Tax Reform: Selected Business Deductions, Exchanges, and Accounting Methods

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the seventh in a series of articles reviewing some of the more important changes.  This post deals with the new rules for selected business deductions, like-kind exchanges, and small business tax accounting methods.

Business Meals and Entertainment

No deduction is permitted after 2017 for business entertainment, amusement or recreation activities, facilities, or related membership dues.  There appears to be a difference of opinion about whether meals for client meetings remain 50% deductible.  Are meals part of entertainment?  IRS Publication 463 states that meals are a form of entertainment.  Therefore, there is a chance that business meals may not be deductible!  IRS guidance is needed.  But it appears that if meals are connected with entertainment they are not deductible.  For business meals not connected with entertainment, they should remain 50% deductible.  Other changes include:

·      Meals furnished to employees for the convenience of the employer are no longer 100% deductible after 2017 but are 50% deductible through 2025.  After 2025 such meals will no longer be deductible.

·      Employee business meals incurred while traveling remain 50% deductible.

·      Meals are 100% deductible if the cost is included in employee wages, billed to or reimbursed by clients, or incurred for social, recreational, or similar activities primarily for the benefit of employees other than the highly compensated (e.g., office holiday parties or summer office picnics).

Business Interest Expense

For tax years beginning after 2017, deductible business interest expense is limited to 30% of adjusted taxable income plus business interest income.  There is no grandfathering of existing debt!  The business interest limitation does not apply to investment interest expense which has its own limitation.  Adjustments required to calculate adjusted taxable income include the following:

·      Nonbusiness income and deductions are excluded.

·      The net operating loss deduction is excluded.

·      The 20% qualified business income deduction is excluded.

·      Depreciation, amortization, and depletion (EBITDA) are excluded for tax years beginning in 2018 through 2021.

·      For tax years beginning after 2021, depreciation, amortization, and depletion expenses are not added back (EBIT) thus lowering the 30% deduction threshold.

The IRS issued Notice 2018-28 wherein it states that for, for purposes of the limitation for C corporations, all interest income is considered business interest income and all interest expense is considered business interest expense.

The limitation is determined at the entity filer level and not at the owner level.  There are complicated pass-through entity allocation rules for allocating excess adjusted taxable income or interest expense.  Disallowed interest can be carried forward indefinitely.  Businesses exempt from the limitation include:

·      Floor plan financing businesses (e.g., auto, boat, farm implement dealers).

·      Companies with $25 million or less average annual gross receipts are exempted.

·      Farming businesses and real property development, construction, rental, operation, brokerage businesses may elect out of the interest expense limitation.  But the election comes at the cost of having to use longer depreciable periods and losing the ability to claim bonus depreciation.

Some implications of the 30% interest expense limitation to consider are the following:

·      Taxpayers may want to elect to “slow down” tax depreciation after 2021 to increase the adjusted taxable income limitation.

·      If earnings decline, there could be a loss of the interest deduction.

·      While the disallowed interest expense carries over, it will still be limited to 30% of EBITDA/EBIT in the future, whereas if the interest expense were part of a net operating loss, it could offset 80% of taxable income.

·      If a taxpayer has multiple entities, some with debt and some without, the debt may need to be restructured across entities since the 30% test appears to be applied on a separate business entity basis.  IRS guidance is needed.

·      Small businesses with a high level of debt that will cross the $25 million gross receipt threshold will need to plan for a possible interest expense limitation.

Like-Kind Exchanges

Tax deferred like-kind exchanges are restricted to real property exchanges after 2017.  After 2017, business or investment personal property exchanges are taxable.  A transition rule permits personal property exchanges to be completed tax-free in 2018 where the taxpayer disposed of the relinquished property (forward exchange) or acquired the replacement property (reverse exchange) before 2018.

Businesses that trade in old machinery and equipment for new will be treated as selling their old machinery and equipment since the exchange is now taxable.  But with 100% bonus depreciation (through 2022) and with §179 expensing, there might not be a net tax increase, at least through 2022.

Small Business Tax Accounting Simplified

For tax years beginning after 2017, tax accounting methods are simplified for businesses having average annual gross receipts for the 3-prior tax years of $25 million or less.  Simplifications include:

·      C corporations may use the cash method of tax accounting.  Previously C corporations could only use the cash method if average annual receipts were $5 million or less.  Prior law exceptions to the required use of the accrual method continue to apply for personal service corporations, partnerships without C corporation partners, and S corporations regardless of the amount of their gross receipts.

·      Businesses with inventory can use the cash method.  Previously businesses with inventory could only use the cash method if average annual gross receipts were $1 million or less ($10 million or less for certain industries).

·      The uniform capitalization of indirect costs to ending inventory is not required for resellers or producers.  Previously resellers were exempt if average annual receipts were $10 million or less, and there was no small taxpayer exception for producers.

·      Construction contractors may use the completed contract method instead of the percentage of completion method for construction contracts entered into after 2017 that are expected to be completed within two years.  Previously the exception to the percentage of completion method had a $10 million average annual gross receipt test.  However, the percentage of completion method is still required for alternative minimum tax purposes and so full simplification for small contractors has not been achieved.