign corporations, (2) determining accumulated post-1986 deferred foreign income of DFICs, (3) applying Section 961 to amounts treated as subpart F income under Section 965, (4) the treatment of affiliated groups making a consolidated return for purposes of Section 965, and (5) determining foreign currency gain or loss under Section 986(c) on distributions of earnings previously taxed under Section 965. The guidance provided in the Notice on these items is summarized below.

1. Determining Aggregate Foreign Cash Positions
If specified foreign corporations have inclusion years that end in or with different taxable years of the same U.S. shareholder, Section 965 could result in double-counting such shareholder’s aggregate foreign cash position for purposes of determining the shareholder’s deduction under Section 965(c).  The Notice provides that Treasury intends to issue regulations providing that in the case of a U.S. shareholder that has a Section 965(a) inclusion amount in more than one taxable year, the aggregate foreign cash position taken into account in the first taxable year will equal the lesser of the U.S. shareholder’s aggregate foreign cash position or the aggregate of the Section 965(a) inclusion amounts taken into account by the U.S. shareholder in that taxable year.  Furthermore, the amount of the U.S. shareholder’s aggregate foreign cash position taken into account in any succeeding taxable year will be its aggregate foreign cash position reduced by the amount of its aggregate foreign cash position taken into account in any preceding taxable year.[3]
 
Additionally, for purposes of determining the aggregate foreign cash position of a U.S. shareholder for a taxable year in which it takes into account a Section 965(a) inclusion amount, future regulations will provide that the U.S. shareholder can assume that its pro rata share of the cash position of any specified foreign corporation with an inclusion year ending after the date the return for such taxable year of such U.S. shareholder is timely filed (including extensions, if any) will be zero as of the cash measurement date with which the inclusion year ends.  If a U.S. shareholder’s pro rata share of the cash position of a specified foreign corporation was treated as zero pursuant to the preceding sentence, and the amount described in Section 965(c)(3)(A)(i) in fact exceeds the amount described in Section 965(c)(3)(A)(ii), the U.S. shareholder must make appropriate adjustments to reflect that the 15.5 percent rate equivalent percentage applies to a greater amount of the aggregate Section 965(a) inclusion amounts taken into account.[4]  The Notice provides that Treasury expects to issue future guidance regarding the appropriate method for making such an adjustment.[5]
 
Net accounts receivables and short-term obligations between related specified foreign corporations may inflate the aggregate foreign cash position of a U.S. shareholder relative to the actual aggregate amount of liquid assets (other than the intercompany receivables) owned by the specified foreign corporations of the U.S. shareholder. Accordingly, for purposes of determining the cash position of a specified foreign corporation with respect to net accounts receivable and short-term obligations, the Notice provides that Treasury intends to issue regulations providing that, with respect to a U.S. shareholder, any receivable or payable of a specified foreign corporation from or to a related specified foreign corporation will be disregarded to the extent of the common ownership of such specified foreign corporations by the U.S. shareholder. 
 
Under Section 965(c)(3)(B)(iii)(V), the Secretary may identify any asset as being economically equivalent to any asset described in Section 965(c)(3)(B).  The Notice provides that Treasury intends to issue regulations that address the treatment of derivative financial instruments for purposes of measuring the cash position of a specified foreign corporation.  Derivative financial instruments include notional principal contracts, options contracts, forward contracts, futures contracts, short positions in securities and commodities, and any similar financial instruments.  These regulations will provide that the cash position of any specified foreign corporation generally will include the fair market value of each derivative financial instrument held by the specified foreign corporation that is not a “bona fide hedging transaction” (as defined in this Section 3.01(c) of the Notice).  The Notice provides additional details relating to derivative financial instruments and hedging transactions.[6]   
 
2. Determining Accumulated Post-1986 Deferred Foreign Income
Certain transactions between specified foreign corporations may result in earnings and profits of a specified foreign corporation being taken into account more than once or not at all by a U.S. shareholder under Section 965(a).  Consistent with congressional intent, the Notice provides that Treasury intends to issue regulations to address the possibility of double-counting or double non-counting in the computation of post-1986 earnings and profits arising from amounts paid or incurred (including certain dividends) between related specified foreign corporations of a U.S. shareholder that occur between measurement dates and that would otherwise reduce the post-1986 earnings and profits as of December 31, 2017, of the specified foreign corporation that paid or incurred such amounts. The Notice includes examples illustrating adjustments that will be included in regulations that are necessary to address these issues.[7]
 
The post-1986 earnings and profits of a specified foreign corporation are reduced to reflect dividends distributed during the corporation’s inclusion year to another specified foreign corporation (“the dividend reduction rule”).[8]  As a result, a dividend paid by a specified foreign corporation to another specified foreign corporation (whether in an inclusion year or a prior taxable year, including a prior taxable year that includes a measurement date) generally reduces the corporation’s post-1986 earnings and profits with respect to any measurement date that such dividend precedes.
 
The dividend reduction rule is intended to address the potential double-counting of the earnings and profits of the distributing specified foreign corporation in calculating the Section 965(a) inclusion amounts taken into account by a U.S. shareholder with respect to the distributing specified foreign corporation and the distributee specified foreign corporation. To the extent that a portion of a distribution reduces the post-1986 earnings and profits of a distributing specified foreign corporation (for example, by reason of a reduction pursuant to Section 312(a)(3)) in an amount in excess of the increase in the post-1986 earnings and profits of the distributee specified foreign corporation, such reduction would not relieve double-counting and thus would be inconsistent with the purpose of the rule. Accordingly, the Notice provides that Treasury intends to issue regulations to clarify that the amount by which the post-1986 earnings and profits of a specified foreign corporation is reduced under Section 965(d)(3)(B) as a result of a distribution made to a specified foreign corporation in the inclusion year may not exceed the amount by which the post-1986 earnings and profits of the distributee corporation is increased as a result of the distribution.
 
In the case of a CFC that has shareholders that are not U.S. shareholders on a measurement date, the Notice provides that Treasury intends to issue regulations providing that the accumulated post-1986 deferred foreign income of the CFC on such measurement date will be reduced by amounts that would be described in Section 965(d)(2)(B) if such shareholders were U.S. shareholders.  In such cases, the regulations will follow the principles of Revenue Ruling 82-16, 1982-1 C.B. 106, to determine the amounts by which accumulated post-1986 deferred foreign income is reduced.[9]
 
The Notice also provides that Treasury intends to issue regulations to clarify the interaction between the rules under Sections 959 and 965 in the inclusion year of a DFIC and the taxable year of a U.S. shareholder of the DFIC in which or with which such inclusion year ends.  Such regulations will describe the following steps for determining the Section 965(a) inclusion amount of a DFIC, the treatment of distributions under Section 959, and the amount of an inclusion under Sections 951(a)(1)(B) and 956 with respect to a DFIC:
 
  1. First, the subpart F income of the DFIC is determined without regard to Section 965(a), and the U.S. shareholder’s inclusion under Section 951(a)(1)(A) by reason of such amount is taken into account.
  2. Second, the treatment of a distribution from the DFIC to another specified foreign corporation that is made before January 1, 2018, is determined under Section 959.
  3. Third, the Section 965(a) inclusion amount of the DFIC is determined, and the U.S. shareholder’s inclusion under Section 951(a)(1)(A) by reason of such amount is taken into account.
  4. Fourth, the treatment of all distributions from the DFIC other than those described in step 2 is determined under Section 959.
  5. Fifth, an amount is determined under Section 956 with respect to the DFIC and the U.S. shareholder, and the U.S. shareholder’s inclusion under Section 951(a)(1)(B) is taken into account.[10]
 
3. Applying Section 961 to Amounts Treated as Subpart F Income under Section 965
Section 965(o) authorizes Treasury to issue regulations or other guidance to provide appropriate basis adjustments to carry out the provisions of Section 965.  To provide certainty regarding the application of the rules described in Section 961 with respect to amounts included under Section 965, the Notice provides that Treasury intends to issue regulations providing that if a U.S. shareholder receives distributions from a DFIC during the inclusion year that are attributable to previously taxed income described in Section 959(c)(2) by reason of Section 965(a), the amount of gain recognized by the U.S. shareholder with respect to the stock of the DFIC under Section 961(b)(2) will be reduced (but not below zero) by the Section 965(a) inclusion amount.
 
4. Treatment of Affiliated Groups  Making a Consolidated Return for Purposes of Section 965
Pursuant to the Secretary’s authority under Sections 965(o) and 1502, the Notice provides that Treasury intends to issue regulations providing that, solely with respect to the calculation of the amount included in gross income by a consolidated group (as defined in §1.1502-1(h)) under Section 951(a)(1) by reason of Section 965(a), all of the members of a consolidated group that are U.S. shareholders of one or more specified foreign corporations will be treated as a single U.S. shareholder. Thus, for example, all members of a consolidated group that are U.S. shareholders will be treated as a single U.S. shareholder for purposes of determining the aggregate foreign cash position of the consolidated group and for purposes of taking such aggregate foreign cash position into account under Section 965(c)(1).
 
These regulations will provide that, consistent with the consolidated return regulations (and notwithstanding the calculation of the amount described in the prior paragraph), appropriate adjustments, for example, adjustments under Section 1.1502-32 to the basis of the stock of each member that is a U.S. shareholder, will be made to reflect the impact of amounts included in gross income under Section 951(a)(1) by reason of Section 965(a), and the impact of other attributes of each member on this calculation, such as the ownership of E&P deficit foreign corporations by particular members and the cash position of specified foreign corporations held by particular members.  These regulations will also provide that taxpayers must make appropriate adjustments reflecting minority ownership interests in a member of the consolidated group that are owned by a person that is not a member of the consolidated group.
 
5. Determining Foreign Currency Gain or Loss under Section 986(c)
The Notice provides that Treasury intends to issue regulations providing that any gain or loss recognized under Section 986(c) with respect to distributions of previously taxed income described in Section 959(c)(2) by reason of Section 965(a) will be diminished proportionately to the diminution of the taxable income resulting from Section 965(a) by reason of the deduction allowed under Section 965(c).[11] 
 
The adjustments with respect to Section 986(c) must be made so as to apply solely with respect to distributions of previously taxed income described in Section 959(c)(2) by reason of Section 965(a).  Accordingly, future regulations will also provide ordering rules for determining the portion of a distribution that will be treated as previously taxed income described in Section 959(c)(2) by reason of Section 965(a).
  Effective Dates Section 965 is effective for the last taxable years of foreign corporations that begin before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.  The Notice provides that Treasury intends to provide that the regulations described in the Notice are effective beginning the first taxable year of a foreign corporation (and with respect to U.S. shareholders, the taxable years in which or with which such taxable years of the foreign corporations end) to which Section 965 applies.  Before the issuance of the regulations described in the Notice, taxpayers may rely on the rules described in the Notice.
  BDO Insights The Notice provides welcomed guidance and logical approaches to address various questions regarding the application of Section 965 and the transition tax. It is likely that additional guidance relating to the transition tax will be forthcoming in the near future given that there are still several unanswered questions relating to Section 965.
 
For more information, please contact one of the following practice leaders:
  Joe Calianno
Partner and International Technical Tax Practice Leader, National Tax Office   Monika Loving
Partner and International Tax Practice Leader   Annie Lee
Partner   Chip Morgan
Partner   Robert Pedersen
Partner   William F. Roth III
Partner, National Tax Office   Jerry Seade
Principal   Natallia Shapel
Partner       Sean Dokko
Senior Manager, National Tax Office       [1] For purposes of Section 965, a DFIC is, with respect to any U.S. shareholder, any specified foreign corporation of such U.S. shareholder that has accumulated post-1986 deferred foreign income (as of a measurement date) greater than zero.  Section 965(d)(1).  The term “accumulated post-1986 deferred foreign income” means the post-1986 earnings and profits of the specified foreign corporation except to the extent such earnings and profits (A) are attributable to income of the specified foreign corporation that are effectively connected with the conduct of a trade or business within the United States and subject to tax under Chapter 1 (“effectively connected income”), or (B) in the case of a controlled foreign corporation (“CFC”), if distributed, would be excluded from the gross income of a U.S. shareholder under section 959 (“previously taxed income”).  Section 965(d)(2). See Section 965(d)(3) for more details on “post-1986 earnings and profits.”
Section 965(e)(1) provides that the term “specified foreign corporation” means (A) any CFC, and (B) any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder (10-percent corporation).  For purposes of Sections 951 and 961, a 10-percent corporation is treated as a CFC solely for purposes of taking into account the subpart F income of such corporation under section 965(a).  Section 965(e)(2).  However, if a passive foreign investment company (as defined in section 1297) with respect to the shareholder is not a CFC, then such corporation is not a specified foreign corporation.  Section 965(e)(3).
  [2] See Section 965 for additional details.
  [3] For an illustration of these rules, see the first example in Section 3.01(a) of the Notice.
  [4] Section 965(c)(3)(A) provides that the term “aggregate foreign cash position” means, with respect to any United States shareholder, the greater of (i) the aggregate of such United States shareholder’s pro rata share of the cash position of each specified foreign corporation of such United States shareholder determined as of the close of the inclusion year, or (ii) one half of the sum of (I) the aggregate described in clause (i) determined as of the close of the last taxable year of each such specified foreign corporation that ends before November 2, 2017, plus (II) the aggregate described in clause (i) determined as of the close of the taxable year of each such specified foreign corporation which precedes the taxable year referred to in subclause (I).  Each date referred to in the preceding sentence is referred to as a “cash measurement date.”
  [5] See the second example in Section 3.01(a) of the Notice for an illustration of these rules.
  [6] For additional details, see section 3.01(c) of the Notice.
  [7] For an illustration of these rules, see section 3.02(a), Examples 1 – 4 of the Notice.
  [8] Section 965(d)(3)(B).
  [9] For an illustration of these rules, see the example in Section 3.02(c) of the Notice.
  [10] For an illustration of these rules, see the example in Section 3.02(d) of the Notice.
  [11] See H.R. Rep. No. 115-466, at 620.
 
 
 

Webinar Recap: BEPS: Global Tax Framework & How It Applies to Your Globally Mobile Population

Mon, 01/08/2018 - 12:00am
The world is getting smaller and more connected. While these connections increase the exchange of ideas, goods, and people, they simultaneously create a web of complex international regulations companies must navigate. And, when it comes to the globally mobile workforce, these regulations get personal.

In our recent webinar, BEPS: Global Tax Framework & How It Applies To Your Globally Mobile Population, Chip Morgan, Debra Moses and Mesa Hodson analyzed how changes to the Organisation of Economic Co-operation and Development (OECD)’s international Base Erosion and Profit Shifting (BEPS) framework affects American companies’ global workforce, and how they can successfully adapt.  

We’ve outlined some of the key provisions below, and you can listen to the full webinar here.
The OECD’s BEPS Action Plan The OECD’s BEPS framework was designed to help combat tax avoidance strategies that exploit the differences in tax regulations from country to country. A number of Actions within the framework will impact how enterprises manage and report on their globally mobile employees, touching on everything from taxation coherence to tax eligibility to transparency. It’s critical that businesses understand the impact of BEPS, and know when and how to involve their tax department and tax and transfer pricing advisors to ensure compliance.
  How companies can adapt and maintain BEPS compliance There are a several steps companies can take when looking to make their global employee mobility practices compliant with BEPS.

Understand where you are today
Adjusting your practices to be BEPS-compliant first requires a thorough understanding of current practices. Evaluate activities of globally mobile employees and current tax strategies to develop a more concrete plan to address risk exposure to expected rule changes. The OECD, and tax authorities around the globe are putting a heightened focus on employment relationships and structures are expected to be examined more closely. These relationships can often drive permanent establishment (PE) determination, employee taxability, transfer pricing implications, and indirect tax applicability, among others. Maintaining and enhancing adequate substance within the employment relationships and structures is going to be critical to manage unanticipated outcomes in the event of an examination by tax authorities.
 
Plan ahead
To create the structure needed to address future compliance issues, companies should establish processes and procedures to track and monitor globally mobile employees sooner rather than later. Solidify protocols and procedures to track mobile employees, including business travelers, in order to assess associated PE risk and comply with reporting and withholding requirements. Tax authorities are getting tech-savvy, and more jurisdictions are sharing data and information. Companies need to prioritize data transparency and visibility to maintain accurate internal records and meet any information requests from regulators. Knowing exactly where employees are and what activities they are performing will be key in managing the detailed country-by-country (CbC) requirements and associated compliance under BEPS.
 
Establish specific rules
Country-by-country (CbC) specific rules for mobile employees can ensure compliance with reporting requirements in each jurisdiction where a company does business, thereby minimizing overall risk exposure. However, the new country-based reporting requirements included in BEPS can be quite detailed. In order to successfully mobilize their workforce and mitigate risks, businesses need to be confident they are using the appropriate method of initiating assignments and adhering to the most up-to-date standards. Companies need to take a multidisciplinary approach to establishing these processes and procedures, including the tax, mobility, HR, finance, payroll, and legal departments in creating processes that not only support, but drive, compliance.   

Document effectively
A key element of any compliance plan is ensuring robust assignment and inter-company documentation are in place. This allows companies to both effectively manage their global employees and to quickly respond to increased scrutiny from tax authorities, if necessary. In the event an audit does occur, contemporaneous documentation to support assignments is often the first line of defense to manage global tax risk. Businesses should review mobility documentation for details on assignees’ activities, roles and responsibilities of the home and host entities, and alignment with the commercial reality and actual practice. It’s important that documents clarify de facto or economic employment of the individual while on assignment, as well as lay the basis for cross-charge of costs between international entities in line with established transfer pricing regulations.
 
Ensure transfer pricing compliance
Assess cost recharge arrangements relative to globally mobile employees to ensure they adhere to transfer pricing guidelines to remain outside any corporate tax requirements in the jurisdictions in which companies do business. Businesses should institute appropriate cross-charging methodology and ensure that entities are adequately compensated. In addition to cross-charge of employee compensation, appropriate allocation for deemed transfer of intellectual property may also be required, adding to the complexity. Taking a holistic approach during the planning process should allow all relevant parties, including any transfer pricing professionals, to work together to navigate these issues.
 
More information
For more information, including several scenario overviews, listen and download the materials from our recent webinar.

Tax Reform and Section 199A Deduction of Qualified Business Income of Pass-Through Entities

Thu, 01/04/2018 - 12:00am

Download PDF Version

Summary On Friday, December 22, President Trump signed sweeping tax reform (the “Act”) into law. The Act provides the most comprehensive update to the tax code since 1986 and includes a number of provisions of particular interest to partnerships and their partners. This alert addresses the Section 199A deduction for qualified business income of pass-through entities.
  Details Section 199A Deduction for Qualified Business Income of Pass-Through Entities

General Rule
For tax years beginning after December 31, 2017, taxpayers other than corporations will generally be entitled to a deduction for each taxable year equal to the sum of:
  1. The lesser of (A) the taxpayer’s “combined qualified business income amount” or (B) 20 percent of the excess of the taxpayer’s taxable income for the taxable year over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
  2. The lesser of (A) 20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year or (B) the taxpayer’s taxable income (reduced by the net capital gain).
A taxpayer’s combined qualified business income (QBI) amount is generally equal to the sum of (A) 20 percent of the taxpayer’s QBI with respect to each qualified trade or business plus (B) 20 percent of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.

Limitation Based on Wages & Capital
The portion of the deduction attributable to 20 percent of the taxpayer’s QBI cannot exceed the greater of (1) 50 percent of his/her share of W-2 Wages paid with respect to the QBI or (2) the sum of 25 percent of his/her share of W-2 Wages plus 2.5 percent of the unadjusted basis of qualified property determined immediately after its acquisition of such qualified property. The term W-2 Wages is defined to mean the sum of total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 Wages do not include any such amount that is not properly allocable to QBI.

For example, a taxpayer (who is subject to the limit) does business as a sole proprietorship conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50 percent of W-2 Wages, or $0, or (b) the sum of 25 percent of W-2 Wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. The amount of the limitation on the taxpayer’s deduction is $2,500.

Phase-in of Wages and Wages & Capital Limitation
The wages or wages plus capital limitation does not apply to taxpayers with taxable income not exceeding $315,000 (joint filers) or $157,500 (other filers). The limitation is phased-in for taxpayers with taxable income exceeding these amounts over ranges of $100,000 and $50,000, respectively. For example, H and W file a joint return on which they report taxable income of $375,000. W has a qualified trade or business that is not a specified service business, such that 20 percent of the QBI with respect to the business is $15,000. W’s share of wages paid by the business is $20,000, such that 50 percent of the W-2 Wages with respect to the business is $10,000. The business has nominal amounts of qualified property such that 50 percent is W-2 Wages is greater than 25 percent of W-2 Wages plus 2.5 percent of qualified property. The $15,000 amount is reduced by 60 percent (($375,000 - $315,000) / $100,000) of the difference between $15,000 and $10,000, or $3,000. H and W take a deduction for $12,000.
 
Definition of Qualified Property
The term qualified property is generally defined to mean, with respect to any qualified trade or business, tangible property of a character subject to depreciation under section 167 that is (i) held by and available for use in the qualified trade or business at the close of the taxable year, (ii) which is used at any point during the taxable year in the production of QBI, and (iii) the depreciable period for which has not ended before the close of the taxable year. Importantly, the Conference Agreement defines the term “depreciable period” to mean the later of 10 years from the original placed in service date or the last day of last full year in the applicable recovery period determined under section 168.

Definition of QBI
QBI includes the net domestic business taxable income, gain, deduction, and loss with respect to any qualified trade or business. QBI specifically excludes the following items of income, gain, deduction, or loss: (1) Investment-type income such as dividends, investment interest income, short-term & long-term capital gains, commodities gains, foreign currency gains, and similar items; (2) Any Section 707(c) guaranteed payments paid in compensation for services performed by the partner to the partnership; (3) Section 707(a) payments for services rendered with respect to the trade or business; or (4) Qualified REIT dividends, qualified cooperative dividends, or qualified PTP income.

Carryover of Losses
Section 199A provides rules regarding the treatment of losses generated in connection with a taxpayer’s qualified trades or businesses. Under these rules, if the net amount of qualified income, gain, deduction, and loss with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year. In practice, this will mean that a taxpayer’s net loss generated in Year 1 will be carried forward and reduce the subsequent year’s section 199A deduction.

For example, Taxpayer has QBI of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. Taxpayer is not permitted a deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, Taxpayer has QBI of $20,000 from qualified business A and QBI of $50,000 from qualified business B. To determine the deduction for Year 2, Taxpayer reduces the 20 percent deductible amount determined for the QBI of $70,000 from qualified businesses A and B by 20 percent of the $30,000 carryover qualified business loss. Ignoring application of other potential limitations and deductible amounts, Taxpayer would be entitled to a Year 2 Section 199A deduction of $8,000 (($70,000 * 20 percent) – ($30,000 * 20 percent)).
 
Definition of Qualified Trade or Business
A qualified trade or business includes any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.

Specified Services Limitation
The specified service trade or business exclusion does not apply to the extent the taxpayer’s taxable income does not exceed certain thresholds: $415,000 (joint filers) and $207,500 (other filers). Application of this exclusion is phased-in for income exceeding $315,000 and $157,500, respectively. In computing the QBI with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 Wages and qualified property. The applicable percentage with respect to any taxable year is 100 percent reduced by the percentage equal to the ratio of the taxable income of the taxpayer in excess of the threshold amount, bears to $50,000 ($100,000 in the case of a joint return).

For example, Taxpayer (who files a joint return) has taxable income of $375,000, of which $200,000 is attributable to an accounting sole proprietorship after paying wages of $100,000 to employees. Taxpayer has an applicable percentage of 40 percent. In determining includible QBI, Taxpayer takes into account 40 percent (1 – (($375,000 - $315,000) / $100,000)) of $200,000, or $80,000. In determining the includible W-2 Wages, Taxpayer takes into account 40 percent of $100,000, or $40,000. Taxpayer calculates the deduction by taking the lesser of 20 percent of $80,000 ($16,000) or 50 percent of $40,000 ($20,000). Taxpayer takes a deduction for $16,000.

Important Considerations
Taxpayers eligible to claim the full 20 percent deduction on QBI will incur a maximum effective rate of 29.6 percent on the QBI. While this rate reduction is beneficial, it will be important to consider the decrease in corporate tax rates from 35 percent to 21 percent. This rate differential is likely to cause taxpayers to reevaluate their choice of entity decisions. There are a number of factors that need to be considered but, from a simple after-tax cash flow perspective, a key determinative factor is the likelihood of the entity distributing vs. retaining operating earnings. While a common thought is to consider possibly incorporating an existing partnership in order to benefit from the 21 percent corporate tax rate, a corporate-to-partnership conversion should not be dismissed. When corporate tax rates were 35 percent, the tax liability imposed on gain recognized under Section 311(b) was typically prohibitive in a conversion transaction. However, with corporate rates dropping to 21 percent, consideration should now be given to the possible liquidation of a corporation and re-formation as a partnership, especially in situations where the corporation has net operating loss carryovers that could shelter the recognized Section 311(b) gain.

The determination of the combined QBI amount is dependent upon the QBI generated from each qualified trade or business activity. Further, the wages and capital-based limitations are determined with reference to wages and qualified property that is allocable to a particular qualified trade or business activity. It is not clear from the statute whether and the extent grouping rules under sections 469 may be applicable. Complexities are likely to arise in situations where a partnership operates multiple activities. Maintaining adequate information and documentation will be necessary to support application of the lower rates. Consequently, partners and partnerships will need to consider the extent to which additional information will be maintained, how it will be communicated to partners, and whether any incremental administrative costs should be borne by the benefiting partners.

Properly tracking partner income and loss allocations will take on greater importance in order to accurately determine a partner’s annual net business income allocations and carryover loss amounts. This importance will be further magnified as a result of the potential imputed underpayment obligations that could arise under the new partnership audit rules going into effect for tax years beginning after December 31, 2017. 
 
For more information, please contact one of the following practice leaders:
    Jeffrey N. Bilsky
National Tax Office Partner
Technical Practice Leader, Partnerships   David Patch
National Tax Office Managing Director
    Julie Robins
National Tax Office Managing Director   Will Hodges 
National Tax Office Senior Manager   Katie Pendzich
National Tax Office Senior Manager    

Compensation and Benefit Programs - Thinking Strategically in the Tax Reform Era

Thu, 01/04/2018 - 12:00am
Summary The Tax Cuts and Jobs Act (the “Act”) was enacted into law on December 22, 2017.  Understanding the implications of this tax reform legislation will be critical in developing a successful total remuneration strategy. 
This article summarizes the key provisions of the Act that will significantly impact various components of an employer’s compensation program – namely, executive compensation, equity awards, qualified retirement plans, fringe benefits, payroll taxes, and employment-related credits – and provides BDO Insights on how these changes may influence plan designs.  Since the tax rate cuts and the provisions described below are scheduled to commence in the first taxable year beginning after December 31, 2017 (unless otherwise noted), employers should immediately assess their total rewards strategies in this tax reform environment. 
Details Companies required to file financial statements with the Security and Exchange Commission (SEC) must determine, pursuant to ASC 740, the impact of these tax law changes in their provision for income taxes.   The SEC issued SAB 118 that provides guidance to employers that cannot complete the analysis of tax law impact before the issuance of its financial statements, including the allowance of a provisional amount based on a reasonable estimate, to the extent an estimate can be made, with subsequent adjustment during a specified measurement period.  The measurement period begins in the reporting period that includes December 22, 2017, and ends when an entity has obtained, prepared, and analyzed the information needed to comply, but no later than December 22, 2018.  During the measurement period, the entity should be acting in good faith to complete accounting under ASC Topic 740.  See BDO’s SEC Flash Report 2017-13.
    Executive Compensation Section 162(m) - $1 Million Deduction Limitation   Prior Law Tax Reform A publicly held corporation generally cannot deduct more than $1 million of compensation in a taxable year for each “covered employee,” unless the pay is excepted from this limit. 
 
Covered employees are the corporation’s CEO as of the close of the taxable year, or any employee whose total compensation is required to be reported to shareholders by reason of being among the 3 most highly compensated employees for the taxable year (other than the CEO or CFO). 
 
Certain types of compensation are not subject to the deduction limitation: (i) performance-based compensation; (ii) commissions; (iii) deferred compensation paid after a person ceases to be a covered employee; (iv) tax-favored retirement plans (including salary deferrals); and (v) fringe benefits excluded from income. 
 
To qualify for the performance-based compensation exception, the compensation must meet certain criteria, including pre-established and objective performance goals certified by a compensation committee composed of outside directors under a program approved by shareholders. Stock options and stock appreciation rights with an exercise price not less than fair market value on date of grant qualify as performance-based compensation, provided the outside directors and shareholder approval requirements are met. Repeals performance-based and commission-based exceptions to the $1 million deduction limitation.
 
Modifies the definition of “covered employees” to include: (i) any person serving as the PEO or PFO at any time during the taxable year; and (ii) the 3 highest compensated officers (excluding the PEO and PFO) reported in the SEC executive compensation disclosures.  

Continues to apply the deduction limit to former covered employees and their beneficiaries.
 
Certain types of compensation are not subject to the deduction limitation: (i) tax-favored retirement plans (including salary deferrals); (ii) fringe benefits excluded from income; and (iii) compensation payable under a written binding contract in effect on November 2, 2017, and not materially modified thereafter. 
 
Extends the $1 million deduction limit to all domestic publicly traded corporations, and all foreign companies publicly traded through ADRs.    BDO Insights

Although performance-based pay is no longer deductible, there are many other reasons for public companies to continue tying pay to performance.  Such pay structures align management’s interests with those of the shareholders, the performance metrics serve as a basis for justifying the executives’ pay in the shareholder disclosures, and the institutional investment community – consisting of large pension funds and mutual fund companies, as well as proxy advisors – will continue to insist on “pay-for-performance” structures.  However, employers now have more flexibility to design such programs since the rigid rules to qualify for the performance-based pay deduction no longer apply.  For example, companies may establish subjective performance goals, whereas prior deduction rules required objective goals determined by a formula; or companies may increase the payout in their discretion, whereas prior deduction rules only allowed discretion to reduce the payout.

The Act realigns the definition of “covered employees” under Section 162(m) with the “named executive officers” under the current SEC executive compensation disclosure rules – including reference to the CEO and CFO as the principal executive officer (PEO) and principal financial officer (PFO).  Under the modified definition, once an employee qualifies as a covered person, the deduction limitation would apply to that person for federal tax purposes so long as the corporation pays compensation to such person (or to any beneficiaries).  Companies will need to maintain lists of covered employees over time and track their compensation into the future (e.g., severance installments, deferred compensation, option exercises, ISO disqualified dispositions, etc.).

Through proper planning, it may be possible to minimize the impact of the deduction limitation by delaying the timing of the income inclusion, which will require planning around the deferred compensation rules of Section 409A.  However, an employer’s objective to preserve its deduction may be at odds with an executive’s desire to receive income earlier.  
 
The Act expands the application of Section 162(m) beyond all domestic publicly traded corporations.  Now all foreign companies publicly traded through ADRs and certain corporations that are not publicly traded are subject to Section 162(m).  Such non-listed corporations have more than $10 million in assets and at least 2,000 shareholders (or at least 500 shareholders who are “non-accredited” investors).  Accredited investors include executive officers, directors and individuals meeting specified income or net worth tests.  The 2,000 (or 500) shareholder count excludes equity plan shareholders.  Accordingly large private C or S corporations may be subject to Section 162(m).

Under transition rules, companies subject to the deduction limitation may continue deducting any performance-based compensation paid to a covered employee pursuant to a written binding contract that was in effect on November 2, 2017, and not materially modified on or after such date. Based on the legislative history, it is unclear if this transition rule applies only to stock option grants made before that date or to all grants made under the stock option plan itself, such that any underlying option agreements entered into after November 2, 2017, would also be grandfathered.   If the latter, the ability to grant grandfathered options would extend until the earlier of the expiration of the plan’s term or the depletion of its share reserve.  Clarifying guidance is expected regarding this transition rule.   Excise Tax on Excess Tax-Exempt Organization Executive Compensation Tax-exempt organizations (governmental and non-governmental) are subject to a 21 percent excise tax on (i) compensation in excess of $1 million paid during the organization’s taxable year to any of their covered employees; plus (ii) any excess parachute payment paid by such organizations to a covered employee.  
 
A “covered employee” is an employee (including any former employee) of the tax-exempt organization who is one of the 5 highest compensated employees of the organization for the taxable year or was a covered employee of the organization (or any predecessor) for any preceding taxable year after 2016. 
 
“Compensation” means wages (as defined for federal income tax withholding purposes), paid by the employing organization or any person or governmental entity related to the tax-exempt organization.   However, compensation does not include any designated Roth contributions.  Compensation is treated as paid when there is no substantial risk of forfeiture of the rights to such pay and includes amounts required to be included in income under Section 457(f).
 
A “parachute payment” is compensation to a covered employee that is contingent on such individual’s separation from employment and the aggregate present value of all such payments equals or exceeds three times the base amount (i.e., the average annualized compensation includible in the covered employee’s gross income for the 5 taxable years ending before the employee’s separation from employment).  Parachute payments do not include payments under a tax-favored retirement plan or an eligible deferred compensation plan of a governmental employer.  For purposes of the parachute payment, the covered person must be a highly compensated employee whose annual compensation in the prior year exceeded an indexed threshold (e.g., $120,000 for 2017).
 
An “excess parachute payment” is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.     BDO Insights

The Act imposes limits on executive compensation of tax-exempt organizations, which are parallel to limitations facing for-profit corporations under Sections 162(m) and 280G.  However, the penalty for excessive compensation or severance is in the form of a 21 percent excise tax on the organization, rather than a deduction loss.       

Notably, the 21 percent excise tax applies as a result of an excess parachute payment, even if the covered employee’s compensation does not exceed $1 million for the taxable year.  Section 280G calculations will be necessary to determine if the excise tax applies to the severance payments for any covered employee.  Preliminary calculations could be useful to identify strategies to avoid the penalty in future years, such as increasing the base amount through bonuses paid more than one year prior to the termination of employment.  Under proposed Section 457(f) regulations, tax-exempt organizations may defer payout of severance in connection with a noncompete covenant.  It is unclear if organizations may use noncompete covenant valuations to reduce the parachute payments – a strategy for-profit corporations typically employ to mitigate the adverse tax consequences of Section 280G.

It is uncertain if the 5 highest paid employees of a governmental entity is determined on an agency basis.  
Equity Compensation Qualified Equity Grants  
Privately held corporations that provide broad-based equity plans (at least 80 percent of full-time US employees receive stock options or restricted stock units with the same rights and privileges) may allow employees to elect to defer the income inclusion for compensation attributable to stock acquired from the exercise of a stock option or settlement of an RSU for 5 years (or an earlier event, such as an IPO, revocation of the election, or becoming an excluded employee). 
 
Excluded employees may not make a deferral election.  Excluded employees are (i) one percent owners at any during the current year or 10 preceding calendar years; (ii) CEO and CFO during the current year or any prior time; (iii) persons related to individuals described in (i) and (ii) through attribution rules; (iv) one of the four highest compensated officers of the corporation (based on the SEC’s shareholder disclosure rules for compensation) during the current year or 10 preceding calendar years.
 
A deferral election is not permitted if (i) a Section 83(b) election was previously made; (ii) the stock was previously traded on an established market; or (iii) certain stock redemptions by the corporation occurred in the preceding year.
 
The employee agrees in the new Section 83(i) election to satisfy the tax withholding requirements at the end of the deferral period. The Section 83(i) election is made, in a similar manner to a Section 83(b) election within 30 days after vesting in the stock.     
    
The amount included in income at the end of the deferral period is based on the value of the stock at the time the employee’s right to the stock first becomes substantially vested (even if the stock declined during the deferral period).  The amount to be included will be treated as a non-cash benefit, but is subjected to withholding at the highest income tax rate applicable to individual taxpayers, 37 percent under the Tax Act.  
 
Subject to a $100 penalty for each failure, employers must notify eligible employees of the deferral opportunity at the time (or a reasonable period before) the income would be taxable under the general rules of Section 83(a).  The penalty is limited $50,000 for a calendar year. 
 
The employer reports on Form W-2, the amount of income covered by a deferral election (i) in the year of deferral and (ii) for the year income is required to be included in the employee’s income.  In addition, the employer must report on Form W-2 the aggregate amount of income covered by deferral elections, as of the close of the calendar year.
    BDO Insights

The new Section 83(i) election is designed to assist non-owners, other than the CEO and CFO of privately owned corporations, pay the income taxes without having to sell a stake in the employer. Notably, the liquidity concerns still exist for Social Security and Medicare tax withholdings due upon vesting, as well as the federal income taxes that become due at the end of the deferral period.

The requirement to withhold at the maximum rate, currently at 37%, is likely to result in over-withholding on rank and file employees (the majority of individuals eligible for deferral).  Under prior law, the mandatory maximum withholding rate was exclusively reserved for employees whose supplemental wages exceed $1 million during the calendar year.   

The employer’s deduction is deferred until the employer’s taxable year in which or with which ends the taxable year of the employee for which the amount is included in the employee’s income.

If the deferral election is made in connection with the exercise of employee stock purchase plans (ESPPs) or incentive stock options (ISOs), the options would cease to qualify as statutory options and would instead be treated as nonqualified stock options subject to federal income tax withholding and FICA taxes.  

The deferrals will be exempt from Section 409A, broadly governing deferred compensation. 
Fringe Benefits Achievement Awards Prior Law Tax Reform An employee achievement award is an item of tangible personal property given to an employee in recognition of length of service or safety achievement and presented as part of a meaningful presentation.  Such award is excluded from an employee’s income if its cost is deductible to the employer.  Under a qualified plan, the employer may deduct the cost of providing the awards if the average cost of all awards for the year (except those costing less than $50) do not exceed $400; and the maximum deduction allowed for any one employee is $1,600 per year.  Under a nonqualified plan, the employer is limited to a total deduction of $400 per employee per year.
 
If the achievement award exceeds the limit on the employer’s deductibility, the amount generally included in an employee’s is the difference between the employer’s cost and the deduction limitation.
  Clarifies that “tangible personal property” does not include the following items:
  • Cash and cash equivalents such as gift cards and gift certificates (other than arrangements conferring only the right to select tangible personal property from a limited array of items pre-selected and pre-approved by the employer);
  • Non-tangible personal property such as vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items.
 
    BDO Insights  

While cash or cash equivalents were never excludable from an employee’s income, the Act clarifies that non-tangible personal property will receive the same treatment as cash, which is consistent with prior rules.  Employers that fulfill the tradition of providing the “gold watch” upon retirement may continue to do so under the previously existing deduction and exclusion rules.       Qualified Bicycle Commuting Reimbursement Prior Law Tax Reform Qualified bicycle commuting reimbursement of up to $20 per “qualifying bicycle commuting month” are excludible from an employee’s gross income.  A qualifying bicycle commuting month is any month in which an employee regularly uses the bicycle for a substantial portion of travel to a place of employment (and during which month the employee does not receive other qualified transportation benefits). 
 
Qualified reimbursement are any amount received from an employer during a 15-month period beginning with the first day of the calendar moth as payment of reasonable expenses during a calendar year (e.g., purchase, of a bicycle, repair, storage).
 
Although this qualified bicycle commuting reimbursements are excluded from an employees’ income, employers may deduct the cost of such fringe benefit. Suspends the exclusion from gross income and wages for qualified commuting reimbursements for taxable years beginning after December 31, 2017, and before January 1, 2026. 
 
A deduction will continue to apply for qualified bicycle commuting reimbursements for any amounts paid or incurred for taxable years after December 31, 2017, and before January 1, 2026.   BDO Insights

Employers that continue to provide bicycle commuting reimbursements are entitled to a compensation deduction for such reimbursements, which are included in their employees’ income during the suspension period, 2018-2025.      Qualified Transportation Fringe Benefits Prior Law Tax Reform Qualified transportation fringe benefits, including transit passes, qualified parking, van pool benefits and qualified bicycle commuting reimbursements are excluded from employee’s income (up to specified limits), while employers may deduct the cost of such fringe benefits. No deduction shall be allowed for any expense incurred for providing any transportation, or any payment or reimbursement to an employee, in connection with travel between the employee’s residence and place of employment, except as necessary for ensuring the safety of the employee.
    BDO Insights

The Act does not repeal the employee’s exclusion from income.  Therefore, qualified parking and transportation fringe benefits (e.g., making a commuter highway vehicle available for employees, purchase of transit passes, vouchers or fare cards, or reimbursement for such items by the employer) continue to be excluded from the employee’s income, notwithstanding the employer’s inability to deduct such costs. Presumably, an employee’s pre-tax contributions to a qualified transportation fringe benefit plan are also nondeductible by the employer.  It remains to be seen if employers will cease transportation fringe benefits which do not qualify for an income tax deduction or continue such benefits to provide competitive employee benefit packages for recruitment purposes.  

In accordance with previously existing regulations, in the event of an unsafe environment (i.e., conditions that, under the facts and circumstances, would cause a reasonable person to consider it unsafe to walk to or from work, or walk to or use public transportation at the time of the employee’s commute), an employer may provide local transportation for the employee and deduct such costs. However, the value of such benefit must be included in the employee’s income at a rate of $1.50 each way.   Qualified Moving Expenses Prior Law Tax Reform Gross income excludes the value of any moving expense reimbursement received, directly or indirectly, by an individual from an employer as payment or reimbursement for expenses which would be deductible as moving expenses if directly paid or incurred by the employee. Suspends the exclusion for qualified moving expense reimbursements for taxable years after December 31, 2017, and before January 1, 2026.  However, the moving expense exclusion continues to apply for members of the Armed Forces on active duty who relocate pursuant to military orders.   BDO Insights

Under prior law, employer payments for nondeductible moving expenses were included in the employee’s income (e.g., house hunting expenses, real estate expenses incurred for selling/buying a residence); while employer payments for deductible moving expenses were excluded from income (e.g., transportation of household goods).  Under the Act, nonmilitary individuals are no longer allowed to deduct moving expenses on their federal income tax return (for 2018 through 2025)  and the employer-paid moving expenses are includible in their income.  For the eight-year period, all moving expenses will be treated the same – nondeductible.

Accordingly, all moving expenses are reportable to employees as taxable compensation and deductible by the employer. 

Employer-paid moving expenses facilitate the national and global recruitment of executives and high-skilled talent that are not available in the regional location of the employer.  The loss of this benefit will add a premium to recruiting for employers who provide a tax gross-up to incentivize the employee to relocate, particularly for relocations abroad.  Companies will have to adjust their relocation packages.  Alternatively, this provision may result in an increase in telecommuting arrangements in lieu of relocations.   Entertainment Expenses Prior Law Tax Reform Generally, no deduction is allowed for expenses relating to entertainment, amusement or recreation activities or facilities (including membership dues with respect to such activities or facilities), unless such meet the “directly-related-to” or “associated-with” the active conduct of the employer’s trade or business test.  Additionally, an employer may deduct expenses for goods, services, and facilities, provided that such expenses are reported as compensation to an employee (or nonemployee). To the extent the employer’s entertainment expense exceeds the amount imputed in income of a “specified individual” (officer, director, 10-percent owner), the employer’s deduction is limited to the amount included in income. Repeals the “directly-related-to” or “associated-with” exceptions to the deduction disallowance for entertainment, amusement or recreation expenses.
 
No deduction would be allowed for entertainment, amusement or recreation activities, facilities, or membership dues related to such activities.   BDO Insights

The new law eliminates any ambiguity as to whether the entertainment expense meets the “directly-related-to” or “associated-with” test, since no deduction is allowed in absence of income inclusion to employees.

Employers that provide certain perquisites to executives (e.g., golf and country club memberships, entertainment travel aboard corporate jet) face a tradeoff between lost deductions for the company or income inclusion for the executives.

The Act treats all employees the same as officers, directors and 10-percent owners (“specified individuals”).  Under prior law, an employer’s deduction was the lesser of the cost of providing the entertainment benefit or the amount included in the specified individual’s income, while such entertainment costs for non-specified employees were fully deductible without regard to the amount included in their income.  For example, an employee’s income inclusion for personal use of a corporate jet is valued using the IRS’s standard industry fare level (SIFL) rates, which are often significantly less than the aircraft costs allocated to the flight.  Under the Act, an employer may only deduct the amount reported to the employee as compensation and loses a deduction for any excess cost allocated to the entertainment benefit provided to any employee.      50 percent Deduction Limitation on Meals Prior Law Tax Reform Section 274(n) imposes a 50 percent limitation on the deduction of meal expenses, unless an exception applies.  Section 274(n)(2)(B) provides that the 50 percent limitation does not apply if a meal qualifies as a de minimis fringe benefit and meets certain requirements under Section 132(e) and corresponding regulations.  Specifically, the eating facility is located on or near the employer’s business premises; such facility is owned/leased and operated by the employer; access to the facility is available to employees in a nondiscriminatory manner; meals are provided during or immediately before or after the employees’ workday; and meals are furnished for the convenience of the employer.  Food and beverage expenses incurred and paid after December 31, 2017, and until December 31, 2025, through an employer’s eating facility that meets requirements for de minimis fringes and for the convenience of the employer are subject to a 50 percent deduction limitation. No deduction is allowed for these food and beverage expenses for tax years beginning after December 31, 2025.
 
Off premises entertainment meals are nondeductible for tax years after December 31, 2017. 
 
    BDO Insights

The Act phases out the deduction for meals provided to employees on or near an employer’s premises for the convenience of the employer which were fully deductible under prior law.  For 2018 through 2025 the expenses are 50 percent deductible and nondeductible after 2025.

Meals incurred for business travel are not considered entertainment meals and therefore continue to be 50 percent deductible. Business travel generally entails travel away from the general area where the employee’s main place of business or work is located.   Affordable Care Act – Repeal of Individual Mandate Prior Law Tax Reform Individuals must be covered by a health plan that provides minimum essential coverage or be subject to a penalty for failure to maintain the coverage (the “individual mandate”).
 
The penalty for any calendar month is 1/12th of an annual amount.  The annual amount is generally equal $695 for 2017 (and $347.50 for each dependent under age 18), subject to a cap. 
 
Exemptions from the requirement to maintain minimum essential coverage are provided based on (1) ability to afford coverage, (2) member of an Indian tribe, (3) recognized religious sects, (4) individuals with a coverage gap for a continuous period less than 3 months, and 5) individuals who suffered a hardship. 
  The Act reduces the individual mandate penalty to zero for taxable years beginning after December 31, 2018.   BDO Insights

The elimination of the penalty for a violation of the individual mandate for taxable years may indirectly impact employers in several ways. 

First, the reporting requirements for employers may change after 2018.  Specifically, Part III of Form 1095-C and Form 1095-B that provide information to enforce the individual mandate, serve no purpose as long as the individual mandate is zero.   Accordingly, future guidance may relieve employers with self-insured plans from reporting the employees and dependents covered each month under the plan for years beginning after 2018.  

Third, without the penalty, full-time employees who purchase insurance on the Exchange and receive a federal subsidy may drop coverage, thereby reducing penalties for employers whose coverage was not affordable to such employees.   Retirement Plans Plan Loan Offsets Prior Law Tax Reform Upon a “loan offset,” the plan reduces the participant’s vested accrued benefit (the security interest held by the plan) to satisfy loan repayment, provided the participant is eligible to receive a distribution (e.g., separation from employment, in-service distribution after age 59 ½).  This is treated as an actual distribution of the participant’s benefit.

To avoid taxation on the loan receivable, the participant may rollover the amount to an IRA or another retirement plan within 60 days after the offset by transferring cash to the IRA or other plan.
  Upon plan termination or a participant’s separation from employment while the participant has an outstanding plan loans, the participant would have until the due date (including extensions) for filing his or her individual income tax return for that year to contribute the balance to an IRA or a new employer’s retirement plan in order to avoid the loan being taxed as a distribution.   BDO Insights

Some plan provisions require outstanding loans to be completely paid after termination of employment to avoid having to collect repayments outside of payroll.  A participant may defer taxation by making a timely rollover of an outstanding loan.  Under the Act, a participant can complete the rollover of the loan by contributing cash equal to the loan balance to an individual retirement account (IRA) or an eligible retirement plan of the participant’s new employer by the due date (including extensions) of the individual’s income tax return for the year in which the loan offset occurred.  Alternatively, under previously existing rules, the participant may avoid triggering a loan offset by rolling over the promissory note to another eligible retirement plan with a loan program that accepts the note.  A direct rollover of the note to an IRA is not permissible, because it is a prohibited transaction for an IRA to lend money to the IRA owner.    Use of Retirement Plans for 2016 Disaster Areas A “qualified 2016 disaster distribution” is a distribution from an eligible retirement plan made on or after January 1, 2016, and before January 1, 2018, to an individual whose principal residence at any time during 2016 was located in a 2016 disaster area and who has sustained an economic loss by such events.
 
Eligible retirement plans included qualified retirement plans, 403(b) plans and governmental 457(b) plans.
 
The total amount of the distribution cannot exceed $100,000 during the applicable period, and is not subject to the 10 percent early withdrawal tax.  Any amount required to be included in income as a result of such distribution is included in income ratably over the three-year period beginning with the year of distribution, unless the individual elects not to have ratable inclusion apply.
 
The individual may, at any time during the 3-year period, recontribute all or a portion of the 2016 disaster distribution to an eligible retirement plan.  The individual may file an amended return to claim a refund of the tax attributable to the amount previously included in income.  If under the ratable inclusion provision, a portion of the distribution has not yet been included in income at the time of contribution, the remaining amount is not includible in income.  
  BDO Insights

This provision can apply to distributions already made during 2016 and 2017 provided the written plan is amended with retroactive effect on or before the last day of the first plan year beginning on or after January 1, 2018 (i.e., by December 31, 2018 for calendar year plans).  These distributions are an alternative to plan loans and hardship distributions

By virtue of the retroactive amendment to January 1, 2016, presumably any hardship withdrawals claimed in connection with the 2016 Disaster Areas may be recharacterized as disaster distributions to enable participants to take advantage of the three-year income inclusion, waiver of the early withdrawal penalty and ability to restore amounts to the retirement plan. 
Payroll Taxes Supplemental Wage Withholding Prior Law Tax Reform If supplemental wages paid to an employee (or former employee) during a calendar year do not exceed $1 million, then the amount of the optional flat rate withholding method is one of two ways that federal income tax may be withheld.
 
Under the optional flat rate withholding method, the employer disregards any withholding allowances claimed or additional withholding amount requested by the employee on Form W-4 and withholds at the flat rate percentage.
 
Under the regulations, the optional flat rate was 25 percent (the rate in effect under Section 1(i)(2)).
 
If a supplemental wage payment, when added to the supplemental wage payments previously made by one employer to an employee during the calendar year exceeds $1 million, the rate used in determining the amount of withholding on the excess is equal to the highest rate of tax applicable under Section 1 (39.6 percent for 2017). Suspends the Section 1(i)(2) rate reductions that applied to tax years after 2000.
 
The highest rate of tax applicable under Section 1 is reduced from 39.6 percent to 37 percent.   BDO Insights

The tax regulations required supplemental withholding at 25 percent (i.e., the rate in effect under Section 1(i)(2)) or 28 percent.  For taxable years beginning after December 31, 2017 and before January 1, 2026, the Act effectively suspends Section 1(i)(2), which served as the basis for the 25% optional flat withholding rate   The change in law creates uncertainty of the correct withholding rate for employers that elect to use the optional flat rate withholding method for 2017 bonuses paid this year, vesting of restricted stock, exercises of options, and other supplemental wage payments.  Will the optional flat rate be 22 percent (since the flat rate has historically mapped to the third bracket rate in effect), stay at 25 percent, or default to the 28 percent stated within the tax regulations?  Since the optional flat withholding rate is set by regulations, employers should continue to apply the 25% rate pending further guidance by the IRS, which is expected to be released in January 2018.    
Employment Related Credits Employer Credit for Paid Family and Medical Leave The Act allows eligible employers to claim a credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave if the rate of payment under the program is 50 percent of the wages normally paid to the employee.  The credit is increased 0.25 percent (but not above 25 percent) for each percentage point by which the rate of pay exceeds 50 percent.  The maximum amount of leave that may be taken into account for any employee in a taxable year is 12 weeks.
 
An eligible employer means any employer that has a written policy that allows all qualifying full-time employees at least 2 weeks of annual paid family and medical leave, and who allow part-time employees (customarily employed for fewer than 30 hours per week) a commensurate amount of leave on a pro rata basis.
 
A qualifying employee means any employee who has been employed with the employer for at least one year and whose compensation in the preceding year did not exceed 60 percent of the compensation threshold for highly compensated employees. 
 
Family and medical leave is defined as leave described under the Family and Medical Leave Act of 1993 (FMLA).  If an employer provides paid leave as vacation, personal leave, or medical or sick leave, such paid leave would not be considered to be family and medical leave. 
 
This program sunsets on December 31, 2019, such that the credit shall not apply to wages paid thereafter.   BDO Insights

Only four states – California, New Jersey, New York, and Rhode Island – currently offer paid family and medical leave.  All four state programs are funded through employee-paid payroll taxes and administered through respective disability programs.  For purposes of this federal credit, any leave which is paid by a state or local government or required by state or local law will not be taken into account in determining the amount of paid family and medical leave provided by the employer.   
For more information, please contact one of the following practice leaders: 
  Joan Vines
Compensation & Benefits Managing Director Carl Toppin
Compensation & Benefits Managing Director     Peter Klinger
Compensation & Benefits Principal Alex Lifson
Compensation & Benefits Principal Andrew Gibson
Tax Regional Managing Partner  

Tax Reform Impacts the Research Tax Credit, Domestic Production Activities Deduction & Orphan Drug Credit

Thu, 01/04/2018 - 12:00am
Summary On December 22, 2017, President Trump signed into law, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (“tax reform” or the “law”). The law preserves and enhances the value of the Credit for Increasing Research Activities under Internal Revenue Code (IRC) Section 41 (Research Credit) while eliminating or reducing the value of related incentives like the IRC 199 Domestic Production Activities Deduction (DPAD) and IRC 45C Orphan Drug Credit (Orphan Drug Credit).
  Details Background
The Research Credit was enacted in 1981 to incentivize taxpayers to increase investments in developing new or improved products, manufacturing processes, software, techniques, inventions, and formulae in the United States. In 2015, the Protecting Americans against Tax Hikes Act (PATH Act) made the credit a permanent part of the IRC and expanded its benefit to certain small businesses and startups. The DPAD and ODC were enacted subsequent to the Research Credit for similar reasons.

Research Credit’s Value Enhanced

Lower Corporate Tax Rate
The law cuts the corporate tax rate from 35% to 21%. In effect, this cut increases the Research Credit’s net benefit by more than 21%, from its previous amount of 65% to the law’s 79%.

The 21% increase in the credit’s net value is due to IRC Section 280C(c).

Enacted to prevent taxpayers from getting a double benefit for their research-related expenses—i.e., a deduction and a credit for the same expenses—Section 280C(c) requires taxpayers to (1) reduce their deduction for IRC Section 174 allowable expenses by the amount of the Research Credit, or (2) elect a reduced credit generally equal to the Research Credit minus the product of the Research Credit and the maximum corporate tax rate.

With the maximum rate now at 21% instead of 35%, the reduced credit now equals 79% instead of 65% of the Research Credit, i.e., 100% less 21% instead of 100% less 35%.

Corporate Alternative Minimum Tax Repealed
The law repeals the corporate Alternative Minimum Tax (AMT) provisions. This means that taxpayers who would have been subject to AMT and who therefore generally wouldn’t have been able to use Research Credits to offset their federal income tax liability now will be able to do so.

Historically, corporations could only use the Research Credit to offset only ordinary income tax liability, and not their AMT. Starting in 2016, the PATH Act allowed eligible small businesses—viz., privately held businesses with $50 million or less in average gross receipts for the three preceding tax years—to utilize the Research Credit against their AMT.

By eliminating the AMT’s Tentative Minimum Tax for corporations, the law allows the Research Credit to reduce a taxpayer’s liability down to 25% of the amount of net regular tax liability that exceeds $25,000, a limitation imposed by IRC Section 38(c).

Modification of Net Operating Loss Deduction
The law limits the amount of Net Operating Losses (NOLs) that a taxpayer can use to offset taxable income to 80% of its taxable income for losses arising in tax years beginning after December 31, 2017. NOL taxpayers may now find the Research Credit a helpful way to offset the taxes they’ll have to pay.

The law also repeals the provision allowing for the current two-year carryback of NOLs and allows an indefinite carryforward of NOLs arising in tax years ending after December 31, 2017.

Section 199 Domestic Production Activities Deduction (DPAD) Repealed
The law repeals DPAD for tax years beginning after December 31, 2017. Section 199 previously provided a tax deduction to taxpayers deriving income from “qualified production activities” performed in the United States, which included manufacturing of tangible property and software development.

Orphan Drug Credit (ODC) Rate Reduced
For tax years beginning after December 31, 2017, the law reduces the ODC rate to 25%, down from 50%.
Even at 25%, though, the ODC is generally more beneficial than the Research Credit for the same costs to which it applies: the ODC rate is 25%, the Research Credit’s 20%, or about 16% after Section 280C(c); the ODC calculation includes 100% of qualified contractor costs, the Research Credit’s typically only 65%; and the ODC equals 25% of qualified costs, the Research Credit 20% of only the qualified costs that exceed a base amount.

The ODC was enacted to incentivize pharmaceutical companies to develop drugs that treat diseases affecting less than 200,000 patients in the U.S. Developers of such drugs are eligible for a tax credit equal to a percentage of their qualifying costs incurred between the date the FDA grants the taxpayer orphan status and the date the FDA approves its drug for patients.

The law also allows for taxpayers to elect a reduced ODC, similar to the 280C(c)(3) election for the Research Credit.

Amortization of Research and Experimental Expenditures
For amounts paid or incurred in a tax year beginning after December 31, 2021, the law will require taxpayers to capitalize and amortize IRC Section 174 research and experimental (R&E) expenditures over a five year period, beginning with the midpoint of the taxable year in which the expenditure is paid or incurred. Costs for research conducted outside of the U.S. will be amortized over a 15-year period. Further, expenditures for the development of any software will be treated as R&E expenditures. For purposes of this rule, software development costs are included in the definition of R&E expenditures. 

Under current law, Section 174 generally allows taxpayers to deduct R&E expenditures as the amounts are paid or incurred during a tax year; alternatively, taxpayers may elect to capitalize and amortize these expenditures over a period of no less than 60 months.

The new provision will impact taxpayers treating R&E costs as deductible expenses by no longer enabling them to recover costs incurred in the year in which they are incurred. Accordingly, taxpayers currently deducting R&E costs in the year incurred will be required to file an Application to for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing such costs for tax years beginning after December 31, 2021.
  BDO Insights With the new provisions of tax reform taxpayers should evaluate how the changes above impact their future tax position and how the Research Credit and ODC can help minimize tax liabilities. Key takeaways include:
  • The cut of the corporate tax rate increases the Research Credit’s net benefit by more than 21%, from its previous amount of 65% to the law’s 79%.
  • Taxpayers who would have been subject to AMT and who therefore generally wouldn’t have been able to use Research Credits to offset their federal income tax liability now will be able to do so.
  • NOL taxpayers may now find the Research Credit a helpful way to offset the taxes they’ll now have to pay given the modification of the NOL deduction.
  • While the ODC credit rate has been reduced to 25%, it still provides a meaningful benefit for eligible taxpayers, generally more beneficial than the Research Credit.
  • Taxpayers seeking to maximize the benefit of immediately deducting R&E expenditures should consider the effective date of the required amortization rule (i.e., December 31, 2021) and if possible, accelerate their R&D activities prior to December 31, 2021.  
 
For more information, please contact one of the following regional practice leaders: 
  Chris Bard
National Leader
Los Angeles, New York   Jonathan Forman
Principal
New York   Jim Feeser
Managing Director
Woodbridge   Chad Paul
Partner
Milwaukee   Patrick Wallace
Managing Director
Atlanta   David Wong
Partner
Los Angeles   Laura Morris
Managing Director
San Francisco   Brad Poris
Managing Director
Long Island   Joe Furey
Managing Director
Chicago   Sanjiv Gaitonde
Senior Manager
Houston     Gabe Rubio
Managing Director
Los Angeles    

​Impact of Reform on Partnerships and Partners

Thu, 01/04/2018 - 12:00am

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Summary On Friday, December 22, President Trump signed sweeping tax reform (the “Act”) into law. The Act provides the most comprehensive update to the tax code since 1986, and includes a number of provisions of particular interest to partnerships and their partners. This alert addresses the following provisions:
  • Recharacterization of Certain Long-Term Capital Gains
  • Taxation of Gain on the Sale of Partnership Interest by a Foreign Person
  • Repeal of Technical Termination Rules under Section 708(b)(1)(B)
  • Modification of the Definition of Substantial Built-in Loss in the Case of a Transfer of a Partnership Interest under Section 743(d)
  • Charitable Contributions and Foreign Taxes Taken into Account in Determining Basis Limitation under Section 704(d)
  • Like-Kind Exchange Transactions under Section 1031
  Details Repeal of Technical Termination Rules (708(b)(1)(B))
The Act repeals the technical termination rules under Section 708(b)(1)(B) for tax years beginning after 2017. No changes were made to the actual termination rules under Section 708(b)(1)(A). Repeal of the technical termination rule is generally a favorable development, since it will eliminate the need to restart depreciation upon the sale or exchange of more than 50 percent capital and profits interest in a partnership. Additionally, the Act will alleviate the common occurrence of failing to properly identify transactions, giving rise to technical terminations, which leads to late filing of required tax returns, failure to make appropriate elections, and imposition of penalties. However, technical terminations are sometimes used to eliminate unfavorable elections, and the creation of a “new” partnership entity is oftentimes required in connection with international investments in U.S. joint ventures. While it may be possible to continue structuring transactions to achieve these objectives, the simplicity of triggering a technical termination will be eliminated.
 
Recharacterization of Certain Long-Term Capital Gains (Sections 1061 & 83)
Under general rules, gain recognized by a partnership upon disposition of a capital asset held for at least 1-year will be characterized as long-term capital gain. Additionally, the sale of a partnership interest held for at least 1-year results in long-term capital gain except to the extent Section 751 applies. For tax years beginning after December 31, 2017, long-term capital gain will only be available with respect to “applicable partnership interests” to the extent the capital asset giving rise to the gain has been held for at least 3-years.

An applicable partnership interest is defined to include any partnership interest transferred, directly or indirectly, to a partner in connection with the performance of services by the partner, provided that the partnership is engaged in an “applicable trade or business.” An applicable trade or business means any activity that is conducted on a regular, continuous, and substantial basis consisting of raising or returning capital and either (1) investing in, or disposing of, specified assets (or identifying specified assets for such investing or disposition) or (2) developing such specified assets. For purposes of this provision, specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.

Consistent with the intent to limit applicability of these rules, the Act provides that applicable partnership interests do not include (A) a partnership interest held directly or indirectly by a corporation or (B) a capital interest in a partnership commensurate with the partner’s capital contributions or the value of the interest subject to tax under Section 83 upon receipt or vesting. However, the fact that an individual may have recognized taxable income upon acquisition of an applicable partnership interest or made a Section 83(b) election with respect to such applicable partnership interest does not change the three-year holding period requirement.

Based on the definitions of applicable partnership interests, applicable trades or businesses, and specified assets, it appears that this rule is targeted at hedge funds and real estate funds with relatively short-term holding periods, i.e., more than one year but less than three years. Private equity and venture capital funds generally have a longer holding period and are unlikely to be affected to the same degree. However, care will need to be taken to ensure the holding period requirements are satisfied in all cases. Further, determination of a partner’s share of capital gains “commensurate with the amount of capital contributed” will likely require detailed record-keeping and tracking of partner Section 704(b) and tax basis capital accounts.
 
Taxation of Gain on the Sale of Partnership Interest by a Foreign Person (Sections 864(c) and 1446)
Revenue Ruling 91-32 generally provides that a foreign partner will recognize effectively connected income (ECI) on a sale of a partnership interest to the extent a sale of underlying partnership assets would give rise to an allocation of ECI to the transferor partner. The revenue ruling effectively adopts an aggregate approach to determining ECI notwithstanding the entity approach mandated by Section 741. In the recently decided case of Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, the Tax Court ruled that the taxpayer’s gain on sale of its partnership interest was not ECI despite the fact that a sale of the partnership’s assets would have generated ECI allocable to the partner, effectively rejecting Rev. Rul. 91-32.

Under the Act, gain recognized on the sale or exchange of a partnership interest will be treated as ECI to the extent the transferor would be allocated ECI upon a sale of assets by the partnership. This provision would effectively re-characterize otherwise non-ECI capital gain from the sale of partnership interest into ECI. Additionally, the Act provides that Treasury shall issue regulations as appropriate for application of the rule in exchanges described in Sections 332, 351, 354, 355, 356, or 361 and may issue regulations permitting a broker, as agent for the transferee, to deduct and withhold the tax equal to 10 percent of the amount realized on the disposition.  The provision treating gain or loss on the sale of a partnership interest as ECI would be effective for transactions on or after November 27, 2017, while the provision related to withholding would be effective for sales or exchanges after December 31, 2017.

This proposal effectively codifies the holding Revenue Ruling 91-32 and reverses the Tax Court’s decision in Grecian Magnesite. As a result of the coordination of allocable gain on a hypothetical sale of partnership assets with total ECI, accurate tracking of Section 704(c) built-in gain and losses will become significantly more important.
 
Modification of the Definition of Substantial Built-in Loss in the Case of a Transfer of a Partnership Interest (Section 743(d))
Section 743(b) provides for an adjustment to the basis of partnership property upon the sale or exchange of a partnership interest providing the partnership has a Section 754 election in effect or where the partnership has a substantial built-in loss. Section 743(d) currently provides that a partnership has a substantial built-in loss with respect to a transfer of an interest in a partnership if the partnership's adjusted basis in all of its property exceeds the fair market value of such property by more than $250,000. Under this existing rule, it’s possible that a transferee partner could acquire a partnership interest with respect to which there is a built-in loss of more than $250,000 without there being a mandatory basis adjustment because the partnership does not have an overall built-in loss meeting the threshold.

The Act modifies the definition of a substantial built-in loss for purposes of Section 743(d). Under the Act, in addition to the present-law definition, a substantial built-in loss also exists if the transferee partner would be allocated a loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest. This provision would apply to transfers of partnership interests occurring after December 31, 2017.

It is not clear whether a relatively high number of partnership interest transfers will be captured under this rule. However, given the negative consequences of a potential downward basis adjustment it will become even more critical that partnerships properly track each partner’s Section 704(b) and tax basis capital accounts. Failure to accurately track capital accounts could lead to incorrect downward adjustments resulting in increased exposure to both the transferring and non-transferring partners.
 
Charitable Contributions and Foreign Taxes Taken into Account in Determining Basis Limitation (Section 704(d))
Under the general rules of Section 704(d), a partner’s ability to deduct its distributive share of partnership losses is limited to the extent of the partner’s outside tax basis in the partnership interest. However, this limitation does not apply to a partner’s allocable share of charitable contributions or foreign tax expenditures. As a result, a partner may be able to deduct its share of a partnership’s charitable contributions and foreign tax expenditures even to the extent they exceed the partner’s basis in its partnership interest. The Act modifies the Section 704(d) loss limitation rule to take into account charitable contributions and foreign taxes. However, in the case of a charitable contribution of property where the fair market value exceeds the adjusted tax basis the Section 704(d) basis limitation would not apply to the extent of the partner’s allocable share of this excess. This provision applies to taxable years beginning after December 31, 2017.

This rule change will increase the importance of ensuring accurate calculation of a partner’s tax basis. Although partners are generally required to determine their own tax basis, it’s not uncommon for partners to look to the partnership to provide relevant data including tax basis capital and liability allocations. The increased importance of outside tax basis calculations will place more pressure on partnerships to accurately track partner capital as well as determining proper liability allocations under Section 752.
 
Like-Kind Exchanges of Real Property (Section 1031)
For exchanges entered into after December 31, the Act limits application of Section 1031 to transactions involving the exchange of real property that is not held primarily for sale. Section 1031 no longer applies to personal property including personal property that is associated with real property. A transition rules applies for exchanges that began before January 1, 2018. Consequently, if the taxpayer has started a deferred exchange prior to January 1, 2018, Section 1031 may still be applied to the transaction even though completed after December 31, 2017.
 
For more information, please contact one of the following practice leaders:
  Jeffrey N. Bilsky
National Tax Office Partner
Technical Practice Leader, Partnerships   David Patch
National Tax Office Managing Director
    Julie Robins
National Tax Office Managing Director   Will Hodges 
National Tax Office Senior Manager   Katie Pendzich
National Tax Office Senior Manager    

BDO Knows Tax Reform: Corporate Tax Reform - Summary of New Laws Taking Effect

Wed, 01/03/2018 - 12:00am
Summary Introduced as the Tax Cuts and Jobs Act, the “Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal year 2018,” P.L. 115-97, was signed into law by the President on December 22, 2017.  While the individual and pass-through (e.g., S corporation) provisions are generally phased out in less than a decade, the tax cuts for C corporations are permanent changes to the Internal Revenue Code.  The reduced tax rate of 21 percent, from 35 percent, is certain to increase the popularity of corporations. The benefits increase the longer earnings are retained and deferred from additional tax (e.g., no dividends or stock dispositions).  S-to-C corporation conversions have been made more taxpayer-friendly in an effort to ensure C corporations are not only more competitive internationally under the new law, but also domestically.  The key topics in the new law covered below include: 1) corporate tax rate reduction and the alternative minimum tax (AMT) repeal, 2) capital contributions and dividends to corporations, 3) debt versus equity (section 385) and the new limitation on deducting interest expense, 4) corporate net operating losses (NOLs), 5) bonus depreciation and full expensing, 6) section 199A deduction for qualified business income earned from S corporations, 7) electing small business trusts (ESBTs), and 8) S-to-C corporation conversions.
  Details 1. Corporate Tax Rate Reduction and the Alternative Minimum Tax Repeal

The top corporate tax rate has been permanently reduced by 40 percent—from 35 to a flat tax rate of 21 percent.  The prior four corporate tax rates, with a top rate applicable to income over $10 million, have been reduced to a single flat rate thereby converting the corporate progressive tax system into a flat tax system.  Personal service corporations (e.g., certain corporations providing health, law, and accounting services), which have historically been subject to some of the highest tax rates and could not benefit from the lower progressive rates, are now taxed at the same rate as other C corporations.  The corporate tax rate of 21 percent may increase the relative use of C corporations for certain businesses based on the facts and circumstances of each situation (e.g., the applicability of the new top individual rate of 37 percent, still subject to the individual AMT, and a new deduction for certain pass-through income discussed below).  Taxpayers have already begun the difficult task of modeling out specific factors that could impact choice of entity determinations (e.g., temporary vs. permanent rate differences).      

The corporate AMT has generally applied to the extent a corporation’s tentative minimum tax, based on a 20 percent rate, exceeds its regular tax, by reducing certain tax incentives and deductions.  While the House bill eliminated the corporate AMT, the Senate proposal did not.  Ultimately, the Conferees opted to repeal it because retaining the corporate AMT could reduce research and development incentives intended to improve competitiveness and innovation.  Further, the historic policy concerns underlying the corporate AMT, with its tax rate threshold of 20 percent, have been greatly diminished as a result of the top corporate tax rate reduction from 35 to 21 percent.  

The corporate AMT repeal is effective for taxable years beginning after December 31, 2017.   Going forward, any corporate AMT credit may offset the regular tax liability for any taxable year after 2017.  The AMT credit is simply the corporation’s prior AMT liabilities.  In addition, the AMT credit is refundable for any taxable year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent for taxable years beginning in 2021) of the excess credit for the taxable year.

2. Capital Contributions and Dividends to Corporations

Certain capital contributions from state and local governments will no longer be excluded from income under section 118.  Section 108(e)(6), however, will not be altered for computations of cancellation of debt income on certain contributions of debt.  And the meaningless gesture doctrine will continue to apply to section 351 exchanges of wholly-owned corporations in which no shares are issued.  While section 108(e)(6) and section 351 concerns arose following broad statutory language found in the House proposal, the subsequent Congressional reports eliminated these concerns.

As in the Senate proposal, the 70 and 80 percent dividend received deduction percentages for corporations have been reduced to 50 and 65 percent, respectively, under the new law.

3. Debt versus Equity and the New Limitation on Deducting Interest Expense

The recent section 385 regulations were identified by the Administration for possible elimination.  That elimination determination was put on hold after statements that new statutory provisions may eliminate or mitigate the need for the regulations.  As indicated, the new law modifies section 163 with an enhanced limitation on the deduction of interest for any business.  The new provision limits the deduction of business interest by any taxpayer to the sum of (1) business interest income; (2) 30 percent of the adjusted taxable income of the taxpayer; and (3) the floor plan financing interest of the taxpayer for the taxable year.  The last element, floor plan financing, applies to dealers of vehicles, boats, farm machinery or construction machinery.  For all other taxpayers, the limitation on net interest expense (interest expense less interest income) will be 30 percent of adjusted taxable income.  Adjusted taxable income for this purpose is the taxable income of the taxpayer with the exclusion of: (1) any nonbusiness income, gain, deduction or loss, (2) business interest and business interest income, (3) any net operating loss deduction, and (4) any deduction allowable for depreciation, amortization or depletion.

Any amount disallowed under the limitation is treated as business interest paid or accrued in the following tax year.  Disallowed interest will have an indefinite carryforward.  In addition, the disallowed interest carryforward will be a tax attribute that carries over in certain corporate acquisitions subject to section 381 (such as tax free liquidations under section 332 and most reorganizations under section 368).  The bill also modifies section 382 to expand the definition of pre-change loss to include any disallowed interest carryforward, making these carryforwards subject to the section 382 limitation in the same manner as NOL carryforwards.

Special rules apply to account for interests held by partners and S corporation shareholders.  Specifically, the partnership must first calculate the limitation on business interest expense at the partnership level.  Any excess interest is allocated to each partner in the partnership.  The partner can then carryforward the excess, but can only deduct the carryforward to the extent the partnership allocates excess business income to that partner in a future year.  Excess business income is the portion of that partnership’s taxable income which bears the same ratio to the partnership’s adjusted taxable income as the excess of 30 percent of the adjusted taxable income over the amount of net business interest bears to 30 percent of the adjusted taxable income of the partnership.  In addition, if a taxpayer is a partner in a partnership, the taxpayer removes all items of income, deduction, gain or loss of the partnership when calculating adjusted taxable income.  Instead, the taxpayer only includes the excess taxable income of the partnership in the taxpayer’s calculation of adjusted taxable income.  S corporations will apply similar rules to that of partnerships.

The following taxpayers are excluded from the application of the new interest limitations: (1) any taxpayer that has annual gross receipts under $25 million, (2) regulated public utilities, (3) an electing real property trade or business, and (4) an electing farming business.

These new rules generally apply to taxable years beginning after December 31, 2017.  The new interest limitations could lead to the repeal of the recent section 385 regulations in whole or in part.  

4. Corporate Net Operating Losses

Under current law, section 172 allows businesses to offset current taxable income by any NOL carryforward or carryback, subject to several limitations. Although no limitation is placed on the use of NOLs under section 172, the AMT as it applies to businesses effectively limits utilization of NOLs to an offset of 90 percent of taxable income. The House bill took the AMT limitation and proposed to incorporate it within section 172, imposing a 90-percent limitation on the use of NOL carryforwards and carrybacks. The House bill also proposed to allow the indefinite carryforward of NOLs, eliminating the current 20-year carryforward limitation, while also eliminating all NOL carrybacks with the narrow exception of certain carrybacks for small businesses and farms in the event of casualty or disaster losses arising in a tax year beginning after 2017. The Senate bill proposed to limit NOL deductions to 90 percent of taxable income, and then 80 percent in tax years beginning after December 31, 2022. Like the House bill, the Senate bill also proposed the elimination of NOL carrybacks and an indefinite NOL carryforward period. The Conference Committee report and new law adopts the Senate bill approach, with the exception that NOL deductions be limited to 80 percent of taxable income for all years beginning after December 31, 2017.

The 80 percent limitation on NOL deductions applies to losses generated in tax years beginning after December 31, 2017, and the elimination of carrybacks and indefinite extension of carryforwards applies only to NOLs generated in taxable years ending after December 31, 2017. NOLs generated in 2017 and earlier would retain their 20-year life and be available to offset 100 percent of taxable income, subject to certain limitations. The result is that taxpayers will have to track NOLs before and after the effective date separately. While NOLs are expected to increase as a result of the expansion of allowable depreciation deductions (see below), there may be an incentive to defer deductions to a year where they can be deducted 100 percent against taxable income as opposed to generating an NOL which is limited to 80 percent. Taxpayers should also consider any carryforward of disallowed interest under revised section 163, which will be an attribute subject to the same limitations on NOLs (specifically section 382), potentially causing taxpayers in a profitable position to consider change of control impacts.

5. Bonus Depreciation and Full Expensing

Under current section 168(k), an allowance for 50 percent “bonus” depreciation gives businesses an immediate deduction for half the purchase price of certain qualified property in addition to the first year tax depreciation expense (calculated after the reduction by 50 percent). The House bill proposed an increase of the first year allowance to 100 percent, allowing taxpayers the ability to deduct the full cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The House bill also proposed expanding property treated as qualifying to include used property not used by the taxpayer before acquiring it. The Senate bill proposed full expensing for property placed in service after September 27, 2017, and before January 1, 2023, (2024 for property with longer production periods) with the percentage decreasing by 20 percent for each successive year beginning in 2023 (80 percent allowance in 2023, 60 percent allowance in 2024, etc.) through a total phase out of the allowance for property placed in service on or after January 1, 2027.  The new law adopted the Senate proposal and also allows the election for 50 percent bonus depreciation in lieu of the 100 percent available, and repeals the election to claim prior year minimum tax credits in lieu of bonus depreciation.  Importantly, the new law expands the definition of qualified property by eliminating the requirement that use of the qualified property commence with the taxpayer.

Section 179 allows a deduction for the full purchase price of certain qualifying property purchased in the tax year. For tax years beginning in 2017, the section 179 deduction is limited at $510,000, and begins to be reduced dollar-for-dollar when equipment purchases exceed $2,030,000. The House bill proposed for tax years beginning in 2018 through 2022 the expense limitation be increased to $5,000,000, and the phase out amount to $20,000,000. The Senate bill proposed the expense limitation be increased to $1,000,000, and the phase out amount to $2,500,000. The Conference Committee report and new law adopts the Senate approach, increasing the section 179 expense limitation on qualifying property to $1,000,000, while also increasing the initial phase out amount to $2,500,000.

As noted above, the expansion of both bonus depreciation and section 179 may increase or accelerate the generation of NOLs. The election to use such deductions will depend on the specific context and whether or not the acceleration will generate an 80 percent limited NOL. Further, the expansion of “qualified” property may increase the desire of buyers to purchase assets as opposed to stock in scenarios where the result is a step up in tax basis based on purchase price which can then be immediately deducted. For the same reason, there may also be an increase in deemed asset sale elections under sections 336(e), 338(g), and 338(h)(10) in scenarios where the structure of the acquisition is a qualified stock disposition or purchase.

6. Section 199A Qualified Business Income Earned from S Corporations

The new law provides individuals, estates, and trusts with a deduction of up to 20 percent of their domestic qualified business income (QBI), regardless of whether it is attributable to income earned through an S corporation, partnership, sole proprietorship, or disregarded entity. 

For taxpayers whose taxable income does not exceed $157,500 (or $315,000 in the case of a joint return of a married couple), the deduction is fixed at 20 percent with no limitations.  For taxpayers whose taxable income is at least $207,500 (or $415,000 in the case of a joint return of a married couple), two additional provisions apply.  First, a limitation based on W-2 wages must be applied at the individual level, and thus may reduce the deduction percentage below 20 percent.  Second, no deduction may be claimed for income from specified service businesses.  For taxpayers whose taxable income is between these two amounts, the W-2 wage limitation and the limitation on specified service businesses are phased in.  It is important to note that QBI does not include reasonable compensation paid to the taxpayer for services rendered with respect to the trade or business under new section 199A(c)(4).

A disqualified business includes a “specified service trade or business,” which is defined in part as a business described in section 1202(e)(3)(A), ignoring the words engineering and architecture (permissible real estate services).  Specifically, a specified service business is one involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. 

The new law also adopts a two-part W-2 wage (e.g., compensation from an S corporation) limitation.  Under this provision, the wage limitation is the greater of 50 percent of the W-2 wages paid with respect to the qualified trade or business or the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of all qualified property used in the business.  The application of this wage limitation may reduce the deduction below 20 percent of the qualified business income, but will never increase the deduction above 20 percent.

The above offers a summary of the changes to section 199A.  An in-depth alert will be issued on the topic on the BDO Tax Reform website.

7. Electing Small Business Trusts

The new law modifies two rules applicable to ESBTs.  First, a nonresident alien may be a potential current beneficiary of such a trust.  Because the tax imposed on the S portion of an ESBT is the final incidence of taxation of such income, there is no further taxation on any amounts distributed to a beneficiary of an ESBT.  Second, if an S corporation allocates a charitable contribution to an ESBT, the limitations on that deduction will be computed under the rules for individuals and not under the more restrictive rules for trusts.  The rate of tax imposed on the taxable income of the S portion of an ESBT will also be reduced to 37 percent to match the highest rate of tax imposed on trusts.

8. S-to-C Corporation Conversions

In the event an S corporation and its shareholders determine that it is advantageous, in light of tax law changes or otherwise, to revoke the S corporation election, two new provisions will cushion the impact of the revocation.  Both changes apply to an “eligible terminated S corporation,” defined as any C corporation that is an S corporation on the day before enactment of the bill, revokes its S corporation election within two years after the date of enactment, and has the same shareholders, in the same proportions, as the corporation had on the date of enactment of the bill. 

First, after the expiration of the post-termination transition period (at least one year after termination of the S corporation election), a distribution of money by the corporation is allocated between the accumulated adjustments account (AAA) and the accumulated earnings and profits (AE&P) of the corporation in the same ratio as the amount of the AAA bears to the amount the AEP.  The portion of the distribution allocated to the corporation’s AAA will reduce the shareholder’s basis in the stock.  The portion of the distribution allocated to AE&P will be a taxable dividend.  These transition period provisions allow C corporation shareholders to benefit from historic AAA distributions, as a tax-free return of capital, where distributions would otherwise be entirely includable in income as dividends. 

Second, if an eligible terminated S corporation using the cash method is required under section 448 to adopt an accrual method, the resulting section 481(a) adjustment, i.e., the amount necessary to prevent items of income or deduction from being duplicated or omitted, is taken into account ratably over six taxable years beginning with the year of change.   Current accounting-method change procedures generally require a positive (taxpayer-unfavorable) section 481(a) adjustment to be taken into account over four taxable years.
Finally, because the tax rate established by sections 1374 (net recognized built-in gains) and 1375 (excess net passive income) are tied to the highest corporate tax rate, the tax rate under these two provisions will also be reduced to 21 percent.  These provisions incentivize S-to-C corporation conversions so taxpayers can benefit from the 21 percent corporate tax rate and the accompanying deferral provided to shareholders until they choose to cash out.
 
For questions related to matters discussed above, please contact:
  Ben Willis
National Tax Office Partner   Kevin Anderson
National Tax Office Partner   Doug Bekker
National Tax Office Partner   Bob Haran
National Tax Office Partner   Kevin Ainsworth
National Tax Office Senior Manager   Tommy Orr
National Tax Office Senior Manager
 

President Signs Tax Reform Bill Into Law

Fri, 12/22/2017 - 12:00am
On December 22, 2017, President Trump signed into law H.R. 1, formerly known as the “Tax Cuts and Jobs Act.”  The provisions are generally effective as of January 1, 2018, with some exceptions.  BDO’s Alert summarizing the highlights of the bill is available here: Conference Agreement Reached Setting Stage for Enactment Before the New Year.
 
BDO will broadcast a 90-minute webcast discussing the major provisions contained in the new law at 2:00 p.m. ET on January 4, January 9, and January 11. Our invitations to these webcasts can be found at:

BDO Event Series: Planning for Tax Reform, January 4, 2018
BDO Event Series: Planning for Tax Reform, January 9, 2018
BDO Event Series: Planning for Tax Reform, January 11, 2018

How Can You Prepare for Tax Reform?

Wed, 12/20/2017 - 12:00am
Stay up to date on the latest tax reform news and browse BDO’s resources.

U.S. Tax Reform Financial Reporting and Audit Considerations

Wed, 12/20/2017 - 12:00am
Summary The enactment of U.S. tax reform appears imminent.

On Wednesday December 20, 2017, the House and the Senate passed the tax reform legislation that had been referred to as the “Tax Cuts and Jobs Act”. The legislation passed contained three amendments from the previously published H.R. 1 bill agreed upon by the House and Senate conference committee. These amendments were required to ensure that the bill did not violate the Senate’s Byrd Rule. The bill’s short title was removed. That means the bill will not be known as the “Tax Cuts and Jobs Act” but rather as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”. The bill will now makes its way to the President for final review and signature.

The bill proposes significant legislative changes to the tax system, which includes substantial international tax reform. When enacted, this will be a major overhaul of the Internal Revenue Code (“IRC”) that will impact every taxpayer in the U.S. The implications are far reaching, and include considerable impacts on financial statement reporting.

There is not much time left to start planning and properly preparing to account for all the implications tax reform will have on financial statements.  We have summarized in this alert the key considerations for financial reporting. A more detailed analysis is forthcoming.   
  Table of Contents Details Tax Law Implications
When enacted, the bill will change the current tax system for corporations, generally beginning with taxable years starting after December 31, 2017. The bill will reduce the corporate tax rate from a graduated set of rates with a maximum 35 percent tax rate to a flat 21 percent tax rate. Additionally, the bill will introduce many changes that impact corporations, such as a net operating loss (NOL) deduction annual limitation, an interest expense deduction annual limitation, elimination of the alternative minimum tax, and immediate expensing of the full cost of qualified property.

The bill will also introduce a substantial international tax reform that moves the U.S. toward a territorial system, in which income earned in other countries will generally not be subject to U.S. taxation. However, the accumulated foreign earnings of U.S. shareholders of certain foreign corporations will be subject to a one-time transition tax. Amounts held in cash or cash equivalents will be subject to a 15.5 percent tax, while amounts held in illiquid assets will be subject to an eight percent tax. Taxpayers can elect to pay the transition tax over an eight year period using specified percentages (eight percent per year for the first five years, 15 percent in year six, 20 percent in year seven, and 25 percent in year eight), or chose to pay the amount in one lump sum. Also, taxpayers can use NOL and foreign tax credit (FTC) carryforwards to offset the transition tax liability (an election can be made to utilize FTC carryforwards before NOL).

Going forward, foreign earnings of U.S. shareholders of certain foreign corporations will be exempt from U.S. taxation, except for certain foreign income that will still be subject to the U.S. anti-deferral rules (i.e., subpart F of the Internal Revenue Code) and new anti-base erosion rules that are designed to ensure U.S. corporations do not shift income to jurisdictions with no or a very low tax rate (e.g., Cayman Island). 

Tax Accounting Implications
U.S. accounting standards under Topic 740 (Accounting Standards Codification or ASC 740) require remeasurement of all U.S. deferred income tax assets and liabilities for temporary differences and NOL carryforwards from the current rate of 35 percent to new corporate rate of 21 percent. The cumulative adjustment will be recognized in income tax expense from continuing operations as a discrete item in the period that includes the enactment date. Consequently, a calendar year-end company will need to adjust its deferred taxes in the December 31, 2017 financial statements. Further, SEC registrants will need to file their year-end financial statements 60-90 days after year-end.

The transition tax on accumulated foreign earnings will cause many U.S. corporations to recognize a U.S. tax on foreign earnings that were previously deemed permanently reinvested outside the U.S. The repatriation tax will also be recognized in income tax expense from continuing operations of the period of enactment. The tax calculation is complex and involves many variables and considerations (e.g., earnings and profits since 1986 and cash and cash equivalent balances at two particular dates). Foreign withholding tax that will be incurred on cash repatriation and foreign exchange translation effects will also be considered in the measurement of the repatriation tax and reflected in the enactment period accounting. The transition tax can be offset by NOL and FTC carryforwards and therefore will be considered a source of income for valuation allowance accounting purposes. Valuation allowance changes due to the transition tax will also be recognized in the enactment period accounting.      

Going forward, the various changes affecting corporations will have significant ASC 740 implications. For example, a new annual limitation on NOL utilization could result in more complexity and unfavorable valuation allowance consequences. A new annual limitation on interest deduction will introduce complexity, judgement and uncertainty into the determination of interest deducibility. New proposed international tax rules designed to eliminate incentives to keep foreign income in low tax jurisdictions will also create new challenges and complexities for ASC 740 purposes. A provision to encourage U.S. export of intellectual property (IP) provides a deduction for IP derived income, likely to be accounted for as a permanent benefit in a company’s effective tax rate instead of being reflected in deferred income taxes. All these will have corollary impacts on valuation allowances and uncertain tax benefits (FIN 48 liabilities) and will ultimately impact the effective tax rate.

Income tax disclosures should not be overlooked. The tax footnote disclosures included in annual financial statements of the enactment period will have to provide sufficient information on the cumulative effect of the tax reform enactment. There is a requirement to disclose significant components of income tax expense from continuing operations including the effect of a tax law and tax rate changes. This disclosure will also include the effect on the valuation allowance due to tax reform enactment. For many public companies, the income tax footnote’s effective tax rate disclosure which reconciles the statutory rate to the effective rate will have a reconciling item or items for the cumulative effect of the tax reform enactment.  The various balance-sheet related disclosures of deferred taxes, NOL and credit carryforwards, and uncertain tax benefit liabilities could also be affected.     
    
Audit Considerations
The expected passage of a major U.S. tax reform so close to year end will create disruption to the audit process and work expected for the 2017 financial reporting season. Being proactive in addressing the changes will be critical to easing the process. Preparers and auditors should learn the significant changes and understand the impact these will have on reported balances. The learning and assessment should begin now given a compressed timeline to avoid the possibility that tax balances may not be accurately accounted for in 2017 financial statements.

Auditing standards require an assessment of the overall risk of material misstatement to plan and perform an effective audit. This legislation will likely result in additional audit risk considerations to all preparers and their external auditors. Preparers should expect targeted audit procedures to address these additional risks and to provide audit evidence necessary to support reported amounts. This will include providing detailed calculations and documentation. Importantly, early discussion and sharing of information with external auditors concerning the underlying accounting impact in advance of management’s final assessment will help prevent last minute audit surprises.

The internal control framework or environment within an organization will also be affected by the passage of this major U.S. tax reform. New controls or revisions to existing controls might have to be designed and implemented. Auditors will need to evaluate the design of these controls and when applicable, test the operating effectiveness of such controls. If management intends to use certain permissible estimates within its calculations, it should be clear how the estimates were developed, the contradictory information that was considered and how management concluded the estimate was materially accurate. 

SEC Reporting Implications
Registrants will need to consider the impact of the Act on the disclosures within Management’s Discussion and Analysis (“MD&A”), specifically as it relates to liquidity, the results of operations, and critical accounting estimates.

A discussion is required of known trends, commitments, events, or uncertainties associated with the Tax Reform that are reasonably likely to result in liquidity increasing or decreasing in any material way, on both a short-term and a long-term basis. A registrant with significant foreign earnings must consider the impact of the one-time transition tax, including any changes to its contractual obligations table if the liability is to be paid in annual installments. Furthermore, the ongoing effects of other changes (e.g., the reduced corporate tax rate, among others) should be discussed.

A discussion of the impact of the Tax Reform on the results of operations should include (i) the one-time impact of the change in the corporate tax rate on deferred tax assets and liabilities (DTAs and DTLs), (ii) the one-time transition tax if the registrant has material foreign operations, and (iii) the ongoing impact of the reduced corporate tax rate and other changes. The first two items above should be consistent with amounts reflected in the effective rate reconciliation in the footnotes to the financial statements.

A discussion will need to be updated to address the material uncertainties associated with the estimates made within the tax provision, including a discussion surrounding the estimate of the one-time transition tax if the registrant has material foreign operations and there are significant uncertainties around the amount reflected in the financial statements.

Additionally, registrants will need to consider the income tax disclosures required under Regulation S-X, Rule 4-08(h), including disclosure of the amounts of income tax expense (benefit) applicable to United States Federal income taxes, foreign income taxes, and each other major component of income taxes as well as a reconciliation between the amount of reported income tax expense (benefit) and the amount computed by multiplying the income (loss) before tax by the applicable statutory Federal income tax rate including detail of the underlying causes for the difference in the two amounts.

If the Tax Reform is signed into law after the balance sheet date but prior to the issuance of interim or/and annual financial statements, the passage will be a known event that (presumably) is reasonably likely to materially affect operating results and liquidity. Therefore, a registrant should discuss the expected effects on future operating results and liquidity. A registrant should also consider disclosing (via a footnote to the contractual obligations table) the material change in other long term liabilities that occurred after year-end.
  BDO Insights Preparers of financial statements face a daunting task of having to learn, understand, and react to a monumental corporate tax overhaul within a compressed time period, as the enactment of the Tax Reform by December 31, 2017 appears imminent. This development comes at the time when many preparers are still working toward the January 1, 2018 adoption of a new revenue recognition standard (ASC 606).  Successful implementation and financial reporting (accounting and SEC) for all of the anticipated Tax Reform effects requires a multidisciplinary approach, drawing on people from finance, accounting, tax, and human resources. External auditors will also face considerably more work and audit considerations in relation to audits of financial statements and internal controls.
  How BDO Can Help: Preparers will have numerous operational challenges and risks from having to determine, within a short period, all of the effects stemming from the Tax Reform and account for them in their financial statements which include the enactment period. 

They are required to demonstrate a clear understanding of complex tax and accounting rules to accurately account for, and disclose, the company’s income tax accrual. 

BDO is well equipped to help preparers navigate the myriad of complex tax, accounting, SEC reporting, and audit considerations needed to be addressed by the enactment of the Tax Reform.

BDO “best in class” professionals have numerous years of experience working with U.S. GAAP, income tax accounting and international tax functions in domestic and international organizations.  By leveraging our extensive experience with companies of all sizes across a wide range of industries, we have the ability to offer a comprehensive range of services through a collaborative and tailored approach.

 
For more information, please contact one of the following practice leaders: 
  U.S. GAAP:     Yosef Barbut
National Accounting Partner   Adam Brown
Partner - National Director of Accounting   SEC Reporting:     Jeffrey Lenz
Partner - National SEC Department   Meghan Depp
Assurance Senior Manager - National SEC Department   U.S. Audit Matters:     Phillip Austin
National Managing Partner - Assurance   Brian Rick
Assurance Senior Manager   Brian Walls
Assurance Senior Manager         International Tax:     Monika Loving
ITS National Practice Leader   Stephen Arber
ITS Managing Director   Income Tax:     Todd Simmens
National Managing Partner - Tax   Michael Williams
National Tax Partner - ASC 740     Daniel Michaels
Tax Senior Manager    

House and Senate pass Tax Reform Bill; President expected to sign

Wed, 12/20/2017 - 12:00am
After a historic second vote in the House on December 20, 2017, both the House and Senate have now passed the "An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018," previously referred to as the "Tax Cuts and Jobs Act."  The bill has been sent to the President, which he is expected to sign. The bill's second stop in the House of Representatives was necessary to ensure compliance with Senate rules.
 
These amendments consist of the following:  (1) The bill’s short title was removed, and will no longer be known as the “Tax Cuts and Jobs Act,” but rather as “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018"; (2) the provision that would have permitted the use of Section 529 educational savings plans to be used for certain homeschooling expenses was removed; and (3) a provision that would have exempted small universities with fewer than 500 tuition-paying students from the endowment excise tax was also removed.  For a summary of key provisions in the conference report, which is now law, click here.

Prepayment of Certain 2018 Expenses by Cash Basis Taxpayers May Yield Deduction Benefit in 2017 Due To Potential Tax Reform

Tue, 12/19/2017 - 12:00am
Summary

As the Tax Cuts and Jobs Act makes its way through the House and Senate Conference Committee and put up for vote in both houses of Congress this week, cash basis taxpayers may be considering prepaying certain expenses in order to obtain relief from some of the Act’s provisions that eliminate or place limitations on tax deductions for taxable years beginning after December 31, 2017.  For federal income tax purposes, cash basis taxpayers generally can take into account amounts representing allowable deductions in the taxable year in which paid.  However, prepaying a 2018 liability or expense in 2017 without an obligation to do so is not a valid deduction, even for a cash basis taxpayer.  Based on case law, the prepayment of the liability or expense could be challenged by the Internal Revenue Service because the payment lacks business purpose or fails to clearly reflect income.  Further, if the benefit period or useful life associated with the prepaid expense exceeds 12 months, the payment is required to be capitalized and amortized.  That said, to the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability relates has been provided by year-end, and the benefit period does not exceed 12 months, cash basis taxpayers that prepay expenses in 2017 for 2018 expenses can claim a deduction in 2017.


Details Tax Reform
On December 15, 2017, the House-Senate Conference Committee members working on the House and Senate tax reform bills signed off on a revised bill.  Issued that evening, the full language of the Tax Cuts and Jobs Act (H.R. 1) encompasses over 1,000 pages, including a 570-page joint explanatory statement describing key differences, if any, between the House and Senate tax reform bill, and a summary of the resolution of such differences in the revised bill.  The revised bill will be sent to both houses of Congress during the week beginning December 18, 2017, for a vote and could set the stage for the bill to be signed by the President prior to the end of 2017. 
 
Among the many provisions affecting individuals and businesses, this alert specifically discusses the (1) modification of deduction for taxes not paid or accrued in a trade or business; (2) repeal of certain miscellaneous itemized deductions subject to the two-percent floor; and (3) entertainment expenses. 

Modification of deduction for taxes not paid or accrued in a trade or business (section 164 of the Code) Under the revised bill, individuals generally can deduct State, local, and foreign property taxes and State and local sales taxes only when paid or accrued in carrying on a trade or business, or an activity described in section 212 (relating to expenses for the production of income).  Accordingly, the provision allows only those deductions for State, local, and foreign property taxes, and sales taxes, which are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F on such individual’s tax return.  For example, in the case of property taxes, an individual may deduct such items only if these taxes were imposed on business assets (such as residential rental property).
 
Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.
 
The provision contains an exception to the above-stated rule.  Under the provision, a taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for married taxpayer filing a separate return) for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or an activity described in section 212, and (ii) State and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the taxable year.  Foreign real property taxes may not be deducted under this exception.

The above rules apply to taxable years beginning after December 31, 2017, and beginning before January 1, 2026.
 
The conference agreement also provides that, in the case of an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, the payment shall be treated as paid on the last day of the taxable year for which such tax is so imposed for purposes of applying the provision limiting the dollar amount of the deduction. 
 
BDO Observation: An individual may not claim an itemized deduction in 2017 on a pre-payment of state or local income tax for a future taxable year in order to avoid the dollar limitation applicable for taxable years beginning after 2017.  The prepayment in 2017 would have no direct link to taxable income for the 2018 tax year; therefore, a payment made to a state or local government in 2017 to apply against the taxpayer’s 2018 tax liability is merely a deposit for which no tax deduction is permitted.  However, if the taxpayer has an estimated income tax payment due in April of 2018 based on 2017 taxable income, prepaying the tax in 2017 rather than 2018 would yield a proper deduction in 2017 and possibly generate the benefit of time value of money if tax rates fall in 2018.

Repeal of Certain Miscellaneous Itemized Deductions Subject to the Two-Percent Floor (Sections 62, 67, and 212 of the Code)
The conference agreement temporarily suspends all miscellaneous itemized deductions that are subject to the two-percent floor under present law.  Miscellaneous itemized deductions include, for example, fees to collect interest and dividends, investment fees and expenses, tax preparation expenses, and unreimbursed business expenses incurred by an employee.  Thus, under the provision, taxpayers may not claim items as itemized deductions for the taxable year beginning after December 31, 2017, and before January 1, 2026.   
 
BDO Observation: To the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability has been provided by year-end, thereby establishing an obligation to pay on the taxpayer’s part, a cash basis taxpayer prepaying the expense in 2017 rather than in 2018 could reasonably claim a deduction in the earlier year, so long as the prepaid benefit period does not exceed 12 months.

Entertainment, etc. expenses (Section 274 of the Code)
Under the conference agreement, no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or (3) a facility or portion thereof used in connection with any of the above items.  As a result, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions).
 
In addition, the provision disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).  For amounts incurred and paid after December 31, 2017, and until December 31, 2025, the provision expands this 50-percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer.  
 
The provision generally applies to amounts paid or incurred after December 31, 2017.  However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025, are not deductible.
 
BDO Observation: A cash basis taxpayer should take action to immediately pay any entertainment expense invoices and expense reports during 2017.  If commitments exist for the 2018 year which are budgeted for (e.g., 2018 season tickets), the taxpayer is advised to request an invoice from the seller before year-end so that the amount can be prepaid in 2017. 
 
Other Types of Expenses
There are a number of expenses that cash basis taxpayers may wish to consider prepaying in order to obtain a tax benefit in 2017.  The federal tax treatment below assumes that the benefit period associated with the prepaid expense does not exceed 12 months.
 
MOVING EXPENSES
The conference agreement generally suspends the deduction for moving expenses for taxable years 2018 through 2025.  However, during that suspension period, the provision retains the deduction for moving expenses and the rules providing for exclusions of amounts attributable to in-kind moving and storage expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces (or their spouse or dependents) on active duty that move pursuant to a military order and incident to a permanent change of station.  Taxpayers outside of the Armed Forces exception may wish to prepay an invoice in 2017 for 2018 moving expenses in order to take advantage of the moving expenses deduction before suspension.

HOME MORTGAGE INDEBTEDNESS
The conference agreement suspends the deduction for interest on home equity indebtedness.  Thus, for taxable years beginning after December 31, 2017, a taxpayer may not claim a deduction for interest on home equity indebtedness. The suspension ends for taxable years beginning after December 31, 2025.  In this regard, cash basis taxpayers should consider prepaying “points” charged in 2017 in order to take advantage of the home equity indebtedness deduction before the suspension period. Although a taxpayer must capitalize interest that is properly allocable to a period that extends beyond the close of the taxable year and amortize it over the period to which it applies, section 461(g)(2) provides an exception for points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the taxpayer’s principal residence to the extent that such payment of points is an established business practice in the area in which such indebtedness is incurred and the amount of such payment does not exceed the amount generally charged in such area.  Points paid in refinancings may not meet the exception.

PREPAID RENT
Accelerating a deduction from 2018 to 2017 can provide time value of money benefits to the extent that the tax rates drop in 2018.  Generally speaking, prepaid rent can be deducted by a cash basis taxpayer in the year of payment so long as the lease agreement calls for rent to be prepaid prior to the beginning of the month to which the rent payment relates.  Cash basis taxpayers must also be aware that the prepaid benefit period cannot exceed 12 months.  Thus, for example, if the lease agreement requires January 2018 rent to be paid by the end of December, the lessee can claim an accelerated deduction by prepaying for the next month.  On the contrary, if the lease agreement calls for January 2018 rent to be due on the first day of that month, prepaying in 2017 would not result in an earlier deduction.  
 
If you have any questions, please contact a member of the Accounting Methods group.  The Accounting Methods group within BDO USA’s National Tax Office has extensive experience assisting taxpayers of all industries and sizes with their accounting method issues and filing accounting method change requests with the IRS.
 
For more information, please contact one of the following practice leaders: 
  David Hammond
Tax Partner   Travis Butler
Tax Managing Director   Yuan Chou
Tax Managing Director   Connie Cunningham
Tax Managing Director     Marla Miller
Tax Managing Director    

Expatriate Tax Newsletter - December 2017

Tue, 12/19/2017 - 12:00am
BDO's Expatriate Newsletter covers timely tax-related updates and regulations from countries around the globe. The December 2017 issue highlights developments in Indonesia, Belgium, France, The Netherlands, Romania, Spain, Sweden, The United Kingdom, and The United States of America.

Topics include:
  • The Netherlands – Application of the 30%-regulation in case of garden leave
  • Sweden – The new Swedish PAYE return
  • United States – House and Senate pass their own versions of tax reform. For more on tax reform, we also suggest: House and Senate Reach Tax Reform Compromise
  Download

Agreement on Tax Reform - Impact to Individuals

Mon, 12/18/2017 - 12:00am
On Friday, December 15, a joint conference committee comprised of House and Senate members released an agreed-upon version of the Tax Cuts and Jobs Act (the “Act”). The Act provides the most comprehensive update to the tax code since 1986 and includes a number of provisions of particular interest to our private clients.
 
The Act now goes before the full House and Senate for a vote the week of December 18, 2017, but is widely expected to pass as a result of some last-minute negotiations to secure a projected unanimous GOP vote in the Senate.
 
As was previously proposed in the earlier Senate bill, individual tax reform is temporary. Unless noted, the provisions discussed below would go into effect on January 1, 2018, and expire on December 31, 2025.
  Ordinary Income Tax Rates The conference agreement replaces the existing tax rate structure, choosing the seven-rate structure previously proposed by the Senate. However, the agreement changed the Senate’s breakpoints for the higher marginal rates and lowered the top marginal tax rate to 37 percent. Further, the agreement does not adopt the House’s proposal to phase out the 12-percent bracket for high income taxpayers.
  Tax Rate Married Filing Jointly and Surviving Spouses Single Head of Household Married Filing Separately Estates & Trusts 10% $0 - $19,050 $0 - $9,525 $0 - $13,600 $0 - $9,525 $0 - $2,550 12% $19,050 - $77,400 $9,525 - $38,700 $13,600 - $51,800 $9,525 - $38,700  
N/A 22% $77,400 - $165,000 $38,700 - $82,500 $51,800 - $82,500 $38,700 - $82,500  
N/A 24% $165,000 - $315,000 $82,500 - $157,500 $82,500 - $157,500 $82,500 - $157,500 $2,550 - $9,150 32% $315,000 - $400,000 $157,500 - $200,000 $157,500 - $200,000 $157,500 - $200,000  
N/A 35% $400,000 - $600,000 $200,000 - $500,000 $200,000 - $500,000 $200,000 - $300,000 $9,150 - $12,500 37% Over $600,000 Over $500,000 Over $500,000 Over $300,000 Over $12,500   Long-term Capital Gains and Qualified Dividends Long-term capital gains and qualified dividends tax rates remain largely unchanged from present law and apply the following rates based on the taxpayer’s taxable income: Tax Rate Married Filing Jointly and Surviving Spouses Single Head of Household Married Filing Separately Estates & Trusts 0% $0 - $77,200 $0 - $38,600 $0 - $51,700 $0 - $38,600 $0 - $2,600 15% $77,200 - $479,000 $38,600 - $425,800 $51,700 - $452,400 $38,600 - $239,500 $2,600 - $12,700 20% Over $479,000 Over $425,800 Over $452,400 Over $239,500 Over $12,700   Kiddie Tax The conference agreement calls for a child’s earned income to be taxed at the rates applied to single filers and a child’s net unearned income to generally be taxed at ordinary income and preferential (i.e. capital gains) rates applied to estates and trusts. Accordingly, a child’s income would no longer be taxed at the parents’ rate.
  Inflation Adjustments The breakpoints for the ordinary income, long-term capital gains, and qualified dividends tax brackets would be adjusted in future years for inflation. However, inflation would be measured using the Chained Consumer Price Index (C-CPI), which generally provides a slower inflationary adjustment than the current Consumer Price Index (CPI) measurement. This measurement of inflation is applied for all individual tax inflation adjustments permitted in the Act and would be permanent, not expiring in 2025 with the other individual provisions.
  Standard Deduction and Personal Exemptions The conference agreement increases the standard deduction beginning in 2018 to $24,000 for joint filers, $18,000 head-of-household filers, and $12,000 for all other individual filers. The deduction would be indexed for inflation in future years. The additional standard deduction for the elderly and the blind was retained; the House had previously proposed to repeal the additional deduction.

Further, the conference agreement suspends the deduction for personal exemptions through 2025. The conference agreement, however, retains the $100 and $300 exemptions for complex and simple trusts, respectively, and a $4,150 exemption for qualified disability trusts which is to be adjusted for inflation in future years. The House had previously proposed to repeal the exemption for qualified disability trusts.
  Child Tax Credit The Child Tax Credit would be increased to $2,000 per qualifying child, with up to $1,400 being fully refundable. A qualifying child is a dependent child who is under age 17. The Credit would begin to phase out for joint filers with adjusted gross income exceeding $400,000 and other filers with adjusted gross income exceeding $200,000.
 
An additional $500 non-refundable credit may be available for other dependents, provided however, that such additional credit is only available to non-citizen dependents if they are a resident of the United States.
 
Currently, the Child Tax Credit is $1,000 per qualifying child and is nonrefundable. The Child Tax Credit currently phases out for joint filers with adjusted gross income exceeding $110,000.
  Adjustments to Income (“Above-the-Line” Deductions) Moving Expenses
The conference agreement suspends through 2025, the deduction for moving expenses except in the case of a member of the U.S. military who moves pursuant to a military order. Currently, individuals may take an above-the-line deduction for certain unreimbursed moving expenses incurred by reason of relocating for work.
 
Alimony
For any divorce or separation agreements entered into after December 31, 2018, the deduction for alimony or separate maintenance payments is repealed. Recipients of alimony or separate maintenance payments will no longer be required to include the alimony payments in their gross income.   Under the new provisions, alimony or separate maintenance payments will be treated similar to child support, in that they are not accounted for in the tax system (no deduction and no inclusion).  Existing alimony and separate maintenance agreements are grandfathered in as are any modifications to existing agreements unless, however, the parties to a modification expressly provide that the new rules should apply to the modified agreement.

Prenuptial agreements are not grandfathered in and taxpayers may wish to revisit those agreements in light of these new provisions.
  Itemized Deductions Medical Expense
The medical expense deduction threshold would be temporarily lowered to permit a deduction against both the regular tax and alternative minimum tax (AMT) for medical expenses in excess of 7.5-percent of adjusted gross income for all taxpayers itemizing deductions in 2017 and 2018. Currently, the 7.5-percent adjusted gross income threshold is only available for taxpayers over age 65 (younger taxpayers have a 10-percent adjusted gross income threshold) and all taxpayers have a 10-percent of adjusted gross income threshold for AMT purposes.

Taxes
The sum of the itemized deductions for state and local real property taxes, state and local personal property taxes, and state and local income or sales taxes may not exceed $10,000 ($5,000 for married individuals filing separate returns). The deduction for foreign real property taxes is suspended through 2025. The $10,000 limitation does not apply to foreign income taxes paid or taxes paid or accrued in carrying on a trade or business.

Further, the agreement provides an anti-abuse provision to prevent a deduction in 2017 on the prepayment of state and local income taxes attributable to future years.

Home Mortgage Interest
The itemized deduction for mortgage interest has been reduced to only permit the deduction of interest on acquisition indebtedness not exceeding $750,000 ($375,000 for married filing separate taxpayers) on the taxpayer’s primary or second home. The interest deduction for home equity indebtedness is suspended.
 
Currently, taxpayers can take a combined acquisition and home equity indebtedness interest expense deduction on $1,100,000 of debt. Debt incurred on or before December 15, 2017, is grandfathered in and subject to the current limitations. Further, taxpayers who entered into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchases such residence before April 1, 2018, are also eligible for the current higher limitations.
 
Charitable Contributions
The conference agreement makes three modifications to current charitable contribution rules. First, the agreement increases the percentage limitation for cash contributions to public charities from 50-percent of adjusted gross income to 60-percent of adjusted gross income.

Second, the agreement denies a charitable deduction for payments made in exchange for college athletic event seating rights. Currently, taxpayers may deduct 80 percent of amounts paid to an eligible college despite receiving tickets to a collegiate athletic event provided a charitable deduction would have otherwise been allowed had the taxpayer not received event tickets in return.

Finally, the agreement repeals the substantiation exception for certain contributions reported by the charitable organization. Currently, taxpayers are not required to obtain a contemporaneous written acknowledgement of contributions in excess of $250 if the donee organization reports the donation on their return.

The conference agreement failed to adopt the House proposal that the charitable standard mileage rate be adjusted for inflation.

Casualty Losses
The deduction for personal casualty losses is suspended through 2025 except in the case of losses attributable to a Federally declared disaster; provided, however, that taxpayers with a personal casualty loss gain for any taxable year during the suspension period may continue to deduct personal casualty losses not attributable to a Federally declared disaster in an amount equal to no more than the personal casualty loss gain.

Further, the conference agreement contains special casualty loss relief for taxpayers who suffered losses in certain 2016 disasters. Primarily, taxpayers affected by such disasters may be able to take up to a $100,000 disaster distribution from their retirement plan. In addition, casualty losses resulting from such disasters would be deductible if they exceed $500, without application of the 10 percent of adjusted gross income threshold. Such losses may be claimed even by taxpayers who elect the standard deduction.

Miscellaneous Itemized Deductions Subject to the 2 percent Floor
All miscellaneous itemized deductions subject to the 2% adjusted gross income floor have been suspended. This includes the miscellaneous itemized deductions for investment fees and expenses, tax preparation fees, and unreimbursed employee business expenses among others.
 
Overall Limitation on Itemized Deductions
The overall limitation on itemized deductions enacted in 1990, often called the “Pease limitation” (named after former Congressman Donald Pease) has been repealed through 2025.
  Other Provisions 529 Plans
The conference agreement expands the definition of qualified higher education expenses that may be paid from a 529 account to include up to $10,000 of expenses for tuition at an elementary or secondary public, private, or religious school, and certain expenses in connection with a homeschool.

Individual Mandate
The shared responsibility payment for individuals failing to maintain minimum essential health insurance coverage has been reduced to $0 beginning after December 31, 2018.
 
Like-Kind Exchanges
Beginning after December 31, 2017, nonrecognition of gain from like-kind exchanges would be limited to real property not held primarily for sale. Transitional relief is provided for exchanges where property was either disposed of or received in an exchange on or before December 31, 2017.
 
Electing Small Business Trusts (ESBTs)
ESBTs are eligible S corporation shareholders and are currently permitted to only have as beneficiaries, individuals or entities that would otherwise be eligible to own S corporation stock directly. A nonresident alien individual is currently an impermissible S corporation shareholder and as such, an impermissible current beneficiary of an ESBT. The conference agreement permits nonresident alien individuals to be a potential current beneficiary of an ESBT.
 
Further, ESBTs are currently permitted to take a charitable contribution deduction in accordance with the contribution deduction rules of trusts. Unlike individuals, trusts do not have a limitation on their contribution deduction and are prohibited from carrying forward excess contributions. The conference agreement calls for ESBTs to determine their charitable deduction going forward in accordance with the rules applicable to individuals. Accordingly, ESBTs would be subject to the charitable deduction percentage limitations and carryforward provisions that individuals are.
  Individual Alternative Minimum Tax (AMT) The individual alternative minimum tax (AMT) has been retained. However, the exemption amounts have been temporarily increased to $109,400 for joint filers and $70,300 for single filers. The current exemptions are $83,800 and $53,900 for joint and single filers, respectively.  The House bill had originally proposed the repeal of the individual AMT. The exemption phase-out thresholds would also be increased to $1,000,000 for joint filers and $500,000 for single filers. The phase-out threshold for estates and trusts would be unchanged. The exemptions and phase-out thresholds are indexed for inflation after 2018.
  Estate and Gift Taxes The lifetime exemption for estate and gift taxes is increased to $10,000,000 as of 2011 (and adjusted forward from there for inflation). As a result, taxpayers making gifts, and the estates of decedents dying in 2018 would have a roughly $11,000,000 basic exclusion amount.  The estate, gift, and generation-skipping transfer taxes are not repealed; the House bill would have repealed estate and generation-skipping transfer taxes.
  Deduction for Qualified Business Income of Pass-Thru Entities The conference agreement permits an individual taxpayer, whether they choose to take the standard deduction or to itemize, to deduct 20-percent of their “combined qualified business income” from a partnership, S corporation, or sole proprietorship, subject to a wage limitation that is phased in for joint taxpayers with taxable income exceeding $315,000 and other taxpayers with taxable income exceeding $157,500.
 
“Combined qualified business income” includes the taxpayer’s qualified trade or business income, qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income.
 
Specified service trades and businesses are generally not eligible for the deduction. However, there are exceptions to permit the deduction for engineering and architecture businesses, and small specified service trades and business. Small specified service trades and business begin to phase out of the deduction for joint taxpayers with taxable income exceeding $315,000 and other taxpayers with taxable income exceeding $157,500; joint taxpayers completely phase out of the deduction with $415,000 of taxable income, other taxpayers completely phase out at $207,500 of taxable income.
 
Estates and trusts are eligible for the 20-percent deduction. The previous Senate proposal would have excluded estates and trusts from eligibility.
  Business Losses and Net Operating Losses Business losses would only be permitted in the current year to the extent they don’t exceed the sum of taxpayer’s gross income and, for joint filers, $500,000 ($250,000 for all other taxpayers). Excess business losses would be disallowed and instead added to the taxpayer’s net operating loss (NOL) carryforward. Currently, suspended passive activity losses are allowed in full upon the taxable disposition of the passive activity.
 
The conference agreement amends the non-corporate NOL rules to limit deducible NOL carryforwards to the lesser of the carryforward amount or 90-percent (80-percent beginning in 2023) of taxable income determined without regard to the NOL deduction.  Taxpayers would no longer be permitted to carryback their net operating losses to the previous two taxable years. 
  BDO Insights Senate budget reconciliation rules resulted in the expiration of most of the individual provisions, including the pass-thru deduction, after 2025 in order to ensure that the new 21-percent corporate rate could be made permanent.
 
The change to the C-CPI as the measure of inflation is a permanent change that will ultimately result in a tax increase once the individual provisions of the Tax Cuts and Jobs Act expire.
 
The pass-thru deduction attempts to make the tax rates of pass-thru entities not unusually disparate to the new lower corporate rate. As a result, businesses likely won’t rush to reorganize as corporations in the short-term. However, the anti-abuse provisions in the pass-thru deduction computation and the permanence of the lower corporate rate may prove to make corporations a more attractive form of entity long-term.
 
Notably, the conference agreement did not include the Senate proposal to require the basis of specified securities be determined on a first-in, first-out basis is not included in the conference report. The Senate had sought to prevent taxpayers from specifically identifying the lot sold in the sale of specified securities. Further, the compromise did not include any amendments to the current residence gain exclusion provisions. Both the House and Senate had proposed changing the use and ownership test to five of the previous eight years and the House had further proposed a phase out of the exclusion for high income taxpayers.
 
The increase in the estate and gift exemption ensures that fewer taxpayers will be subject to the estate tax. Moreover, the failure of the committee to agree to a repeal of the estate and GST taxes ensures that our traditional estate and gift planning techniques remain relevant for high-net-worth families.

   
For more information, please contact one of the following regional practice leaders: 
  Jeffrey Kane
National Managing Partner   John Nuckolls
National Senior Technical Director   Traci Kratish Pumo
National Technical Director   Brooke Anderson
Partner, Central Region   Chuck Barragato
Partner, Northeast Region   Sharon Berman
Partner, Atlantic Region   Mike Campbell
Partner, West Region   Martin Cass
Managing Director, Southeast Region

Conference Agreement Reached Setting Stage for Enactment before the New Year

Mon, 12/18/2017 - 12:00am

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Summary On Friday evening, December 15, 2017, the conference report to H.R. 1, “Tax Cuts and Jobs Act” (the “Act”) was released.  The conference report was agreed to by the House and Senate conferees last week and reflects the resolved differences between the House bill and the Senate amendment.  While the final compromise looks more like the Senate bill, it reflects many compromises, some additions, deletions, and other modifications that are in step with Congressional priorities.  This Alert discusses the major provisions contained in the conference report.  It is important to note that most provisions in the bill expire after December 31, 2025, to comply with Senate budget reconciliation rules.  The exception is the reduction in corporate income tax rate; the new 21-percent rate will be permanent.

The House and Senate are expected to vote on the conference report this week.  The President is expected to sign the bill before end of the year.
  Details

Key provisions of the report affecting individual taxpayers include lower tax rates in modified brackets, higher standard deductions, and limitations on certain itemized deductions such as state and local taxes.  For corporations, the tax rate is reduced to a flat 21 percent and the alternative minimum tax is repealed.  Certain partners and shareholders will be eligible to deduct 20 percent of their income from pass-through entities.  Foreign taxation shifts to a territorial system, and the deemed repatriation tax rate is 15.5 percent for earnings held in cash or cash equivalents, and 8 percent on all other earnings.  The report also includes increases in certain property expensing and depreciation limits, and changes to accounting methods, as detailed below.
 

INDIVIDUAL TAXES
The conference report includes a reduction of individual rates, which are generally effective January 1, 2018, and expire December 31, 2025.  For individuals:
 

  • The top individual rate will be 37 percent for joint filers with more than $600,000 of taxable income and single filers with more than $500,000 of taxable income.  The current top rate is 39.6 percent for joint filers with taxable income over $466,951 and single filers with taxable income over $415,051.
  • The standard deduction will be increased to $24,000 for joint filers and $12,000 for single filers. The personal exemption is repealed through 2025. Currently, the standard exemption is $12,600 for joint filers and $6,300 for single filers.
  • The Child Tax Credit is increased to $2,000 per qualifying child, with up to $1,400 being fully refundable. An additional $500 credit may be available for other dependents. The Credit begins to phase out for joint filers with adjusted gross income exceeding $400,000 and single filers with adjusted gross income exceeding $200,000. Currently, the Child Tax Credit is $1,000 per qualifying child and is nonrefundable. The Child Tax Credit currently phases out for joint filers with adjusted gross income exceeding $110,000.
  • The adjusted gross income limitation for cash contributions to certain charitable organizations is increased to 60 percent. Currently, the adjusted gross income limitation for cash contributions to public charities is 50 percent.
  • The itemized deduction for medical expenses is made more available for taxpayers under age 65 by reducing the adjusted gross income floor for 2017 and 2018 to 7.5 percent for all taxpayers.  Currently, the adjusted gross income floor is 10 percent for taxpayers under age 65 and 7.5 percent for taxpayers over age 65.
  • The itemized deduction for state and local taxes has been limited to $10,000 for the aggregate sum of real property taxes, personal property taxes, and either (i) state or local income taxes or (ii) state and local sales tax. Currently, each of those state and local taxes is a separate itemized deduction with no limitation. Further, the bill prohibits a deduction in excess of the $10,000 limitation for 2018 state and local taxes actually paid in 2017.
  • The itemized deduction for mortgage interest has been reduced to only permit the deduction of interest on acquisition indebtedness not exceeding $750,000. The additional interest deduction for home equity indebtedness is repealed through 2025. Currently, taxpayers can take a combined acquisition and home equity indebtedness interest expense deduction on $1,100,000 of debt. Debt incurred on or before December 15, 2017, is grandfathered in to the current limitations. Further, taxpayers who entered into a written binding contract before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchase such residence before April 1, 2018, are also eligible for the current higher limitations.
  • All miscellaneous itemized deductions subject to the two percent adjusted gross income floor have been repealed through 2025. This includes the miscellaneous itemized deductions for investment fees and expenses, tax preparation fees, and unreimbursed employee business expenses among others.
  • The overall limitation on itemized deductions enacted in 1990, often called the “Pease limitation” (named after former Congressman Donald Pease) has been repealed through 2025.
  • For any divorce or separation agreements entered into after December 31, 2018, the deduction for alimony or separate maintenance payments is repealed. Similarly, the exclusion from gross income for alimony or separate maintenance payments is repealed, thus requiring recipients to include those payments in their gross income. Existing alimony and separate maintenance agreements are grandfathered in as are any modifications to existing agreements unless, however, the parties to a modification expressly provide that the new rules should apply to the modified agreement.
  • The lifetime exemption for estate and gift taxes is increased to $10,000,000 as of 2011 (and adjusted forward from there for inflation). As a result, taxpayers making gifts, and the estates of decedents dying, in 2018 would have a roughly $11,000,000 basic exclusion amount.  (Estate, gift, and generation-skipping transfer taxes are not repealed; the House bill would have repealed estate and generation-skipping transfer taxes.)
  • The shared responsibility payment for individuals failing to maintain minimum essential health insurance coverage has been reduced to $0 beginning after December 31, 2018.
  • The individual alternative minimum tax (AMT) has been retained. However, the exemption amounts have been increased to $109,400 for joint filers and $70,300 for single filers. The current exemptions are $83,800 and $53,900 for joint and single filers, respectively.  (The House bill would have repealed the individual AMT.)
  • The earlier Senate proposal to require the basis of specified securities be determined on a first-in, first-out basis is not included in the conference report. The Senate had sought to prevent taxpayers from specifically identifying the lot sold in the sale of specified securities.
 
CORPORATE TAX
For corporations:
 
  • The corporate tax rate has been reduced by forty percent—from thirty-five to twenty-one percent.   The corporate AMT has been repealed.   The net interest deduction limit has been kept at 30 percent of adjusted taxable income with an indefinite carryforward period.  Small businesses with less than $25 million in annual gross receipts over a three-year period are exempted from the interest limitation.  While the conference agreement does repeal the section 199 domestic production deduction, the effective date of the repeal is not until December 31, 2018. 
  • Net operating losses (NOLs) are limited to 80 percent of taxable income and may only be carried forward, indefinitely.  NOLs are likely to increase based on expanded expensing of capital investments in certain property – including property that had previously been used by, and provided benefit to, another taxpayer.  The property must be placed in service between September 27, 2017, and January 1, 2023, to be fully deducted.  The 100-percent allowance is phased down by 20 percent per year beginning in 2023.
  • Certain capital contributions from state and local governments will no longer be excluded from income under section 118.  Section 108(e)(6), however, will not be altered for computations of cancellation of debt income.  And the meaningless gesture doctrine will continue to apply to section 351 exchanges of wholly-owned corporations in which no shares are issued.  Like-kind exchanges under section 1031 will be limited to real property.  The 70 and 80 percent dividend received deduction amounts for corporations have been reduced to 50 and 65 percent, respectively.
  • Under the conference report, shareholders of S corporations may obtain a deduction equal to the lesser of 20 percent of qualified business income, which requires a complex computation, with respect to such trade or business, or 50 percent of the W-2 wages with respect to such business.  Further, a nonresident alien individual may now be in indirect shareholder of an S corporation as a potential current beneficiary of an electing small business trust.
 
TAXATION OF PARTNERSHIPS AND PASS THROUGH ENTITIES
 
  • For tax years beginning after December 31, 2017, partners and shareholders of S corporations and LLCs may deduct up to 20 percent of their qualified business income from the partnership or S Corporation.  For taxpayers in a service business (e.g., law or accounting), no deduction is permitted unless their taxable income is less than $157,500 ($315,000 if married filing a joint return).
  • Under the conference agreement, application of Section 1031 is limited to transactions involving the exchange of real property that is not held primarily for sale. The like-kind exchange rules will no longer apply to any other property, including personal property that is associated with real property. This provision will be effective for exchanges completed after December 31, 2017. However, if the taxpayer has started a forward or reverse deferred exchange prior to December 31, 2017, section 1031 may still be applied to the transaction even though completed after December 31, 2017.
  • The technical termination rules under section 708(b)(1)(B) are repealed for tax years beginning after 2017. No changes are made to the actual termination rules under section 708(b)(1)(A).
  • Under general rules, gain recognized by a partnership upon disposition of a capital asset held for at least one year is characterized as long-term capital gain. Further, the sale of a partnership interest held for at least one year will generate long-term capital gain, except to the extent section 751(a) applies. Under the conference agreement, long-term capital gain will only be available with respect to “applicable partnership interests” to the extent the capital asset giving rise to the gain has been held for at least three years.
 
INTERNATIONAL TAX
The conference report contains provisions relating to the establishment of a participation exemption for the taxation of foreign income.  These new rules include:
 
  • A dividend exemption system, which generally provides for a 100 percent dividend received deduction for the foreign-sourced portion of dividends received by a domestic C corporation (other than a RIC or REIT) from specified 10-percent owned foreign corporations with respect to which the domestic corporation is a U.S. shareholder when certain conditions are satisfied;
  • Sales or transfers involving specified 10-percent owned foreign corporations (including rules relating to (a) limiting losses on certain sales or exchanges of such foreign corporations in situations involving a domestic corporation eligible for the dividends received deduction; (b) treating as a dividend for purposes of applying the participation exemption any amount received by a domestic corporation which is treated as a dividend for purposes of section 1248 in the case of the sale or exchange by a domestic corporation of stock in a foreign corporation held for one year or more; (c) the interaction of section 964(e), the subpart F rules and the participation exemption in the case of certain sales by a CFC of a lower-tier CFC; (d) requiring branch loss recapture in certain cases when substantially all of the assets of a foreign branch are transferred by a domestic corporation to specified 10-percent owned foreign corporations with respect to which the domestic corporation is a U.S. shareholder subject to certain limitations; and (e) the repeal of the foreign active trade or business exception under section 367(a));
  • An election to increase percentage of domestic taxable income offset by overall domestic loss treated as foreign source (modifies section 904(g)); and
  • A transition tax generally requiring U.S. shareholders of “specified foreign corporations” (as specifically defined in section 965) to include as subpart F income their pro rata shares of deferred foreign income of such foreign corporations. The total deduction from the amount of the section 951 inclusion is the amount necessary to result in a 15.5-percent rate of tax on accumulated post-1986 foreign earnings held in the form of cash or cash equivalents, and eight percent rate of tax on all other earnings. The calculation is based on the highest rate of tax applicable to corporations in the taxable year of inclusion, even if the U.S. shareholder is an individual.  There are numerous rules relating to the application of the transition tax (e.g., rules for allowing a reduction of the amount included in income of a U.S. shareholder when there are specified foreign corporations with deficits in earnings and profits). There is an election to pay the liability relating to the inclusion in eight installments at certain specified percentages along with a special election for S corporation shareholders to defer the payment of the liability until certain events. Additionally, the IRS has regulatory authority to carry out the intent of the provision, including the ability to prescribe rules or guidance in order to deter tax avoidance through use of entity classification elections and accounting method changes, or otherwise.
  • There are provisions in the conference report that provide for a deduction for domestic C corporations (that are not RICs or REITs) for certain specified percentages of foreign-derived intangible income of the domestic corporation and global intangible low-taxed income which is included in income of such domestic corporation subject to certain limitations (this provision generally follows the Senate amendment with certain clarifications and modifications).
 
The conference report also modifies the foreign tax credit system in several ways, including:
 
  • Repealing the section 902 indirect foreign tax credit and providing for the determination of the section 960 credit on a current year basis (the conference report generally follows the House bill with certain modifications);
  • Sourcing income from the sales of inventory solely on the basis of production activities; and
  • Providing a separate foreign tax credit limitation basket for foreign branch income.

Additionally, the conference report includes a number of significant modifications to the CFC subpart F rules including:
 
  • The repeal of an inclusion based on the withdrawal of previously excluded subpart F income from qualified investment;
  • The elimination of an inclusion of foreign base company oil-related income;
  • The modification of the stock attribution rules for determining status of a foreign corporation as a CFC (this modification would make it more likely for a foreign corporation to be treated as a CFC as a result of stock of certain related foreign persons being attributed downward to a U.S. person);
  • The modification of the definition of U.S. shareholder by incorporating a 10 percent value test in determining who is a U.S. shareholder (thus, making it more likely for a person to be a U.S. shareholder and a foreign corporation to be a CFC);
  • The elimination of the requirement that a corporation be a CFC for 30 days before subpart F inclusions apply; and
  • A provision providing that a U.S. shareholder of any CFC must include in gross income for a taxable year its “global intangible low-taxed income” in a manner generally similar to inclusions of subpart F income (complex calculation). The Conference Report generally adopts the Senate amendment with clarifications and modifications).
 
Moreover, the conference report includes a number of provisions designed to address base erosion, including rules relating to:
 
  • Providing for a base erosion minimum tax, which requires certain corporations to pay additional corporate tax in situations where such corporations have certain “base erosion payments” and certain threshold conditions are satisfied (the conference report follows the Senate amendment with certain modifications);
  • Limiting income shifting through intangible property transfers (including treating goodwill and going concern value and workforce in place as section 936(h)(3)(B) intangibles and, with respect to aggregate basis valuation, requiring the use of that method of valuation in the case of transfers of multiple intangible properties in one or more related transactions if the Secretary determines that an aggregate basis achieves a more reliable result than an asset-by-asset approach.);
  • Disallowing a deduction for certain related party interest or royalty payments paid or accrued in certain hybrid transactions or with certain hybrid entities under certain circumstances. The conference report generally follows the Senate amendment, but provides that the Secretary shall issue regulations or other guidance as may be necessary or appropriate to carry out the purposes of the provision for branches (domestic or foreign) and domestic entities, even if such branches or entities do not meet the statutory definition of a hybrid entity;  and
  • Not permitting shareholders of surrogate foreign corporations to be eligible for reduced rates on dividends under section 1(h). The conference report follows the Senate amendment with a modification providing that the provision applies to dividends received from foreign corporations that first become surrogate foreign corporations after date of enactment.
 
The conference report also contains rules relating to:
 
  • Restricting the insurance business exception to the PFIC rules;
  • Repealing the fair market value method of interest expense apportionment; and
  • Codifying Rev. Rul. 91-32 and providing withholding rules relating to a foreign person’s sale of a partnership interest where the partnership engages in a U.S. trade or business.
 
Some notable provisions that were included in the House bill, Senate amendment, or both, that were not included in the conference report include (but are not limited to) the following provisions relating to:
 
  • Excepting domestic corporations that are U.S. shareholders in CFCs from the application of section 956;
  • Generally permitting transfers of intangible property from controlled foreign corporations to United States shareholders in a tax efficient manner;
  • Accelerating the election to allocate interest, etc., on a worldwide basis;
  • An inflation adjustment of de minimis exception for foreign base company income;
  • Making permanent the controlled foreign corporation look-thru rule of section 954(c)(6);
  • Current year inclusion of foreign high return amounts by United States shareholders of controlled foreign corporations (but see provision relating to “global intangible low-taxed income” provision discussed above),
  • Limiting deductions of interest by domestic corporations which are members of an international financial reporting group (House Bill) or worldwide affiliated group (Senate amendment),
  • Imposing an excise tax on certain amounts paid by certain U.S. payors to certain related foreign recipients to the extent the amounts are deductible by the U.S. payor (but see provision above relating to the base erosion minimum tax),  and
  • Possessions of the United States.
 
COST RECOVERY PROVISIONS
 
  • Property defined under section 168(k) and placed in service after 2007 and before 2020 is currently allowed a 50 percent deduction for the taxable year in which the property is placed in service.  The conference report would allow full expensing for the property placed in service after September 27, 2017, for a five-year period.   There would be a phase down of the full expensing by 20 percent per year for property placed in service after January 1, 2023 (January 1, 2024 for longer production period property).  Bonus property previously had only been allowed for new property.  The conference report expands bonus property to include used property. 
  • Annual depreciation limitations for luxury automobiles under section 280F is currently $3,160 in the first year, $5,100 in the second year, $3,050 in the third year, and $1,876 in the fourth and later years.  The conference report was significantly increased under the conference report to $10,000 in the first year, $16,000 in the second year, $9,600 in the third year, and $5,740 in the fourth and later years. 
  • Computer or peripheral equipment is removed from the definition of listed property and no longer subject to the heightened substantiation requirements currently required.  
  • Depreciable property used in a farming business currently has special recovery periods, such as seven years for certain machinery and equipment, grain bins, and fences, as well as cotton ginning assets.  The life was reduced to a five-year recovery period for property placed in service after 2008 and before 2010.  The conference report renews the five-year recovery period.  Also, the required use of 150 percent declining balance method currently required for property other than real property and trees or vines bearing fruits or nuts would be repealed for property with lives of 10 years or less.
  • Under the conference report, the MACRS recovery periods maintains the present law general recovery MACRS recovery periods of 39 years for nonresidential real property and 27.5 years for residential rental property.  The Senate amendment had lowered the life to a 25-year recovery period for all real property.
  • Definition of qualified improvement property eliminates the separate definitions for “qualified leasehold improvement”, “qualified restaurant property”, and “qualified retail improvement property”.  The 15-year recovery period remains unchanged.
  • Generally, under section 179, business taxpayers may elect to deduct the cost of qualifying property with an annual limit of $500,000 through 2015, after which the amount was adjusted for inflation.  The $500,000 limitation is reduced by the amount of which the cost of the property placed in service during the taxable year exceeds $2 million.  The conference report increases the expensing limitation from $500,000 to $1 million.  Further, the phase out under the conference report would begin when the amount of the property exceeds $2.5 million, up from the $2 million dollar amount.
  • The section 179 definition of qualified real property under the conference report is expanded to include improvements to nonresidential real property including roofs, heating, ventilation, air conditioning, fire protection, alarm systems, and security systems. 
 
TAX ACCOUNTING METHOD PROVISIONS
 
  • Under section 448, C corporations, a partnership with a C corporation partner, or a tax shelter generally may not use the cash method of accounting.   There are exceptions, one of which is for C corporations or partnerships with a C corporation partner with average annual gross receipts of not more than $5 million dollars over the prior three years.  The conference report increases the three-year average gross receipts threshold from $5 million to $25 million.
  • Section 447 generally requires that corporations or partnerships with a corporate partner engaged in farming must use the accrual method of accounting.  The conference report permits farms that meet the $25 million average three-year gross receipts threshold to use the cash method, even if it is a corporation or partnership with a corporate partner. 
  • Taxpayers subject to the UNICAP provisions under section 263A are required to capitalize all direct costs and an allocable portion of most indirect costs that are associated with production or resale activities.  Under the conference report, businesses which meet the $25 million average annual gross receipts test would be exempt from the UNICAP requirements. 
  • Under section 471, inventory accounting is normally required to clearly reflect income.  Under the conference report, businesses that meet the $25 million average annual gross receipts test would be exempt from inventory reporting.  Taxpayers would be permitted to use a method of accounting that either treats inventories as non-incidental materials and supplies or conforms to the taxpayer’s financial accounting.
  • Section 460 generally requires percentage-of-completion accounting for long-term contracts.  One exception is for construction contracts that are expected to be completed within a two year period and have annual average gross receipts over the preceding three years of $10 million or less.  Under the conference report, the exception would increase the $10 million annual average gross receipts over the prior three years to $25 million.
  • Under a special rule for income inclusion, an accrual basis taxpayer is now required to recognize an item into income no later than the year in which the item is taken into account on the applicable financial statement.  Thus, an accrual method taxpayer with an applicable financial statement would include an item in income under section 451 upon the earlier of when the all events test is met or when the taxpayer includes such item in revenue in an applicable financial statement.  An exception would apply for any item of income for which a special method of accounting is used.  If a contract has multiple performance obligations, taxpayers may allocate the transaction price in accordance with the allocation made in the taxpayer’s applicable financial statement.   Also, the conference report codifies the current deferral method of accounting for advance payments for goods, services, and other specified items under Rev. Proc. 2004-34.
  • Under section 199, a deduction of nine percent of the lesser of qualified production activities income or taxable income is generally permitted.  The deduction for section 199 – domestic production activities deduction – has been repealed.
  • Taxpayers may elect to currently deduct the amount of certain reasonable research or experimental expenditures paid or incurred in connection with a trade or business under section 174, or elect to capitalize and amortize such expenditures over not less than 60 months   Alternatively, a taxpayer may elect to amortize research or experimental expenditures over ten years.   Under the conference report, specified research or experimental expenditures, including software development, would be required to be capitalized and amortized over a five-year period (15 years if expenditures are attributable to research conducted outside of the United States) and no longer currently deductible.  Land acquisition and improvement costs, and mine (including oil and gas) exploration costs would be exempt from this rule.  Upon retirement, abandonment or disposition of the property, any remaining basis would continue to be amortized over the remaining amortization period.  The provision would apply for expenditures paid or incurred in tax years beginning after December 31, 2022.
 
For more information, please contact one of the following practice leaders:
    Todd Simmens
Controversy and Procedure Technical Practice Leader   Ben Willis
Corporate Technical Practice Leader   Joe Calianno
International Tax Technical Practice Leader     John Nuckolls
Private Client Services Technical Practice Leader   Jeff Bilsky
Partnership Technical Practice Leader   Dave Hammond
Accounting Methods Technical Practice Leader   Traci Kratish Pumo
Private Client Services Managing Director    

House and Senate Reach Tax Reform Compromise

Thu, 12/14/2017 - 12:00am
Summary On December 13, 2017, House and Senate Republicans reached a compromise on tax reform legislation, the “Tax Cuts and Jobs Act.” The compromise bill reportedly includes agreements on corporate and individual tax rates, the treatment of pass-through income, the estate tax, and itemized deductions such as those for mortgage interest and state and local taxes, among other areas. The text of the bill is expected to be released on Friday, with votes in the full House and Senate next week.   
  Details These are among the changes reportedly included in the compromise legislation… While bill language is not yet available, these agreed-to provisions are the first provisions reportedly out of the Conference Committee. The corporate tax rate would be set at 21% for tax years beginning in 2018, as opposed to the current rate of 35% and the previously proposed cut to 20%.
 
  • The highest individual tax rate would be reduced from 39.6% to 37%.  The Senate legislation originally called for a 38.5% top rate.
  • Individuals receiving pass-through income from entities such as partnerships and S corporations would be able to deduct 20% of this income from their taxable income, a lower rate than the 23% proposed in the Senate plan.  The House bill would have capped the rate at which this income was taxed at 25%.  This deduction would be subject to various limitations and applicable to only certain income sources.   
  • The estate tax would remain in place; however the lifetime exemption is expected to increase to roughly $11 million in 2018 (and be indexed for inflation).  Both the House and Senate had proposed an increased exemption amount.  The House had further proposed the future repeal of the estate tax.
  • The alternative minimum tax for corporations would be repealed, matching the House bill.  The individual AMT would remain, but the threshold amounts would increase.
  • Mortgage interest would be deductible based on indebtedness up to $750,000, which is the midpoint between the House proposal of $500,000 and the Senate’s plan to keep the existing $1 million cap. 
 
For more information, please contact one of the following practice leaders:
  Todd Simmens
Controversy and Procedure Technical Practice Leader   Ben Willis
Corporate Technical Practice Leader   Joe Calianno
International Tax Technical Practice Leader     John Nuckolls
Private Client Services Technical Practice Leader

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