Understanding the Impacts of the Tax Cuts and Jobs Act on Technology and Biosciences
Technology & Biosciences
Fortunately, we have two partners here today who will share with you some very interesting information about the new tax law, and in many cases information you are not reading about online or hearing in the news. Charles Webb will focus on domestic tax matters. While he will start off with individual matters, he will then quickly shift to matters involving technology companies.
Since more than 80% of our technology clients are international, Robert Verzi will then focus on international tax matters, which are by far the most complicated parts of the new tax law. I want to encourage you to submit questions online, and at the end of the presentation, Robert and Charles will address those if time allows. If not, they will follow up with you via email.
Please note that within the actual text of the new tax law, in over 100 places, the law says that Congress is asking the IRS to provide more guidance in the future. We have seen very little guidance from the IRS, and expect this will take many years.
That being said, we are advising clients on all matters today. While this session will cover a lot of material, we want each of you to know that our goal is to meet with every client to discuss the impact to you and your company. Depending on the complexity of your situation, these meetings will be short phone calls, or multi-hour meetings with a lot of follow-up. Without further delay, here’s Charles Webb.
Charles Webb: Hello, this is Charles Webb, and happy Friday, happy Super Bowl weekend, happy Groundhog Day, and happy Tax Reform Act of 2017. Thank you for joining us today. What I’d like to do is jump immediately into the changes in the tax rates.
So as you may have seen some of the press, the biggest change is to the corporate rate, which dropped down from a high of 34 to 35%, depending upon where we are on the scale, to a rate that is now 21%. That’s effective January 1. Some questions have come up as to fiscal year, and what congress and IRS implemented will still be prorated, so if you are in a fiscal year, that 34, 35% will be prorated with a 21% tax rate.
One the individual side, you can see that there’s been a definite change. Let’s look at the highest marginal rate at 39%, which kicked in for singles at $418,000, and then for married couples that was at $470,000. Already a rate cut you can see is down to 37% in the highest marginal, at $500,000 for singles, and $600,000 for married. But quickly, even into the lower rates, you can see at a 28% rate, which previously that kicked in at $91,900 for singles and $153,000 for married couples, now kicks in at $82,000 and $165,000, respectively. So theoretically everyone should experience some kind of tax cut.
On the next page, we get an example of someone with $600,000 in taxable income, this is a married filing joint. With $600,000 in 2017, they would have had a tax rate of 34%, and in 2018, it would be at 26.9%.
Let’s go down to $300,000 as taxable income for those married filing jointly, and you can also see a change there. Definitely a rate change of at least 4% for those individuals. The good news is also the capital gains rate. The capital gain rate was carried in tax. There was some discussion of this rate through the years. Capital gain rates have changed. Sometimes at one point they were the same as ordinary rates, but the good thing is we will have retained that 0, 15, and 20%.
So we want to be sensitive as we go forward, because we still have the issue of classifications of income, whether that’s ordinary or capital. We want to be sensitive of that as we go through our planning and transactions.
So let’s jump into what we’ve seen so much press on, and this is on the itemized deductions for individuals. As you’ll see, the standard deduction increased to $24,000 married filing jointly, and $12,000 for singles. As part of that, personal exemptions were removed. So, instantly we see that $24,000 is a large threshold in order to be able to itemize. As part of that, mortgage interest is now limited to $750,000 where it was at $1 million.
Some questions have come up, like, “What about a second home if you have the mountain home or the beach home?” We are interpreting that at this point, you still would hit the threshold at $750,000. There are some grandfather rules here, but generally, you would use the $750,000 overall for the limitation. Obviously that’s impacting our folks in higher real estate areas, as in California or New York, and so that could come into play.
The second component of that, which is the major change that we’ve seen so much press on, is the limitation on state income tax and the real estate tax that’s now limited to $10,000. So again, those states where you’ve got those higher property and state income tax, you can see that easily hit the $10,000 rather quickly.
So combine that: If you got a state limitation of $10,000 and your mortgage of $14,000, it definitely will impact those who would be in that market.
Another component of that is the lesion of the 2% itemized deduction. So no longer are tax prep fees or investment advisory fees deductible. So for companies, we want to possibly look and reevaluate where in the past you may not have paid for employees’ continued education, or maybe some of their mileage. That was definitely impactful to those employees as well as those companies who let the employee itemize, and that will now go away.
So I comment for folks that on the next page, we’ll look at casualty losses. Those are also repealed. The charitable contribution limit went from 50% up to 60%. So one of their planning ideas is, as you’re analyzing your expenses during the year, there may be the possibility that we would alternate years, and possibly when we do our charitable contributions.
If we know we’re close to the threshold or may not meet the threshold, then we may want to hold off on making certain charitable contributions. It’s the same as if we’re buying a house where we have a new home owner that is potentially in the market and did not have the mortgage interest deduction in the past.
We want to be sensitive then when they buy that house. If the new home owner is in an apartment and has never before deducted mortgage interest, and now they move and the mortgage interest starts in, say, the last three months of the year, then they would be unable to be over that threshold.
Again, the threshold is at $24,000 for married filing jointly. It’s a rather high threshold, so it’s something that we want to be sensitive to.
Other change is alimony. Historically, alimony in which one spouse would be potentially in a higher tax bracket where the other spouse is possibly in a lower tax bracket, part of the negotiations in the divorce settlement would take that into account. So again, that goes away 2018, but Congress is allowing divorce decrees to be modified during 2018.
As I mentioned, the personal exemption goes away, so dependency exemptions are put in place in exchange for that. Congress is enhancing the child tax credit, up from $2,000, and part of that is refundable at the $1,400 level. You’ll note that previously the child care credit also was limited at a rather low AGI level. That has now been increased. So another benefit that more Americans will be able to use is the child care credit that previously had not been able to do so.
Another note is on the education 529 plan. Previously, that was just limited to higher education. That now has been amended to allow for expenses out of the 529 plan to go to elementary and secondary school expenses. Obviously, the biggest change we also hear about is the removal of the charge for the Affordable Care Act, the Shared Responsibility Act. Please note that that is still in effect through 2018, but it is repealed thereafter.
Another major change to individuals is to alternative minimum tax. As we may remember, the alternative minimum tax was implemented many, many years ago when those tax shelter days were there. The thresholds that were enacted as part of AMT were based upon levels in the 1980s and early ’90s. Those thresholds slowly changed, if at all.
So many Americans who were caught up in the AMTs were trapped, especially in the mid-range of tax payers. The new provision drastically increases AMT exemption. You’ll see that for married filing jointly, that exemption goes up to $1 million. For single it’s $500,000, so again, drastically cutting a lot of Americans who were caught in that AMT trap.
Also note that the estate and gift exclusion went from $5 million to $10 million, and it’s indexed for inflation now. So for 2018 it will go up to an exemption of $11.2 million. For married couples, it’s $22.4 million. As always with estate and gifts, with each new round of congressional changes and administration, it has always been a difficult area to plan for because it changes. So while it’s this high, we definitely recommend taking advantage of this higher threshold as it stands.
The biggest change and more in the more complex areas that we’ve enacted, is the new section 199-A. Section 199-A was put in place as the government’s way of leveling out the playing field between business entities: your S-corporations, your LLCs, your partnerships, and C-corporations. As we mentioned, the new corporate rate is 21%, and the highest closer rate is 37%. So keep in mind, when you have a C-corporation, there is still the deal of double taxation.
The C-corporation pays tax on its earnings, and then when it distributes out those earnings, taxes get paid again at the individual rate level. So they’re still in effect, and there’s a difference between whether we want to be a C-corp or an S-corp. There’s no blanket statement that we can say why we’re going to be a C or S, because it depends on whether you retain earnings in the entity, or you will be distributing those out. Will you be selling the company in a few years?
That may make a difference in how you want to establish yourself. Theoretically, Congress did not want companies to go out and make a major change in how they’re structured. That being said, there’s a lot of unanswered questions, as Mitchell had mentioned, and so we’ll monitor that as the year goes. One disadvantage is the 199-A deduction. The 199-A is a 20% deduction against a closer income, and the new term that’s coming to place is called QBI, qualified business income.
Under old laws we had $100,000 in income, and we taxed that at whatever the applicable tax rate was. With 199-A, and the establishment of a QBI deduction, again qualified business income deduction, we now get a 20% deduction against whatever the [inaudible 00:14:56] income is. So now we’re taxed on $80,000, and you then apply the tax rate against that.
So you may see some press say that because of 199-A, there is a differential between your federal tax rate under old and new of roughly 10%. 39% theoretically is the highest marginal rate, under the old law. Under the new law it is down to 29.6%.
But as with anything in tax law, there’s always complexity that kicks in. So again, remember that the general deduction is 10% of qualified business income, QBI. But as part of that, there’s a limitation that congress imposed, and the 20% is limited to the amount of W2 wages. And how is it W2 wages further defined is 50% of W2 wages, 25% of W2 wages from a business, plus 2.5% of the costs of depreciable tangible property?
So the second component of this was added at the last minute, and it’s a big influx from the real estate industry, because the real estate industry came in and said, “Wait, we may not have a large amount of W2 wages, and we may be paying management fees, so we should be able to take advantage of the new 199-A deduction as well.” Therefore, congress implemented this as part of the new law, which takes into account real estate, or companies with large tangible property. Again, we take into account tangible property, and we apply a 2.5% cost.
In the tech world, obviously we have a lot of intangible property, and so there’s some degree of guidance we’ll need from IRS as we apply the exact definition of what’s going to be included in the 2.5%. As you’ll remember, the limitation is based upon W2 wages, and in our technology world, especially in the startup world, we often use a lot of either outsourcing or independent contractors, and often times the technology world doesn’t have a lot of W2 wages. Especially in the early stages of technology as they grow. Again, possibly with the use of independent contractors.
So what we’ve seen is companies, because of this limitation, reevaluate their W2 wage base. Possibly pulling on some of those individuals that are being treated as independent contractors and pulling them in onto payroll, and also then reconsidering the outsourcing. So part of the emphasis of what Congress was intending to do was get wages more in the US, and also to increase wages.
So, noting that, let’s give an example. Let’s look at an S-corporation with $800,000 qualified business income. We have wages of $100,000, and in this example, we have zero cost of depreciable property. The initial easy calculation is 20% of QBI, which would be 20% of $800,000 to give us $160,000. But remember, we have the other limit, and that other limit is 50% of W2 wages, and in this case it’s 50% of $100,000 to give us $50,000. So on its face, we would think that the 199-A deduction is $160. But, because of the W2 limit, we’re at $50,000.
Let’s give another example and say that we do have a company that has zero in wages, but they have $10 million in depreciable property. Again, when we say depreciable property, this is the original cost basis. This is not the adjusted basis after depreciation. So that number would change and stay constant throughout. So in this case, we have a QBI of 20% of $200,000, and with the depreciable property limit, it’s 25% of W2 wages, plus the 2.5% of depreciable property. So in this example, our 199 deduction is $200,000.
So technology companies qualify. However, what I wanted to carve out is that 199 is specifically noted for specified services businesses. These include your attorneys, accountants, consultants. Also caught up in there is brokerage services investing in financial services.
Keep it in mind that the intent of Congress with 199 is to instill small business, so small businesses to invest in making products, or items. As part of that, engineers were put in there. So engineers and architects, their services specifically are carved out, and they would meet the definition and be considered specified services.
But in the tech world, I wanted to highlight the very last item, which says any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees are owners. So let’s give an example of a technology company that’s starting up, and they’re building up their software, and they’re building out their platform. But at the same time, maybe they need additional money to help fund that, so they take some of their programmers and they do consulting services on the side.
So one of our dilemmas and unanswered questions is, do we split out our consulting business from our software development practice? Our advice at this point, until we know more, is just to know that we would not want to restructure. That being said, we would want to stay tuned and monitor this very closely, especially in the technology world, because what is that definition?
You’ll see some opinions that are out there where people are trying to be creative by spinning out saying their domain name, or they’re spinning out their logo, and trying to set this up to get around this definition of whether a trade or business is based upon the reputation.
So companies are bifurcating various elements of a trader business, so that the reputation or skill of the employees is isolated from the components of it. Again, we believe that IRS is keenly aware of some of these planning strategies, and will issue regulations. We do not have exact answers on how, if it’s a control group, or if there’s a lot of common control. We expect the IRS to issue guidance, to somehow limit the ability for companies to spin those out.
Again, let’s stay tuned on this one. It is something in the tech world that we need to consider. So as part of that, Congress did realize there’s a complexity and wanted to help out small business, including the specified services industry. So they implemented a threshold so that companies beginning with gross income of $315,000 or below do not need to bifurcate, and there’s no special limitation on the specified services.
However, there’s a phase out, and it’s at $415,000. Then the specified services does become an issue regarding how the deduction is applied. Again, to reemphasize, the 199-A deduction is tested at the individual level, not at the entity level. So our concern is how we structure things.
In a technology company we may have our angel investor, the funding person, who’s clearly over the limit. But the idea person, or the founder of the technology company, is maybe in a lower income tax bracket, and therefore would not be impacted by this limit.
So again, we have to be sensitive when we start to do restructuring. Thinking about this, we have to look through and consider all the investors and their income levels, and the impact that would have on them.
Next major area we go to is in business deductions. So historically, congress has always had some type of special incentive for depreciation. It was at a 50% bonus depreciation, and it was on original use. Under the new law, beginning with assets placement service after September 27, 2017, there is a 100% bonus depreciation that’s allowed on qualified property.
Again, the incentive is that Congress is thinking that increased purchase of assets would cause this 100% dispensing. One of the other major benefits that is added is that the original bonus depreciation was only own new assets, and was not on used assets. So often times in the tech world, as we either looked at an asset acquisition or in our structuring, if there was an asset acquisition and we were purchasing those assets from the cellar, they were considered used assets. So, the ability to take owner’s depreciation was limited.
Now under the new law, used assets do qualify. So a consideration as we go into our MNA, if we’re considering an asset versus a stock, we possibly want to consider that or throw that in as part of the equation, since we now will get that 100% bonus depreciation on used assets.
Coupled with the bonus depreciation is the increase to section 179. Keep in mind that 179 is the ability under the tax code to expense capital improvement. So your question may be, well if I have 100% bonus depreciation, why would I need section 179? It really depends. There are various factors that often come into play depending on state jurisdictions, state taxations, and certain circumstances where you may want to do the 179.
For example, many states do not allow bonus depreciation and never have. However, they allow section 179. So in those states, you may want to reconsider whether you do the 179. The other big change was the expansion of the 179 and what qualifies. Previously, major improvements of real property such as roofs and HVAC were not allowed to fall under the 179 category.
Now, under the new law, they do qualify. So roofs, HVAC, security systems, and fire protection- those would now be qualified under the section 179. I’ll also note that Congress did increase the limitations on luxury automobiles. You’ll see the big increase. In just the first year depreciation, it was at $3,160. Now it’s up to $10,000.
A major change also is the ability to deduct interest expense. So you’ll note that the new limitation, which is 30% of adjust gross income, applies to businesses. Small businesses are exempt under $25 million, but we note that we still need guidance as to how that $25 million will be calculated.
On its surface you think, “Well, my company is nowhere near the $25 million.” We don’t know if you’re part of a larger venture capitalist firm, or a PE group, where that $25 million test would be. So a caution is we may think that we’re not subject to this limitation, but we need to monitor the guidance that comes up from the IRS as to how that $25 million will be calculated. Will it be a control group? Will they pull in corporations and partnerships? Again, I mentioned the venture capital group, so you also have a venture capitalist that may own several different entities as different ownership percentages.
There’s a possibility that $25 million in gross receipts will be pulled in and it will now be limiting our interest expense deduction. We’ll note that the interest expense deduction will be allowed to be carried forward indefinitely. But again, in our tech world, as we have a lot of startup companies doing a lot of R&D in the beginning and we’re using highly leveraged infusion of money, we’re going to have that 30% limited at just a taxable income.
We also note that theoretically, if we got a large interest expense deduction, not expecting that we may be in a net operating loss for gap purposes or financial statement purposes, by adding the 30% limit onto the interest expense then we may be in a taxable income situation. So again, it’s something to monitor, especially in the technology world as we have that highly leveraged structure.
I’ll also note that the limitation is tested at the individual level, so it’s something to be sensitive to as we do our planning and structuring. Another major change that impacts technology companies is the new rule applicable to net operating loss deduction and NOL. Under old rules, there was a two year carry back of a net operating loss, and then a 20 year carry forward. It was also certain AMT, or alternative minimum tax revisions, that applied.
So what was beneficial in the technology world was that often as we grew, we would have R&D expenses in a few years. Then we would go to market with our product, have a good year, and we were also then able to average out a lot of our taxable income due to the ability of this two year carry back period. Under the two year carry back period, you could take a net operating loss for one year, carry back and get a refund from federal and state government for that net operating loss. So in the new law, that carry back goes away, and now it can be carried forward indefinitely. Which is a good thing, but here’s the kicker. There’s now a new limit for losses generated in 2018 of 80% taxable income.
So again, I will go back to our technology company. We go to market, our product’s out there, and we have a really good year. Historically, we’ve always thought, “Well, we’ve got plenty of net operating losses, and we don’t owe tax anytime soon.” But this is going to catch us because we’ve got this now 80% limit.
So, we go to an example of this, and I’m using 2018. For this example, there is a new company starting in 2018 that generates a net operating loss of $1 million, and that’s going to be carried over to 2019. In 2019, we have taxable income. But now, under this new limit, we’re going to be limited to 80% of taxable income.
Normally, we would have plenty of net operating loss to carry forward and offset that 2019 taxable income. So, previously we had no tax. Now, we have tax on $160,000, and a flat rate of 21%, so we have an unexpected tax of $33,600. So the reason I split this out is there some discussion on how this 80% limit applies.
We read the tax code as saying there are two buckets of net operating losses. There are the pre-2,000 operating losses, which we believe to be fully offset against future income. The way we interpret the tax code currently is that the net operating losses will be limited for NOLs starting in 2018. However, there’s some discussion that that was not the intent of the law, and some firms may interpret this and believe there may be technical corrections, or there may be some change that will say no, all NOLs are limited, whether pre or post.
If you’re doing a tax provision, most firms are going with the guidance that you’ll need to split your net operating losses into two buckets and isolate that onto your financials accordingly to recognize that you have the pre and post. As I mentioned, alternative minimum tax, or corporate AMT, was repealed in full. And because of that, we don’t need to separate our AMT net operating losses.
Nor do we need to keep track of separate depreciation. One of the pains and complexities of the tax law previously was that we had to maintain a federal tax depreciation schedule, a gap or book depreciation schedule, a state depreciation, and an AMT.
So the good news is we no longer have to keep the AMT depreciation schedule under this. One quick note, and important to recognize, is if the corporation had ever been subject to AMT, Congress has allowed there to be a credit. A credit is spread out over the next five years between 2018 and 2021. The actual calculation is a little complex and outside the scope here, but basically, that credit will be refundable. So if you previously have had AMT, you may have that buried in your deferred tax access schedule. It may be at whole value, and it may not be sitting on your balance sheet.
You will need to make sure that you reclassify that as of December 2017 to make sure that AMT is now a full blown receivable, not offset by evaluation allowance. It needs to be recognized, and you also want to split it between a current and noncurrent, because theoretically, 50% of that credit will be refundable in 2018.
The next thing that impacts the technology world is the R&D tax credit remains. Very good news for technology. Congress recognized the importance of the R&D credit, and retaining R&D in the United States. Keep in mind the R&D credit is not available for R&D done outside the United States. So, as part of that, and possibly to pay for some of the provisions, Congress implemented a new provision that’s applicable for years after 2021- that all the expenses now must be capitalized and amortized over a five year period. That’s for expenses in the US. If the R&D expenses are outside the US, then they must be amortized over 15 years.
I know many of you are saying, “Well, I don’t need to worry about this because that’s not until 2021”, but I think we need to definitely consider it. As we’re looking at structuring, as we’re currently offshoring, or potentially considering offshoring, we need to think about this new provision which will sneak up on us.
If we’re signing contracts to possibly outsource our R&D to overseas with a company, that’s going to catch us because of the 15 year amortization of that R&D that will make a major dent to the taxable income, which normally was not there. So again, while it’s not applicable until 2021, it could sneak up on us.
We also advise that this gives us many years to approach Congress and possibly our lobbyists to get this provision changed. So we’ve got a few years, but two approaches: let’s lobby and try to get this provision changed, and at the same time, let’s reconsider our structure and our contracts.
Next is provision deals with meals and entertainment. This is an area that has a lot of unanswered questions, but right off the top, Congress was very clear that this allowance for entertainment related to facilities- so football, your concerts, special events- is now 100% deductible. There’s a rumor that Super Bowl tickets have plummeted now because they know that they can no longer can write that Super Bowl ticket price off.
Where some of the ambiguity lies is with the meals on the premises. Clearly, Congress says that meals that are provided on premises in cafeterias- so for example your Google model, where Google does provide their own cafeteria for its employees- it’s intended to disallow that at 50%, and it will ultimately go away in 2025. Where some of the ambiguity lies is if I decide to take a client out, and I say “Let’s meet for lunch”, and the client wants to discuss the taxes. Either I pick it up as a CPA, or the client decides they’ll pick it up, the ambiguity is, is that really ordinary and necessary? Is that entertainment, or is that necessarily a meal that’s fully deductible?
So this is where some of the guidance is ambiguous. Are your holiday parties deductible? We believe yes, how they’re currently written. The holiday party is 100% deductible. The one-off or special event that you have throughout the year is deductible.
Where the ambiguity lies is what if we have pizza and beer on Fridays, or we decide every day during tax season that we bring in dinner, is that considered entertainment? Or could that be considered necessary for the employer? So again, stay tuned for this, there is a lot of ambiguity but it is something that we want to monitor.
Also, I’ll note the removal of like-kind exchanges. Generally, this looks to just apply to rural property. But now one of the changes you’ll note is that like-kind exchanges are down away with personal property. So previously, when we traded in a car, we traded in equipment. Then, when we traded that in, the trade-in value reduced, and it was adjusted in the depreciation calculation value going forward.
Now that the like-kind exchange rule is removed for personal property, your trade-in value on the car or the truck now has to be recognized as gain or loss based upon that value. So something to think about and watch where we normally would not have paid tax when we traded that in, we’ll now need to consider it.
We also see the differences on crypto-currency. As we go down the route of crypto-currency, it could possibly fall under the rules that are related to these like-kind exchange rules. The other major change is the new implementation of section 83-I. A lot of us are familiar with section 83-B, but there’s a new code section for qualified equity grants. On the surface, it sounds like a very good benefit where stock options, equity grants, and RSUs fall under this new provision.
One of the problems in the past has been when you vested in stock, or you were granted certain stock or equity, then you had to pay tax on that event. That obviously made it difficult for employees, or anyone receiving that equity grant. They had to pick up tax, but they didn’t have the cash because in technology a lot of times we don’t have a readily available market to sell that stock. So we may have it, but we can’t sell it, so we don’t have the cash to pay for the taxes applicable. So one of the beneficial things of this new 83-I is it allows the employee to make an election to defer the income tax applicable to that taxable compensation. So on its face it looks very good.
As we delve into it a little more, there’s definitely some handcuffs and limitations. To be qualified under 83-I, you’ll note that you have to have a written plan that gives stock to 80% of the employees. While I know a lot in the tech world, we want to make equity grants applicable to everyone in the organization, this limitation of using 80% is preventing some companies from implementing it.
You’ll also note that as part of the 83-I, certain employees are carved out. A 1% owner is carved out. The CEO, the CFO, including any of their family members, they’re carved out of the ability to use 83-I. Also, any of the high compensated officers, or any of them that have been officers in the ten previous years.
So we’ll note it’s a great benefit, but note that is not always as beneficial for everyone, and sometimes the ones that are receiving these equity grants are the ones that are specifically carved out in this new provision. One note, there’s also a carve out related to employee achievement awards. Under this code section, if a company gave tangible personal property to an employee based upon an event, then that was excluded.
This was the watch given to someone who’s retiring, or a special gift given to someone as they reached certain milestones. That is still there, but Congress specifically codified the cash or cash equivalents. Gift coupons- so if you give a Starbucks card to employees, or tickets or cash equivalents, meals, vacations- those specifically are taxable.
So we’ll say that where the practicality of this may have to be outweighed in a business decision, I wanted to note that Congress is putting businesses and employers on notice. If you give any of these cash equivalents, they technically now are taxable to the employee.
Also note that we have a lot of press on no deduction for sexual harassment settlements, or the attorney fees or settlement fees related to that.
So we talked about the net operating losses, but in addition to that loss limitation, there’s a new exception for excess business losses. They are specifically stating that there is a limit of $500,000 for married filing joint, and $250,000 for single. So it’s capturing a lot of our venture capitalists who may want to put in, well say $500,000. In the technology world, an individual is putting in easily $500,000 and now they’re going to be captured by this new access loss limitation.
So as we start to structure in the tech world, or start to look at it, we’ll need some additional guidance. It’s counterintuitive that we may limit some of our venture capitalists on the amount of money they put in knowing that they’re going to have this new limitation.
A couple other quick considerations I’d like to bring up. Your impact to financial statements. Under gap, if there is a tax law signed by the President, that’s considered enacted, and you recognize the effect of that enacted law in the quarter or during the period that it was enacted. So, as you recall, around the holidays Congress passed the provision, but the President had not signed it yet. So as of December 22nd, many companies were hoping that there would be some pressure for the President not to sign it.
But in his promise to American people, he did sign on December 22nd. So as a result, you’re seeing a major impact by Wall Street. Companies are now having to recognize the impact of that, and specifically this comes to the deferred tax act. Keep in mind, a deferred tax asset is a future tax deduction. It’s an asset, and it represents the difference between book deductions and tax deductions.
So obviously some in the tech world, or specifically banks, have greater write offs for [inaudible 00:49:00], but they don’t necessarily for taxed. So those assets were valued, because they’re future deductions, at a 35% tax bracket. Since they now will be deducted in the future at 21%, the value of those assets has been reduced. Thus, the impact that we’re seeing on financial statements, and what you’re seeing in Wall Street now, especially the banks, you’ll see with JP Morgan, they’re [inaudible 00:49:31] Wells Fargo, they’re these companies that are having a major write down. Obviously it’s driving the analysts crazy. But they realized, this is impacting their earnings per share as we have a write down of those assets.
I will note on the HR side, there’s a new tax credit for companies where you pay an employee for leave, [inaudible 00:49:58] and family medical leave. It’s a new 2.5% credit to potentially look at.
There are changes to payroll. The new tables are out. Some companies have already implemented them, but under the guidance by IRS, they need to be implemented by February 18. Congress and many people were expecting this new increase in paycheck to be there on February 15, so we’ll stay tuned as you start to get your checks in the next week or two of the impact and the additional money that you have.
I will also note one change to payroll to watch out for is this new elimination of a deduction for qualified moving expenses. Historically, we as Americans, we move around a lot or we pay for jobs. So whether we pay for someone from Silicon Valley to move to Atlanta, or Atlanta to move to Silicon Valley, historically we’re always able to pay for that moving expense deduction, and it was nontaxable to the employee.
Starting in 2018, that is now taxable to the employee. There’s no getting around that. You can’t pay the moving van or the moving company directly, it’s any moving expense. So we caution as you budget and plan for new hires, and you know there’s a move. For some companies they’re actually grossing up that reimbursement of moving expenses, or they’re giving an added bonus.
So we caution if you got that, you would want to build that additional cost into your budget of that particular hire. So you would either gross up a federal, depending on the negotiated rate with the employee, at 25% plus your state, whatever that number may be. So something to consider to make sure HR departments are aware of that.
I’ll make a quick note. There’s been some changes to the cash method that’s been expanded to companies to allow small businesses to potentially use cash method, which is more frequent than was done in the old law.
So with that, I’m going to turn it over to Robert Verzi on the international side. Thank you.
Robert Verzi: Thanks Charles. This is Robert Verzi, I specialize in international tax, and I’m a partner here at Aprio. The international tax provisions have changed dramatically, and I would not say this has anything to do with simplification, but it has to do with trying to move money and income back onto the US shore.
I’ll go over some of the significant provisions in the international realm. First of all, we’re transitioning to a quasi-territorial system. The current system prior to 1-1-18 was not a territorial system, it was a foreign tax credit system whereby repatriation of foreign earnings from your controlled foreign corporation would not be taxed until a dividend was actually paid back to the parent, unless it was some other kind of tainted income or sub-part of income.
What the territorial system does, is once you earn the income offshore in a foreign company, paying that dividend back to the US will now be exempt from US income tax. So that’s part of the good news. There’s some not so good news that is accompanying that territorial system, and that’s what is known as a onetime tax to clean out all of your previously undistributed earnings from your foreign subsidiaries to sort of catch up, wipe everything clean so we can proceed with a territorial system.
There’s also a very significant base erosion and provisions that have been enacted. One deals with the current taxation of global intangible low taxed income, and we’ll discuss what those provisions are and how to deal with them. There’s also another provision that tends to increase the US tax base, and that’s the base erosion anti abuse tax.
There’s some more good news. There are incentives for companies who leave their US … or leave their IP within the IP if those companies do have significant export sales or export of services, and there will be some other miscellaneous changes that will also go.
Okay, the end of deferral from a US perspective, previously as I had mentioned, our foreign tax credit system allowed for foreign earnings to be deferred and left off shore and not taxed in the US until they were actually physically removed. I’m sure you’ve read many articles about how Apple and Google have left billions of dollars offshore and have not paid any US tax on those earnings.
All of those earnings are now going to be subject to US income tax at the first tax year that begins prior to 11-18. So for your calendar year tax payer, your 2017 corporate return is going to have a big surprise in it. It’s going to pull in all of your offshore deferred earnings and subject those earnings to a reduced tax rate.
Now this transition tax rate, depending on what form your offshore earnings are invested in. If they’re invested in cash and accounts receivable, those earnings would be subject to tax at 15.5%. If those earnings are invested in assets other than cash or cash equivalents, then you would enjoy a much lower rate of 8%.
Now we get to those rates, it’s not that the rate is still at 35% for a corporation. We still get a deduction. I mean, they were 55.7% if you’re in the cash earnings pool, or 77.1% if you’re in the non-cash pool.
Some more good news is that if you do get caught up with having to pay this transition tax, you’ll be able to spread it over eight years. The first eight years, year one being 2018, and the next four years after that you would be subject to have to pay 8% of that tax amount, and then you have a 15%, 20%, and 25% payment.
So it’s back loaded, which should be helpful for tax payers who were caught up in this provision. Now, the 15.5% and the 8% rate generally are going to apply to C-corporations. What if you have a CSC that’s owned by an LLC partnership? Well then that onetime tax or onetime income inclusion will be taxed at the individual level, and if you use that 55.7% and 77.1% exclusion amount, you get to an effective rate where individuals have 17.5% and 9.05% tax on individuals.
Now one thing I’ll mention is if you’re an S-corporation, you get to indefinitely defer this one time inclusion. Why S-corps? Well I suspect there’s probably a few very, very large S-corps out there that would be crippled by this deemed inclusion, so they got a pass from Congress, and some of those are going to be enjoying this deferral for a long time.
Now before you get too excited about the deferral election, my reading of the rule says if you do elect to defer, you’re basically forgoing this low tax rate unless you have a triggering event. A triggering event would be the sale of your S-corps, the S-corps becoming a C-corps, and the S-corps selling all of it or the majority of its assets. In that case, you would go back and you would pay this tax at that time, and then you would potentially have the 8% or the eight year spread.
Say for example you have an S-corps. You make the election, but then you sell your CFCs the next year. My view is that you don’t get this benefit of the low rate, you potentially have to pay tax at the normal individual rates for capital gains and dividends, which would most likely be 23.8%. If you were selling a CFC that was in a treaty country, if you were selling a CFC that’s not in a treaty country, then you would potentially be taxed at the 37% highest marginal rate.
So keep that in mind when you’re deciding whether you want to make this election to defer with respect to an S-corps. Now this onetime tax, or the transition tax, is going to create a record keeping nightmare for many of our clients. First of all, we’ll have to determine what earnings and profits are for your offshore foreign company.
Earnings and profits, as you may or may not know, is not the same as a book profit. So a lot of companies, when these provisions weren’t relevant, we’re not typically keeping up with their earnings and profits. They were basically used as retained earnings and put on form 54-71 to report the activities of the CSC. Since they were not paying any dividends, there wasn’t a major concern that the earnings and profits weren’t accurate.
Now that we’re having to include all of these earnings and profits, I think it’s very important that companies are going to have to go back, technically all the way to 1987 if the CSC were formed at that time, and compute the earnings and profits. And that’s a multi-step task.
First, you have to convert your foreign gap into US gap. Then we have to convert the US gap into US tax, and then US tax would be to US earnings and profits. So it’s a multi-step process, it will take a lot of time, especially if you have businesses that have a lot of fixed assets. There’s a major difference in depreciation between US tax and US CSC, at least in profits.
The next step, which may be even more difficult, is determining what taxes you’ve actually paid on those foreign earnings. The reason why that’s important is that when you’re pulling all these deferred earnings back into tax in the US, you’re allowed a partial credit against the US tax on that same offshore profit.
But in order to claim credits, you have to prove that you actually have paid them. The IRS has very strict rules regarding how you document evidence that the tax was paid, and it’s basically not going to be a dusty copy of a foreign tax return. You’re going to have to show that the tax was actually paid and credited to your account with that foreign government, so it’s a lot of record keeping that may result.
Another positive benefit of this onetime tax is if you have multiple foreign corporations, one having income, and one having a deficit. You can offset, in certain circumstances, those deficits against the profits.
That could reduce the amount of income that’s subject to this onetime tax. The next step after we do the aggregation is to look at how much of your net offshore EMP is in the form of cash or non-cash. And again, the different rates apply to whether your earnings or profits are in the form of cash or non-cash, so that’s another issue.
Another decision you’ll have to make is whether you want to use NOL against this onetime tax, or whether you want to just claim foreign tax credit. If you have income that was in a high taxed country, then it’s very possible that foreign tax credits that are pulled up with the earnings and profits may offset the US income tax on those offshore earnings. In that case, you want an election not to use your net operating loss, because you can already shelter your onetime tax income with credits, and you’d want to make sure you preserve your NOL.
Now the catch is you have to make an affirmative election to make sure that your losses are indeed used first. And then finally, after you make all these decisions, come up with all these records, you make the tax calculation. Put the amount on the return, and determine whether you want to make the election to defer the payment, or you want to make the payment in the current year.
This is a very brief and simple example of transition tax. We have a US company that has one foreign corporation that has a $1000 of earnings and profits. It’s determined that those earnings and profits are in the form of cash, and it had no tangible assets which could be relevant in the transition tax calculation. But let’s walk through the calculation really quick.
You have $100,000 in earnings. Again, we get this 55.71% exclusion, that’s what’s known as a participation exemption, which leaves you with $443 of income that’s subject to US tax at 35%. Basically, the effective rate would be 15.5% because we get the benefit of the 55.71% exclusion.
Now if this company had foreign taxes paid on those earnings in the foreign country, then those foreign taxes would be available to offset some of this US income tax. So that’s why it’s very important to know what your foreign tax pools are going to be before you decide how much tax you’re going to have to pay under the transition rule.
This is probably one of the most controversial, and one of the more surprising, tax rules relating to a territorial system. This is the global intangible low tax income, affectionately known as GILTI. It’s a new category of income that partially ends deferral of certain earnings that are related to intangible assets.
Now the fact that it’s global intangible low tax income is somewhat misleading, because this would apply to basically any income that’s earned offshore that’s above a certain return that you would be allowed to earn on your fixed assets. So let’s take a simple example. Say you have a successful foreign subsidiary that’s maybe a software distributor, and it doesn’t own any of its own intangible assets. Say that it has minimal, if any, fixed assets in the foreign jurisdiction. So you look at your GILTI income of $1,000,000, then you would check that to see if it’s over the floor. In our example, the floor would be 10% of whatever your tangible assets were, and in our case, there were none.
So in this case, all of your income would be pulled back as GILTI income. The benefit of the GILTI is that you get a deduction of 50% of your GILTI income, which goes down to 37.5% in 2026. So in this case, you have GILTI of $1,000,000, you have the 50% deduction, so that’s the $500,000 of income, multiplied by the 21% rate, you get an effective rate of 10.5% going up to 13.25%. And again, this provision applies to individuals as well.
The problem with individuals is they’re not eligible for this GILTI 50% deduction. So arguably, they would have the entire amount included in their income without benefit of this deduction. So in our case, that could be $500,000 dollars taxed at ordinary income rates, because you wouldn’t get to have qualified dividend rates on [inaudible 01:06:45] income.
Now there’s a change. This is very unclear, and different firms have different views on it, but taxpayers can make an election to be taxed as a corporation. In that case, some practitioners believe that the 50% GILTI deduction would be allowed. But that’s something that remains to be seen, and we’re going to have to get guidance from the internal revenue service.
As far as a GILTI example, I just sort of ran one through already. But if you look at this, we have two CFCs, we have $500 of income in CSC 1, $100 in CSC 2. We have tangible assets of $1,000. So we’re going to be able to get a return of 10% on those tangible assets, which would help reduce our base of income, and is subject to these GILTI provisions.
So if you run through the numbers, and in the interest of time I won’t go through each step, but this is basically how you would compute your GILTI income in a simple situation. Now one thing I’ll mention that GILTI does have a low tax intangible income. The advantage of the provision is it does allow for an exemption from GILTI if your income in the foreign country is subject to an effective rate of 90% of the 21% rate or 18.9%.
So if you have an effective tax rate on your offshore global intangible income, you may be able to avoid these GILTI provisions by electing to be treated under the high tax exception and showing that your GILTI income was in fact subject to a tax of around 19%.
Now here’s one of the positives in the new tax bill. It’s called the foreign derived intangible income. Basically this is a reward for companies that will leave or bring back their foreign intangible onto US shore. And basically this is sort of the good twin of the GILTI FDII. If the GILTI is the evil twin, the FDII is the good twin.
So if you have export sales of products, and you have export of services, you may qualify not for the 21% rate. But the 13.125% rate going from 18% to 25%, and the exclusion rate for this deduction for FDII would go up and you’d have an effective rate starting in 2026 of 16.4%.
It’s a good benefit. I think it’s going to discourage many multinationals from migrating their IP offshore. If their IP is already offshore, I doubt if it’s going to motivate any to bring the IP back on shore if they’re getting a GILTI rate of 10.5%. But it is a positive for companies who are not large enough to set up a complex structure to migrate IP offshore. This is definitely a welcome relief from the top corporate rate.
There’s a couple other provisions that come into effect starting in 2018. One is the B.E.A.T., or the beat, which is the base erosion anti abuse. It’s basically like an alternative minimum tax. Although the corporate AMT has been repealed, in effect we have another corporate AMT for companies, actually very large companies. You have to have an average of gross receipts of over $500 million for the preceding year, and you have to have a base erosion percentage of 3%.
What that base erosion percentage is, you look at your base erosion payments made to foreign related parties. Base erosion payments are things like interest, royalties, and rents. So you look at that compared to all of your deductions that you claim on the return, including your cost of [inaudible 01:11:08] and what not. If that amount comes to more than 3%, then you could be subject to this base erosion, or beat tax as an alternative minimum tax, and basically that’s going to be 5% of your taxable income computed without regard to these base erosion payments.
So it’s a multi-step process. You have to look at what your base erosion payments are, and compare that to your total deductions on the return. If that’s more than 3%, then you’re subject to the provision. Then you re-compute your taxable income, excluding those base erosion payments, and multiply that by 5% in 2018 and 10% going in future years, and that would be an additional tax you’d have to pay.
Charles mentioned the revised 163-J rule that I think will have a significant impact on a lot of foreign owned companies that tend to have a high leverage ratio. So watch out for that. In the first several years, it’s based on [name 01:12:17], and then it gets even worse. It’s based on [name 01:12:18] for taxable years beginning after 2021. So that’s only going to have a bigger impact on the disallowing of interest.
Another sleeper provision that’s thrown in there is if you’re a company that has foreign ownership, or if you’re a CPA that has clients with foreign owners. If you fail to report related party transactions under IRS form 757, 5472, instead of a $10,000 penalty under current law, you’d have a $25,000 penalty for failure to report. It’s becoming a lot more expensive to not report your related party transactions to the IRS.
With that, I’ll send it back to Charles, and he has a few more sections to cover.
Charles Webb: Thank you Robert.
What we wanted to hit on is just a few items in state and local taxation, and I’m skipping back a little bit to individual taxation. Obviously, this caught a lot of the states off guard as far as their taxation. From a corporate perspective, again as taxable income possibly will change with depreciation, a lot of states are scrambling now to change their tax rates or look at the overall effect.
So again, you want to keep in mind that we may not be able to file tax returns corporately or individually until we have those states weigh in on the various components of it. Whether it’s the bonus depreciation or other aspects that may be applicable to the actual taxable income.
One thing I want to point out is in certain states, we want to be mindful now that we have this limitation on the personal level of a $10,000 limit for property tax and income tax, that the states are reconsidering or evaluating various alternatives to that.
So it’s true we’ve seen a lot of press on can we somehow have a contribution to state taxes instead of being a tax? Well certain states, and one of those includes Georgia, have a special program that’s been in effect for several years, and one of those is the rule hospital credit donation.
And basically under the program, if you gave a certain dollar amount as a charitable contribution to this Royal Hospital Fund, then you are allowed to get up to 90% tax credit applicable to that.
So what that is doing is shifting a tax that normally would be limited to the $10,000, now is shifting to a charitable contribution that is not necessarily limited. You’ll note that charitable contributions are not deductible up to 16% of AGI.
So I want to point that out because again, I think you’re going to see a lot of states start to implement this program. The Royal Hospital donation fund has been in effect in Georgia for a few years, but really didn’t get much funding. But now as people are reevaluating it, even though you may only get 90%, still you’re going to get the full deduction as a charitable contribution.
So states around the country are quickly getting on to this methodology in implementing various components that shift a tax. And the reason we note it for you to watch for 2018, a lot of these funds are limited or cashed out, so they move very quickly. So where this hospital fund in Georgia was opened, it quickly is filling up, because the state can only set aside a certain dollar amount to be treated as a donation.
So again, please monitor that for your specific state and local applicability. So I also want to point out that when you’re evaluating your state deduction going forward, and your ability to itemize, it varies by state. Some states require that if you itemize for federal purposes, you also have to itemize for state. Some states vary in that you get a choice whether you get the standard or not.
So we remember the federal standard deduction for married filing jointly is now up to $24,000. However, if you’re close to that $24,000, and Georgia allows you to make a difference, you can actually itemize in Georgia, or follow, excuse me, off of federal.
So there may be instances in certain states where you want to evaluate. You may want to itemize on your federal tax return so that you can get the itemization on your applicable state. So again, Georgia is a perfect example that if we’re close to the certain standard deduction, it is only at $3,000. So if we apply the standard deduction for federal and state, we would severely limit our deduction in the state. So something to be cognizant of. I think we’ll also see some state legislators possibly make this change as we go forward.
So with that, we thank you very much for the time, and we hope you have a good weekend. We’ll sign off from there, thank you.