On December 22, 2017, President Trump signed one of the most sweeping tax reform laws in over thirty years which impacts every taxpayer and every industry.
The law is known as the Tax Cuts and Jobs Acts. It is controversial, lengthy and complex with both benefits and drawbacks. Some provisions are yet in need of further clarification through Technical Corrections or Regulations. Following are some of the more significant changes.
Individual Income Tax Changes
For individuals, the top rate is reduced slightly to 37% with the top bracket for married filing joint set at $600,000 ($500,000 for single taxpayers). Despite campaign promises, Alternative Minimum Tax (AMT) remains for individuals though the exemption amounts are increased slightly.
Charitable deductions remain and have an increased limitation of 60% of Adjusted Gross Income (AGI). In addition, medications deductions which previously could only be taken at adjusted gross income levels of over 10%, through 2018 can now be taken for amounts in excess of a slightly reduced threshold of 7.5% of adjusted gross income.
That’s the good news. On the other hand, state and local tax deductions are limited to $10,000, materially penalizing taxpayers in the higher income tax states such as California and New York. Mortgage interest remains deductible but is capped on new mortgages at loan amounts of $750,000 and home equity interest is nondeductible. Miscellaneous itemized deductions, which included unreimbursed employee expenses are fully repealed. Employer job moving expense reimbursements which were previously not taxable, now are. Moving expense deductions are also eliminated.
The standard deduction for individuals who do not claim itemized deductions is increased for taxpayers married filing joint to $24,000 ($12,000 for individuals) which is nearly double prior amounts, most itemized deductions are repealed or materially reduced. Given the amount of eliminated or materially reduced itemized deduction and increased standard deduction, it is anticipated more individuals will be filing just claiming the standard deduction.
Education tax deferred 529 savings plans for college expenses can now also be used for private school education at any level. The child tax credit has now been increased to $2,000 per child. The phaseout for eligibility begins at $400,000 for joint filers.
On the other hand, any amounts paid under alimony agreements entered into after 2018 will no longer be excludable from gross income. Hence taxpayers with pending divorce actions, need to finalize any such agreements prior to this year end.
Estate and Gift Taxes
The estate and gift tax exclusion has now been doubled so that U.S. individuals can now exclude roughly $11.2 million in value from estate tax ($22.4 million combined for married US couples). The increased exemption applies through 2025. This amount is to be adjusted for inflation so should increase each year. In addition, the annual exemption amount has now increased to $15,000. This annual exemption amount applies to both U.S. citizens and residents as well as noncitizen nonresidents where the transfer could otherwise be subject to such U.S. transfer taxes. It should be noted that the state legislation in the 14 or so states that still have an estate tax does not automatically change with federal tax law changes.
About half the states impose a separate estate tax (Connecticut is the only state that still has also a gift tax). Individuals residing in states where an estate tax is imposed, should look to update their estate planning documents since the state tax exemption generally does not follow changes in federal tax law but is typically a specified amount. Hence if not properly structured to take advantage of e.g., spousal exclusions, lifetime gifting or transferring through tax planning mechanisms such as Grantor Retained Annuity Trusts (GRATS) or Intentionally Defective Grantor Trusts (IDGTs) which minimize estate tax exemptions by leveraging and discounting values, individuals could wind up unnecessarily paying state estate or inheritance taxes.
As to noncitizen nonresidents from countries with which the U.S. has no estate or gift tax treaty, the U.S. transfer tax exemption remains at $60,000 for U.S.-sourced property subject to transfer tax. If an individual is not U.S. domiciled and not a U.S. citizen, this $60,000 exemption applies to U.S.-sourced property such as real estate, U.S. corporate stocks, and U.S. partnerships with U.S. effectively connected income. Treaty provisions likewise are unaffected other than where applicable ratio involves use of the U.S. exemption amount, which is now increased.
Hence, estate planning to minimize estate and gift taxes for inbound investments remains important especially where an individual resides in a country where a tax credit for U.S. estate taxes might not exist or where the overall estate/inheritance tax rate is lower even assuming an estate tax credit is allowed. As discussed later in this article, given the very low corporate tax rates now in effect of 21%, it’s fairly tax efficient to structure inbound U.S. investments through the use of a double corporate structure with a foreign corporation holding a U.S. corporation. Earnings within the corporation are limited to 21%. Outbound liquidations on termination of the business can often also be structured to be tax-free putting non-U.S. citizens and nonresidents in a more tax-favored position than U.S. citizens and residents. The use of such a double corporate structure acts as an effective shield against U.S. transfer taxes thereby avoiding such a tax entirely for those who are U.S. nonresidents/noncitizens and looking to acquire property that would otherwise be subject to U.S. transfer taxes.
Business Tax Changes
Corporate Tax Rate Changes and Qualified Business Income Deduction
There are even more changes impacting businesses. The largest favorable tax change is the corporate tax rate is reduced to a flat 21%, along with a repeal of corporate Alternative Minimum Tax (AMT). This is for “C” corporations. Congress also sought to reduce the effective rate for passthrough businesses by promulgating a passthrough income deduction known as the “qualified income deduction” (QBI) of 20% for partnerships, sole proprietorships and “S” corporations. However, as explained in more detail following paragraphs, Congress made it so complex that some taxpayers will find themselves unable to even claim it.
A detailed explanation of the mechanics of this deduction would take many pages. There are also quite a number of open issues that require clarification from IRS such as whether owner wages are eligible for inclusion in the calculation. At a very simplified level, the deduction is calculated to be the lesser of (1) “combined qualified business income” or (2) taxable income less capital gains. The net lower number of (1) or (2) is essentially taken at 20% for the QBI deduction.
Honing in on (1) “qualified business income,” is calculated at an aggregate amount, as the lesser of (1) essentially the allocable share of partnership operating income less operating expenses; or (2) the greater of (a) the allocable share 50% of W-2 wages paid; or (b) the allocable share of 25% of W-2 wages + 2.5% of the acquisition cost of all “qualified property.” The “qualified property” adjustment was intended to benefit real estate businesses. It is limited to tangible property. Intangibles and land do not count as “qualified property.” Specified lives for “qualified property” of 10 years for tangible property unless actual depreciable life is longer are specified.
If taxable income is below the key “threshold amounts,” only operating income less expenses is taken into account as “qualified business income.” The taxable income “threshold amounts” are $315,000 (phased out at $415,000) if filing joint; $157,500 (phased out at $207,000) if filing in any other status. The threshold is to be inflation adjusted and is measured at the taxpayer level.
The QBI deduction for services in the following specified trades or businesses is limited for deduction eligibility to the aforenoted threshold amounts: performing arts, health, law, accounting, actuarial science, consulting, athletics, financial, brokerage and a wide range of specified investment services as well as any trade or business where the principal asset is the reputation or skill of a proprietary individual or employee. If taxable income for passthrough entities with specified services is in the “phaseout range,” (viz., 100,000 for taxable income over $315,000 if married filing joint and $50,000 for single taxpayers with taxable incomes above $157,000) the wages calculation detailed in the preceding paragraph must be utilized.
Depending on circumstances, per the formula, the deduction may rest on the amount of W-2 wages a business has paid out in a given year and/or cost of its qualified property rather than net income of the business for the year. If a business has no W-2 wages or qualified property, the taxpayer may wind up unable to claim a deduction.
On the other hand, if a business has no qualified income but has wages and qualified property, the deduction could also be limited because the lesser of two net amounts applies for eligible income above the threshold. Where net operating income is less than wages expense and 2.5% of acquisition property, the deduction per the “lesser of formula” will net to wages expense plus 2.5% of the cost of acquisition property if taxable income is above the threshold amounts.
Hence, while it’s labeled “qualified income passthrough deduction,” with a stated intent of equalization between tax treatment of corporations taxed at 21% and passthrough entities, this result is not achieved consistently. Unlike a rate reduction, it’s not a deduction per se for passthrough businesses in all circumstances.
Since W-2 wages are a limitation, some may consider re-structuring as an S corporation vs. a partnership as owners are issued W-2s by S corporations, but not if partners in a partnership (viz., LLCs taxed as partnerships or LPs.). However, the tax effects of adopting a corporate vs complete passthrough structure has its own set of limitations and drawbacks which should be carefully weighed beforehand.
For example, owners reverting to sole proprietorship or partnership status after an S election can only be achieved by means a technical tax liquidation of the S corporation even if the legal entity remains intact. This generally triggers taxable gain on the variance between tax basis and fair market value of all S corp. assets, including intangibles. In contrast to partnerships and sole proprietorships where such an action is more likely to be tax exempt, any distributions of assets from an S corporation to its owners invariably triggers tax gain recognition on the difference between asset basis and fair market value.
Planning Issues and Opportunities With C Corporations
Switching to a “C” corporation, may seem like a good choice since a 21% rate is imposed across the board regardless of the type of income or activity, amount of property held or wages. However, the analysis should not stop there. This is because any earnings that are distributed from a “C” corporation to U.S. taxpayers are subject to additional federal tax of 23.8%. Adding the two rates together, you are higher than a single top rate of 37%.
However, with respect to nonresident noncitizens who are taxed only on U.S. sourced income, the reduced 21% tax rate for “C” corporations presents a tremendous inbound investment opportunity. As noted previously, the stock of “C” corporations held by nonresident noncitizens is taxable only if transferred upon death. If the “C” corporation is held by a foreign entity, it should escape U.S. transfer taxation entirely since no transfer of U.S. ownership can occur on death or by gift. In addition, dividends in countries where the U.S. has treaties are subject to rates often materially lower than U.S. residents and citizens are subject to. For example, the double tax treaty between U.S. and Israel imposes a 12.5% withholding tax on eligible dividends remitted to corporate owners. The 12.5% rate is materially lower than the 23.8% rate imposed on U.S. residents and citizens and leads to a combined federal tax rate of 33.5% (corporate tax rate of 21% plus dividend tax rate of 12.5%) instead of the combined tax rate of 44.8% (corporate tax rate of 21% plus dividend tax rate of 23.8%) imposed on U.S. individual taxpayers.
Prior to the new Tax Act, a dual corporate structure created the imposition of a maximum 35% corporate tax rate in the U.S. in addition to the 12.5% treaty rate for a combined income tax rate of 47.5% (exclusive of any state or local income taxation). Hence this is a very substantial rate reduction. Furthermore, outbound liquidations of U.S. corporate entities by foreign owners are also in a materially favored tax position where earnings and profits are not subject to further taxation.
It should be noted that, an “accumulated earnings tax” of 20% is imposed at the corporate level when earnings exceeding business needs are retained and not distributed by a “C” corporation. Hence U.S. “C” corporations cannot be utilized to retain large amounts of passive income that are undistributed.
While no longer a material rate difference, unlike passthrough businesses, “C” corporations are not eligible for reduced tax rates on capital gains. Change in entity elections are generally tied to a five-year term so switching to a “C” corporation can’t necessarily be undone overnight. If you are a U.S. citizen or resident, the pros and cons of utilizing a “C” corporation structure, along with issues such as what types assets and type of business activity should be analyzed carefully beforehand.
Depreciation and Expensing of Business Assets:
Moving on to other business tax changes, two avenues now exist to fully expense all acquisitions of depreciable qualified property. The first is Code Section 179 expensing of acquisitions which is now increased to $2 million with a phaseout at $2.5 million. There is also expanded eligibility for expensing capitalizable amounts to building systems for nonresidential structures such as roofs, HVAC, fire & alarm and security systems for those owning or leasing real estate.
Assuming the $2.5 million acquisition threshold is reached, bonus depreciation of 100% for qualified depreciable assets acquired and placed in service as early as after September 27, 2017 can be claimed through 2023. Alternatively, 50% of the cost can be written off in the year the asset is placed into service. Luxury cars have somewhat higher depreciation limits now set at 10,000 year 1; 16,000 year 2; 9,600 year 3; 5,760 all subsequent years.
Interest Expense Limitation
Another very key change which is especially restrictive for domestic businesses is the repeal of the pre-existing earning stripping limitation in IRC § 163(j) which had disallowed interest expense if the debt to equity ratio was greater than 1.5 to 1. This was intended to impact inbound corporate investment structures. This old limitation is now replaced with a very onerous and limited interest limitation of basically 30% of EBITDA for commonly held entities (including now not just corporations but also partnerships and sole proprietorships) where gross receipts exceed $25 million.
Key to note is that aggregation rules applicable to commonly held businesses such as for filing consolidated returns or for grouping rules on qualified plans also are used in ascertaining whether or not this threshold is reached. Once the threshold is reached by a commonly-held group, it applies to each entity in the group. For example, assume brothers A and B are partners in two separate partnerships, X and Y. Partnership X has 10 million in average gross receipts and Partnership Y has $16 million in gross receipts. For purposes of this rule, the gross receipts of both entities are added together such that both Partnerships, X and Y are now each subject to the interest limitation rule.
This limitation has no correlation with cash flow, and hence businesses that are significantly leveraged could find themselves with substantial tax liabilities based on significant amounts phantom taxable income that do not correlate to cash flow. There are special elections to opt out for real estate and farming at the expense of slightly longer depreciable life on buildings and leasehold improvements which involves essentially electing slightly longer ADS straight line depreciable lives for e.g., limited businesses using ‘floor plan financing” such as for vehicle dealers, are also exempted regardless of the level of gross receipts.
Though campaigning on a promise of repeal of “carried interests” for partnerships, in fact the only change in the area of partnership profits interests is that they must held for three years whereas it was previously two years. Hence closer attention should be given the holding period for such interests.
Other Business Tax Changes
Other eligible thresholds set at $25 million are use of the cash method, inventory capitalization rules and percentage of completion exception for long term contracts (which applies primarily in the constructions space). The increased threshold for cash method will allow with taxpayers in a business that has inventory, such as in the retail merchandise space, to stay on the cash method (viz., expensing inventory as used) or go back to it as the previous cap was set at $10 million.
Net operating losses in a business can only be carried forward and offset against 80% of taxable income in any given year.
Entertainment expenses, which used to be deductible at the 50% level, no longer are deductible though meals generally remain deductible at the 50% mark.
Mandatory Repatriation Tax – US Taxpayers
Turning to international taxes, now all U.S. taxpayers who are (1)“controlled foreign corporation” (CFC) owners (10% or more by vote or value as to taxpayer + foreign entity more than 50% held by U.S. shareholders) or (2) who have ownership in a foreign corporation which is also held by another domestic corporation and in either case (1) or (2) the foreign corporation has offshore corporate deferred earnings and profits, are faced with a deemed dividend repatriation and tax to be paid over an eight-year period. Technically, U.S. taxpayers that could fall into this liability include US individuals, partnerships and trusts who have not filed “check the box” elections on their foreign entities.
The rate imposed is 15.5% on earnings attributable to cash and cash equivalents; 8% on the balance. After this, inbound dividends are tax free through no foreign tax credits are available. S corporations are likewise subject to this deemed repatriation, but can elect to “opt out.” In this regard, it should be noted that there is a 75-day window to file elections such as from partnership to S corp. if an LLC. The tax applies to status as of December 31, 2017.
This mandatory “repatriation tax” imposed only on pre-existing corporate offshore earnings and profits has resulted in U.S. corporations requiring to report this material liability on 2017 Q4 financial statements. The net effect is materially reduced earnings and profits reports for all large U.S. corporations that have had unrepatriated earnings and profits.
On the other hand, prospectively, such foreign earnings and profits received from controlled foreign corporations and repatriated via cash movement to the U.S. are not subject to additional US federal taxation though also precluding any foreign tax credit on such dividend income. State tax rules vary on this issue and should be checked separately.
There is some talk about declaring a dividend to avoid the repatriation tax. However, dividends are fully taxable and this repatriation tax allows for an 8-year payout period. In addition, it’s taxed at rates lower than dividend income rates: 8% and 15.5% rates instead of 23.8% for dividends (exclusive of any withholding taxes the country of formation may levy but would be creditable). Some advisors have also looked at salary declarations given the IRC § 911 exclusion. Such salaries would be taxable in the country of formation and excludable from U.S. taxation if satisfying the residency criteria within the 911 exclusion currently set at $104,000 for e.g., 2018.
GILTI – US Taxpayers
While ostensibly moving U.S. corporations to a quasi-territorial system of taxation, under the 2017 Act, Congress nevertheless retained the pre-existing anti-deferral tax regimes including Subpart F income of Controlled Foreign Corporations and Passive Foreign Investment Company taxation of “excess distributions” where a passthrough qualified electing fund election or mark to market election has not been made.
This was done to minimize the risk that U.S. corporations would move funds to low or no tax jurisdictions and keep them there. Hence, while dividend repatriation is tax-free offshore earnings in foreign subsidiaries deemed to be “Subpart F” income are subject to immediate U.S. taxation and not tax-free. Taxpayers in the international tax space should remain mindful of this anti-deferral regime as it can prove to be a trap for the unwary. It should be noted that dividend declaration is not a workaround since this is an automatic inclusion based on Subpart F income rules.
In addition, to preclude continued offshore revenue generation where the income ultimately flows into low or no tax jurisdictions a “Global Intangible Low Tax Income” (GILTI) category was added to the Subpart F income anti-deferral regime. Such income is therefore deemed subject to U.S. taxation immediately.
GILTI is the excess (if any) of (A) the shareholder's net CFC tested income for the tax year, over (B) the shareholder's net deemed tangible income return for the tax year. A taxpayer’s “net deemed tangible income return” looks to a deemed return on tangible assets and amounts to essentially 10% of the shareholder’s pro rata share of qualified business asset investment over certain specified interest expense. If the return is small, a U.S. shareholder may be subject to a large portion of CFC income is subject to current taxation essentially as Subpart F income.
Prospectively, corporate U.S. shareholders of a controlled foreign corporation (CFC) with applicable GILTI are subject to taxation to a net effective tax rate of 10.5% on the income, with the income and any taxes paid calculated in a separate foreign tax credit “basket” with any foreign tax credit limited to 80% of taxes paid. In any event, assuming the CFC is in a low tax jurisdiction, it would mean that there would likely be little creditable income taxes because little was paid in taxes to credit relative to the U.S. tax liability.
Disposition of Partnership Interests with U.S. Effectively Connected Income by Non-US Taxpayers
The 2017 Tax Cuts and Jobs Act also contains a new 10% withholding requirement on the gross proceeds upon disposition of any interest in any entity viewed as a partnership under U.S. tax rules and held by a foreign partner where the underlying partnership has U.S. effectively connected taxable income. Hence this withholding requirement applies to both domestic and foreign entities if viewed as partnerships under U.S. income tax rules.
Sales or even deemed sales (such as a contribution by one partner of e.g., cash followed by within two years a distribution to another partner of cash) of partnership interests are now subject to U.S. tax. A Tax Court decision rendered last year, Grecian Magnesite, had confirmed a long-held view that in the absence of depreciation recapture or the presence of either unrealized receivables or appreciated inventory, such sales transactions were not subject to U.S. tax. In rendering its decision, the Tax Court overturned a hotly-contested 26-year old Revenue Ruling.
As a reaction to this very recent decision, this provision, which had originally been proposed in 2012 by Obama over concerns as to the sustainability of this Revenue Ruling, was added into the Tax Act. It effectively gave a very short life to the Grecian Magnesite taxpayer victory.
The implications of this provision potentially reach beyond income taxes to transfer (estate, gift) taxes. While there is specific statutory guidance relative to transfer taxation and corporate stock, there is a void regarding proper transfer tax treatment of partnerships and LLC interests held by foreign investors or foreign partnership interests with U.S. effectively connected income held by foreign partners.
Outside of a very short sixty-year old Revenue Ruling and an even older court decision, there is no specific much less recent guidance on how to treat these interests for transfer tax purposes. Nevertheless, with Congress codifying such low corporate tax rates, the use of dual corporate blocker structure of a foreign corporation holding a domestic corporation which effectively shields private non-US investors from U.S. transfer taxation will likely be more common reducing the potential occurrence of this issue at least for the foreseeable future. (It should be noted that while a single foreign entity acts as an estate/gift tax shield, in that situation the entity would be subject to unfavorable branch profits tax regime for any U.S. effectively connected income.)
FDII Incentives - US Taxpayers
In light of the tremendous incentive to keep intangibles offshore in low tax jurisdictions, a new royalty export incentive was promulgated to incentivize outbound U.S. licensing or leasing to foreign persons or the performance of services for foreign persons or relative to property outside the U.S.
While the underlying rules are very complex, fundamentally a new deduction for foreign derived intangible income (FDII) in the amount 37.5% was created.
FDII is essentially gross income that is not attributable to a CFC, a foreign branch, domestic or oil gas income reduced by certain related deductions and an amount equal to 10% of the aggregate adjusted basis of U.S. depreciable assets. While interpretive guidance has yet to be issued, on its face, there may be WTO issues relative to offshore challenge of this legislation as a falling within the scope of a proscriptive tax subsidy or countervailing duty.
BEAT – Large Non-US Corporations
The Tax Cuts and Jobs Act also created a minimum tax for “base erosion” to prevent companies from potentially stripping out of the U.S. potentially taxable income by means of deductible related party payments such as licenses, interest and the like. The tax is called BEAT (Base Erosion Avoidance Tax) and applies only to very large US corporations with average gross receipts of at least $500 million per year
The tax works similarly to an alternative minimum tax that is triggered when the U.S. tax liability falls below a specified percentage of its taxable income after adding back such “base eroding” payments to related parties. U.S. taxpayers are required to pay a tax at a rate equal to the excess of 10% of modified taxable income over its regular tax liability over certain specified tax credits. The tax also applies to branch profits operations assuming the gross receipts threshold is met.
More detail and record keeping requirements as to related party transactions are now required. The minimum penalty for failure to timely and completely report information on Form 5472 is increased from $10,000 to $25,000.
Subject to certain reporting requirements, an “active trade or business” exception previously allowed a U.S. person to transfer eligible property to a foreign corporation for use in the active conduct of a trade or business outside of the U.S. without triggering taxable income. Consistent with a territorial taxation approach as well as the political view that looks to retain jobs domestically, this exception was repealed. The effect is to cause any outbound transfers of assets by U.S. persons to be taxable on the difference between tax basis and fair market value.
A deemed paid tax credit for foreign corporate taxes that heretofore existed for dividends paid by lower tier corporate entities has also been repealed for any transactions other than those falling within the scope of Subpart F income. Only corporations were eligible for this tax credit in any event.
There are also new punitive tax measures regarding incorporation of foreign branches (direct foreign operations or entities previously treated as passthrough), and the use of hybrid agreements or instruments (documents that treat the item as interest or royalty for U.S. federal tax but not similar treatment under the tax laws of the foreign country or counterparty). Any such pending agreements should be closely reviewed for compliance with the new tax law.
The legislation colloquially known as the 2017 Tax Cuts and Jobs Act impacts each taxpayer and business in the U.S. It is very lengthy and complex legislation that at certain times has raised more questions than answered. Overall, US tax reform does create a very favorable inbound investment environment for foreign investors utilizing a corporate tax structure. For those currently in the U.S., a review of structure and to ensure utilization of potential tax benefits under the new law and at the same time avoiding increased liabilities is strongly recommended.
Consult experienced INAA advisors in each country at an early stage in specific cases.
Magda Szabo, CPA, JD, LL.M. is a Tax Partner, Janover LLC in New York & New Jersey.