Details of major U.S. tax reform bill, including international tax details
by Kyle Lodder, CPA
The recently enacted Tax Cuts and Jobs Act (TCJA) is a sweeping tax package. Here’s a look at some of the more important elements of the new law that have an impact on individuals and businesses, along with specific international provisions.
Unless otherwise noted, the changes are effective for tax years beginning in 2018 through 2025.
- Tax rates.The new law imposes a new tax rate structure with seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The top rate was reduced from 39.6% to 37% and applies to taxable income above $500,000 for single taxpayers, and $600,000 for married couples filing jointly. The rates applicable to net capital gains and qualified dividends were not changed. The “kiddie tax” rules were simplified. The net unearned income of a child subject to the rules will be taxed at the capital gain and ordinary income rates that apply to trusts and estates. Thus, the child’s tax is unaffected by the parent’s tax situation or the unearned income of any siblings.
- Standard deduction.The new law increases the standard deduction to $24,000 for joint filers, $18,000 for heads of household, and $12,000 for singles and married taxpayers filing separately. Given these increases, many taxpayers will no longer be itemizing deductions. These figures will be indexed for inflation after 2018.
- The new law suspends the deduction for personal exemptions. Thus, starting in 2018, taxpayers can no longer claim personal or dependency exemptions. The rules for withholding income tax on wages will be adjusted to reflect this change, but IRS was given the discretion to leave the withholding unchanged for 2018.
- New deduction for “qualified business income.”Starting in 2018, taxpayers are allowed a deduction equal to 20 percent of “qualified business income,” otherwise known as “pass-through” income, i.e., income from partnerships, S corporations, LLCs, and sole proprietorships. The income must be from a trade or business within the U.S. Investment income does not qualify, nor do amounts received from an S corporation as reasonable compensation or from a partnership as a guaranteed payment for services provided to the trade or business. The deduction is not used in computing adjusted gross income, just taxable income. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), (1) a limitation based on W-2 wages paid by the business and depreciable tangible property used in the business is phased in, and (2) income from the following trades or businesses is phased out of qualified business income: health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
- Child and family tax credit.The new law increases the credit for qualifying children (i.e., children under 17) to $2,000 from $1,000, and increases to $1,400 the refundable portion of the credit. It also introduces a new (nonrefundable) $500 credit for a taxpayer’s dependents who are not qualifying children. The adjusted gross income level at which the credits begin to be phased out has been increased to $200,000 ($400,000 for joint filers).
- State and local taxes.The itemized deduction for state and local income and property taxes is limited to a total of $10,000 starting in 2018.
- Mortgage interest.Under the new law, mortgage interest on loans used to acquire a principal residence and a second home is only deductible on debt up to $750,000 (down from $1 million), starting with loans taken out in 2018. And there is no longer any deduction for interest on home equity loans, regardless of when the debt was incurred.
- Miscellaneous itemized deductions.There is no longer a deduction for miscellaneous itemized deductions which were formerly deductible to the extent they exceeded 2 percent of adjusted gross income. This category included items such as tax preparation costs, investment expenses, union dues, and unreimbursed employee expenses.
- Medical expenses.Under the new law, for 2017 and 2018, medical expenses are deductible to the extent they exceed 7.5 percent of adjusted gross income for all taxpayers. Previously, the AGI “floor” was 10% for most taxpayers.
- Casualty and theft losses.The itemized deduction for casualty and theft losses has been suspended except for losses incurred in a federally declared disaster.
- Overall limitation on itemized deductions.The new law suspends the overall limitation on itemized deductions that formerly applied to taxpayers whose adjusted gross income exceeded specified thresholds. The itemized deductions of such taxpayers were reduced by 3% of the amount by which AGI exceeded the applicable threshold, but the reduction could not exceed 80% of the total itemized deductions, and certain items were exempt from the limitation.
- Moving expenses.The deduction for job-related moving expenses has been eliminated, except for certain military personnel. The exclusion for moving expense reimbursements has also been suspended.
- For post-2018 divorce decrees and separation agreements, alimony will not be deductible by the paying spouse and will not be taxable to the receiving spouse.
- Health care “individual mandate.”Starting in 2019, there is no longer a penalty for individuals who fail to obtain minimum essential health coverage.
- Estate and gift tax exemption.Effective for decedents dying, and gifts made, in 2018, the estate and gift tax exemption has been increased to roughly $11.2 million ($22.4 million for married couples).
- Alternative minimum tax (AMT) exemption.The AMT has been retained for individuals by the new law but the exemption has been increased to $109,400 for joint filers ($54,700 for married taxpayers filing separately), and $70,300 for unmarried taxpayers. The exemption is phased out for taxpayers with alternative minimum taxable income over $1 million for joint filers, and over $500,000 for all others.
Unless otherwise noted, the changes are effective for tax years beginning in 2018.
- Corporate tax rates reduced.One of the more significant new law provisions cuts the corporate tax rate to a flat 21%. Before the new law, rates were graduated, starting at 15% for taxable income up to $50,000, with rates at 25% for income between 50,001 and $75,000, 34% for income between $75,001 and $10 million, and 35% for income above $10 million.
- Dividends-received deduction.The dividends-received deduction available to corporations that receive dividends from other corporations has been reduced under the new law. For corporations owning at least 20% of the dividend-paying company, the dividends-received deduction has been reduced from 80% to 65% of the dividends. For corporations owning under 20%, the deduction is reduced from 70% to 50%.
- Alternative minimum tax repealed for corporations.The corporate alternative minimum tax (AMT) has been repealed by the new law.
- Alternative minimum tax credit.Corporations are allowed to offset their regular tax liability by the AMT credit. For tax years beginning after 2017 and before 2022, the credit is refundable in an amount equal to 50% (100% for years beginning in 2021) of the excess of the AMT credit for the year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the credit will be allowed in tax years beginning before 2022.
- Net Operating Loss (“NOL”) deduction modified.Under the new law, generally, NOLs arising in tax years ending after 2017 can only be carried forward, not back. The general two-year carryback rule, and other special carryback provisions, have been repealed. However, a two-year carryback for certain farming losses is allowed. These NOLs can be carried forward indefinitely, rather than expiring after 20 years. Additionally, under the new law, for losses arising in tax years beginning after 2017, the NOL deduction is limited to 80% of taxable income, determined without regard to the deduction. Carryovers to other years are adjusted to take account of the 80% limitation.
- Limit on business interest deduction.Under the new law, every business, regardless of its form, is limited to a deduction for business interest equal to 30% of its adjusted taxable income. For pass-through entities such as partnerships and S corporations, the determination is made at the entity, i.e., partnership or S corporation, level. Adjusted taxable income is computed without regard to the repealed domestic production activities deduction and, for tax years beginning after 2017 and before 2022, without regard to deductions for depreciation, amortization, or depletion. Any business interest disallowed under this rule is carried into the following year, and, generally, may be carried forward indefinitely. The limitation does not apply to taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less for the three-year period ending with the prior tax year. Real property trades or businesses can elect to have the rule not apply if they elect to use the alternative depreciation system for real property used in their trade or business. Certain additional rules apply to partnerships.
- Domestic production activities deduction (“DPAD”) repealed.The new law repeals the DPAD for tax years beginning after 2017. The DPAD formerly allowed taxpayers to deduct 9% (6% for certain oil and gas activities) of the lesser of the taxpayer’s (1) qualified production activities income (“QPAI”) or (2) taxable income for the year, limited to 50% of the W-2 wages paid by the taxpayer for the year. QPAI was the taxpayer’s receipts, minus expenses allocable to the receipts, from property manufactured, produced, grown, or extracted within the U.S.; qualified film productions; production of electricity, natural gas, or potable water; construction activities performed in the U.S.; and certain engineering or architectural services.
- New fringe benefit rules.The new law eliminates the 50% deduction for business-related entertainment expenses. The pre-Act 50% limit on deductible business meals is expanded to cover meals provided via an in-house cafeteria or otherwise on the employer’s premises. Additionally, the deduction for transportation fringe benefits (e.g., parking and mass transit) is denied to employers, but the exclusion from income for such benefits for employees continues. However, bicycle commuting reimbursements are deductible by the employer but not excludable by the employee. Last, no deduction is allowed for transportation expenses that are the equivalent of commuting for employees except as provided for the employee’s safety.
- Penalties and fines.Under pre-Act law, deductions are not allowed for fines or penalties paid to a government for the violation of any law. Under the new law, no deduction is allowed for any otherwise deductible amount paid or incurred by suit, agreement, or otherwise to or at the direction of a government or specified nongovernmental entity in relation to the violation of any law or the investigation or inquiry by the government or entity into the potential violation of any law. An exception applies to any payment the taxpayer establishes is either restitution (including remediation of property), or an amount required to come into compliance with any law that was violated or involved in the investigation or inquiry, that is identified in the court order or settlement agreement as such a payment. An exception also applies to an amount paid or incurred as taxes due.
- Sexual harassment.Under the new law, effective for amounts paid or incurred after Dec. 22, 2017, no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement.
- Lobbying expenses.The new law disallows deductions for lobbying expenses paid or incurred after the date of enactment with respect to lobbying expenses related to legislation before local governmental bodies (including Indian tribal governments). Under pre-Act law, such expenses were deductible.
- Family and medical leave credit.A new general business credit is available for tax years beginning in 2018 and 2019 for eligible employers equal to 12.5% of wages they pay to qualifying employees on family and medical leave if the rate of payment is 50% of wages normally paid to the employee. The credit increases by 0.25% (up to a maximum of 25%) for each percent by which the payment rate exceeds 50% of normal wages. For this purpose, the maximum leave that may be taken into account for any employee for any year is 12 weeks. Eligible employers are those with a written policy in place allowing qualifying full-time employees at least two weeks of paid family and medical leave a year, and less than full-time employees a pro-rated amount of leave. A qualifying employee is one who has been employed by the employer for one year or more, and who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.
- Qualified rehabilitation credit.The new law repeals the 10% credit for qualified rehabilitation expenditures for a building that was first placed in service before 1936, and modifies the 20% credit for qualified rehabilitation expenditures for a certified historic structure. The 20% credit is allowable during the five-year period starting with the year the building was placed in service in an amount that is equal to the ratable share for that year. This is 20% of the qualified rehabilitation expenditures for the building, as allocated ratably to each year in the five-year period. It is intended that the sum of the ratable shares for the five years not exceed 100% of the credit for qualified rehabilitation expenditures for the building. The repeal of the 10% credit and modification of the 20% credit take effect starting in 2018 (subject to a transition rule for certain buildings owned or leased at all times after 2017).
- Orphan drug credit reduced and modified.The new law reduces the business tax credit for qualified clinical testing expenses for certain drugs for rare diseases or conditions, generally known as “orphan drugs,” from 50% to 25% of qualified clinical testing expenses for tax years beginning after 2017. These are costs incurred to test an orphan drug after it has been approved for human testing by the FDA but before it has been approved for sale. Amounts used in computing this credit are excluded from the computation of the separate research credit. The new law modifies the credit by allowing a taxpayer to elect to take a reduced orphan drug credit in lieu of reducing otherwise allowable deductions.
- Increased Section 179 expensing. The new law increases the maximum amount that may be expensed to $1 million. If more than $2.5 million of property is placed in service during the year, the $1 million limitation is reduced by the excess over $2.5 million. Both the $1 million and the $2.5 million amounts are indexed for inflation after 2018. The expense election has also been expanded to cover (1) certain depreciable tangible personal property used mostly to furnish lodging or in connection with furnishing lodging, and (2) the following improvements to nonresidential real property made after it was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; security systems; and any other building improvements that aren’t elevators or escalators, don’t enlarge the building, and aren’t attributable to internal structural framework.
- Bonus depreciation.Under the new law, a 100% first-year deduction is allowed for qualified new and used property acquired and placed in service after September 27, 2017 and before 2023. Pre-Act law provided for a 50% allowance, to be phased down for property placed in service after 2017. Under the new law, the 100% allowance is phased down starting after 2023.
- Depreciation of qualified improvement property.The new law provides that qualified improvement property is depreciable using a 15-year recovery period and the straight-line method. Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property placed in service after the building was placed in service. It does not include expenses related to the enlargement of the building, any elevator or escalator, or the internal structural framework. There are no longer separate requirements for leasehold improvement property or restaurant property.
- Depreciation of farming equipment and machinery.Under the new law, subject to certain exceptions, the cost recovery period for farming equipment and machinery the original use of which begins with the taxpayer is reduced from 7 to 5 years. Additionally, in general, the 200% declining balance method may be used in place of the 150% declining balance method that was required under pre-Act law.
- Luxury auto depreciation limits.Under the new law, for a passenger automobile for which bonus depreciation (see above) is not claimed, the maximum depreciation allowance is increased to $10,000 for the year it’s placed in service, $16,000 for the second year, $9,000 for the third year, and $5,760 for the fourth and later years in the recovery period. These amounts are indexed for inflation after 2018. For passenger autos eligible for bonus first year depreciation, the maximum additional first year depreciation allowance remains at $8,000 as under pre-Act law.
- Computers and peripheral equipment.The new law removes computers and peripheral equipment from the definition of listed property. Thus, the heightened substantiation requirements and possibly slower cost recovery for listed property no longer apply.
- New rules for post-2021 research and experimentation (“R & E”) expenses.Under the new law, specified R & E expenses paid or incurred after 2021 in connection with a trade or business must be capitalized and amortized ratably over a 5-year period (15 years if conducted outside the U.S.). These include expenses for software development, but not expenses for land, or depreciable or depletable property used in connection with the R & E (but do include the depreciation and depletion allowance for such property). Under pre-TCJA law, i.e., for R&E expenses paid or incurred before 2022, these expenses are deductible currently or may be capitalized and recovered over the useful life of the research (not to exceed 60 months), or over a ten-year period, at the taxpayer’s election.
- Like-kind exchange treatment limited.Under the new law, the rule allowing the deferral of gain on like-kind exchanges of property held for productive use in a taxpayer’s trade or business or for investment purposes is limited to cover only like-kind exchanges of real property not held primarily for sale. Under a transition rule, the pre-TCJA law applies to exchanges of personal property if the taxpayer has either disposed of the property given up or obtained the replacement property before 2018.
- Excessive employee compensation.Under pre-Act law, a deduction for compensation paid or accrued with respect to a covered employee of a publicly traded corporation is deductible only up to $1 million per year. Exceptions applied for commissions, performance-based pay, including stock options, payments to a qualified retirement plan, and amounts excludable from the employee’s gross income. The new law repealed the exceptions for commissions and performance-based pay. The definition of “covered employee” is revised to include the principal executive officer, principal financial officer, and the three highest-paid officers. An individual who is a covered employee for a tax year beginning after 2016 remains a covered employee for all future years.
- Employee achievement awards clarified.An employee achievement award is tax free to the extent the employer can deduct its cost, generally limited to $400 for one employee or $1,600 for a qualified plan award. An employee achievement award is an item of tangible personal property given to an employee in recognition of length of service or a safety achievement and presented as part of a meaningful presentation. The new law defines “tangible personal property” to exclude cash, cash equivalents, gift cards, gift coupons, gift certificates (other than from an employer pre-selected limited list), vacations, meals, lodging, theater or sports tickets, stocks, bonds, or similar items, and other non-tangible personal property.
Here’s a look at some of the more important elements of the new tax law that have an impact on foreign taxation. In general, they are effective starting in 2018.
- Deduction for foreign-source portion of dividends.The new law provides a 100% deduction for the foreign source portion of dividends received from specified 10%-owned foreign corporations by domestic corporations that are 10% shareholders of those foreign corporations. No foreign tax credit is allowed for any taxes paid and accrued as to any dividend for which the deduction is allowed, and those amounts are not treated as foreign source income for purposes of the foreign tax limitation. In addition, if there is a loss on any disposition of stock of the specified 10%-owned foreign corporation, the basis of the domestic corporation in that stock is reduced (but not below zero) by the amount of the allowable deduction.
- Sales or exchanges of stock in foreign corporations.Under this new law provision, if a domestic corporation sells or exchanges stock in a foreign corporation held for over a year, any amount it receives which is treated as a dividend for Section 1248 purposes, will be treated as a dividend for purposes of the deduction for dividends received discussed above. Similarly, any gain recognized by a CFC from the sale or exchange of stock in a foreign corporation that is treated as a dividend to the same extent that it would have been so treated had the CFC been a U.S. person is also treated as a dividend for purposes of the deduction for dividends received.
- Incorporation of foreign branches.Under the new law, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign sub, the transferred loss amount must generally be included in the U.S. corporation’s gross income.
- Deemed repatriation.Under the new law, U.S. shareholders owning at least 10% of a foreign sub must include in income for the sub’s last tax year beginning before 2018, the shareholder’s pro-rata share of the undistributed, non-previously-taxed post-1986 foreign earnings of the corporation. The inclusion amount is reduced by any aggregate foreign earnings and profits deficits, and a partial deduction is allowed such that a shareholder’s effective tax rate is 15.5% on his aggregate foreign cash position and 8% otherwise. The net tax liability can be spread over a period of up to 8 years. Special rules apply for S corporation shareholders and for RICs and REITs.
- Global intangible low-taxed income (GILTI).Under the new law, a U.S. shareholder of any CFC has to include in gross income its global intangible low-taxed income (GILTI), i.e., the excess of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return (10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder). The GILTI is treated as an inclusion of Subpart F income for the shareholder. Only an 80% foreign tax credit is available for amounts included in income as GILTI.
- Deduction for foreign-derived intangible income and GILTI.Under the new law, in the case of a domestic corporation, a deduction is allowed equal to the sum of (i) 37.5% of its foreign-derived intangible income (FDII) for the year, plus (ii) 50% of the GILTI amount included in gross income, see above. Generally, FDII is the amount of a corporation’s deemed intangible income that is attributable to sales of property to foreign persons for use outside the U.S. or the performance of services for foreign persons or with respect to property outside the U.S. Coupled with the 21% tax rate for domestic corporations, these deductions result in effective tax rates of 13.125% on FDII and of 10.5% on GILTI. The deduction rates are reduced for tax years after 2025.
- Subpart F changes.The new law made several changes to the taxation of subpart F income of U.S. shareholders of CFCs. Among other things, the new law expands the definition of U.S. shareholder to include U.S. persons who own 10% or more of the total value (not just vote) of shares of all classes of stock of the foreign corporation. In addition, the requirement that a corporation must be controlled for 30 days before Subpart F inclusions apply has been eliminated.
- Base erosion prevention.To prevent companies from stripping earnings out of the U.S. through payments to foreign affiliates that are deductible for U.S. tax purposes, a base erosion minimum tax applies to corporations, other than RICs, REITs, and S corporations, with average annual gross receipts of $500 million or more that made deductible payments to foreign affiliates that are at least 3% (2% in the case of banks and certain security dealers) of the corporation’s total deductions for the year. The tax is structured as an alternative minimum tax and applies to domestic corporations, as well as on foreign corporations engaged in a U.S. trade or business in computing the tax on their effectively connected income.
- Other new law provisions limit income shifting via intangible property transfers, deny deductions for related party payments in hybrid transactions or with hybrid entities, and deny qualified dividend status to dividends received by individuals from surrogate foreign corporations. Finally, the new law introduces a series of modifications to the foreign tax credit system, as well as a number of other international reforms.
If you would like to discuss how these changes may affect your particular tax situation, please give us a call.
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