Tax Strategy: Changes to business deductions, exclusions, credits under tax reform
When tax reform was first being discussed, it was framed as a revenue-neutral proposal to offset lower tax rates with the elimination of many tax breaks.
As it has turned out, the lower tax rates were largely achieved, but without the loss of too many tax breaks. A slight majority of the projected $1.5 trillion addition to the deficit from the new tax legislation comes from the business provisions, rather than the individual provisions.
Based on 10-year projections from the Joint Committee on Taxation, the individual provisions contribute about $862 billion to that deficit figure. The pass-through tax deduction, taking into account the limit on pass-through losses, contributes about $265 billion to the deficit.
The other corporate and business provisions contribute $654 billion to the deficit. The international provisions create revenue of $324 billion, but only because of the one-time tax on unrepatriated earnings. Otherwise, the international provisions would be close to revenue-neutral.
On the business side, besides the $265 billion added to the deficit for pass-through entities, $1.348 trillion is added to the deficit for the lower corporate rate, $40 billion is added to the deficit for the repeal of the corporate Alternative Minimum Tax, and the expensing and small-business accounting provisions add an additional $246 billion to the deficit.
This column will focus on the business deductions, exclusions and credits that were removed to produce some revenue to partially offset those deficit numbers; in short, here’s the bad news.
- Limit on interest deduction. The new 30 percent of adjusted gross income limit on the deduction of net interest was projected to raise $253 billion in revenue. The provision does come with a small-business exception and a five-year carryforward. Still, this provision is likely to have a very negative tax impact on debt-heavy businesses or businesses that are already struggling to produce sufficient revenue.
- Net operating loss deduction. The elimination of the carryback of net operating losses and restriction of the carryover of NOLs to offsetting only 80 percent of future years’ profits is projected to raise $201 billion in revenue.
This new provision is likely to severely reduce the value of net operating losses. The elimination of the two-year carryback will prevent loss companies from obtaining quick refunds for prior-year taxes to help them through tough times. The elimination of the carryback and the restriction on carryovers is also likely to make it tougher for struggling businesses to survive, and reduce their attractiveness to possible merger candidates.
- Amortization of research and experimental expenditures. The required five-year amortization of research and experimental expenditures over five years starting after 2021 is projected to raise $120 billion in revenue.
This appears to be due to the new tax law’s elimination of the option for immediate expensing under the current law. The research and development credit was, however, preserved under the new tax law.
- Domestic production activities deduction. The repeal of the Code Sec. 199 domestic production activities deduction is projected to raise $98 billion in revenue. Its repeal was tied closely to the reform of the international tax system and the move toward a territorial tax system in conjunction with lowered corporate tax rates.
- Entertainment and meals expenses. The repeal of the deduction for entertainment expenses and modification of the deduction for meal expenses is projected to raise $24 billion in revenue.
Entertainment expenses, including expenses for a facility used in connection with entertainment, even if associated with the active conduct of a trade or business, are no longer deductible. After 2025, the deduction for employer-provided meals for the convenience of the employer and as a de minimis fringe benefit to employees are no longer deductible.
These changes could potentially have an adverse impact on restaurants and dining clubs located in business areas. The Boston Bruins also recently won a Tax Court case claiming that meals provided at away games were also a de minimis fringe benefit. The benefit of that Tax Court case may now also be lost after 2025.
- Transportation expenses. The repeal of the deduction for qualified transportation fringe benefits for employees is projected to raise $18 billion in revenue. The repealed deduction applies broadly to van pools, transit passes and qualified parking. The repeal does not apply to qualified bicycle commuting reimbursements, but such reimbursements are now includible in the employee’s income. It remains to be seen whether this will diminish the frequency with which employers provide parking or transit assistance, but it is certainly not likely to help.
- Orphan drug credit. The reduction in the credit for clinical testing expenses for certain drugs for rare diseases is projected to raise $32 billion in revenue. The change basically cuts the credit in half from 50 percent to 25 percent. The research and development credit and immediate expensing elections might still be available for these expenditures. Still, this credit had appeared to be helpful in the development of treatments for rare diseases, and focusing on it for reduction seems counterproductive to the community at large.
- Banking and finance provisions. Two banking and finance provisions are projected to raise $15 billion and $17 billion in revenue respectively. These are a limitation on the deduction of Federal Deposit Insurance Corp. premiums and the repeal of the exclusion for advance refunding bonds.
- Insurance provisions. Also, a couple of insurance provisions are projected to raise $15 billion and $13 billion respectively. These relate to changes in the computation of life insurance reserves and modification of property and casualty insurance discounting rules. Whether these costs will be passed along to the consumer in the form of higher premiums remains to be seen.
- Excessive employee remuneration. The remaining deduction that comes close to producing at least $10 billion in revenue is a projected $9 billion from eliminating the exceptions to the prohibition of executive compensation deductions in excess of $1 million. The exceptions for performance-based compensation and commissions are eliminated. Employers may react by broadening performance-based compensation programs, although that could be fairly expensive. Or they may try to shift some compensation to being paid after separation or retirement.
- Expired provisions. Somewhat forgotten in the discussion of the new tax law are many regularly expiring provisions that had expired at the end of 2016 and were not renewed by the tax reform legislation. These include many energy-related provisions and provisions related to Indian employment, property on Indian reservations, railroad tracks, mine safety, race horses, motorsports entertainment, production activities in Puerto Rico, rum excise taxes, economic development in American Samoa, qualified timber gains, and empowerment zone incentives. It appears that some efforts are continuing in Congress to try to restore at least some of these tax breaks.
While on the whole the new tax legislation should be good for businesses with the new corporate tax rate, pass-through business deduction, elimination of the corporate AMT, and expensing rules, businesses must also focus on the negative to make sure that they take steps to diminish, to the extent possible, the adverse impact of the loss or reduction of a number of business tax breaks.