On Dec. 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act of 2017 (the Tax Act) into law, instituting the first major overhaul of federal income taxes in more than 30 years. The Tax Act provides for a 21 percent corporate tax rate that will be effective in 2018, which wound up being a little higher than the 20 percent target in the separate bills passed by the House and the Senate.
Several provisions – from the taxation of foreign earnings to the loss of certain deductions – will have important implications. The effects will vary by industry, so taxpayers and their CPAs should evaluate the legislation closely and model the law’s provisions to enable timely tax planning.
Lower Tax Rates
The Tax Act lowers the nominal corporate tax rate to 21 percent, down from 35 percent, which had been the highest in the industrialized world. For companies that use fiscal years, they will have the benefit of a blended rate under existing Section 15.
Existing Section 15, which governs rate changes and was not amended by the Tax Act, will require a blended tax rate for fiscal-year taxpayers for the fiscal year that includes Jan. 1, 2018. The effective-date provision in the law has caused some confusion because the Tax Act’s language provides that the new, lower rate applies for “[tax] years beginning after Dec. 31, 2017,” which most people assume (quite reasonably, based on the effective date language) means the lower rate does not apply to fiscal tax years that began before Jan. 1, 2018. That is, the 21 percent rate applies for calendar-year taxpayers to their tax years beginning Jan. 1, 2018, and for fiscal-year taxpayers to tax years beginning after Jan. 1, 2018. However, that reading is incorrect for fiscal-year taxpayers, as Section 15 redefines the effective date in this context.
Section 15(a) provides the following: “[I]f any rate of tax imposed by this chapter changes, and if the [tax] year includes the effective date of the change (unless that date is the first day of the [tax] year), then – (1) tentative taxes shall be computed by applying the rate for the period before the effective date of the change, and the rate for the period on and after such date, to the taxable income for the entire [tax] year; and (2) the tax for such [tax] year shall be the sum of that proportion of each tentative tax [that] the number of days in each period bears to the number of days in the entire [tax] year.”
Section 15(c), in part, states: “[F]or purposes of subsection … (a) … if the rate changes for [tax] years ‘beginning after’ or ‘ending after’ a certain date, the following day shall be considered the effective date of the change.”
Temporary 100 Percent Expensing
Bonus depreciation increases from 50 percent to 100 percent for “qualified property” placed in service after Sept. 27, 2017, and before 2023. The Tax Act follows what was in the House bill, in that the original use of the property need not commence with the taxpayer. The increased expensing phases down starting in 2023 by 20 percentage points for each of the five following years. A transition rule allows for an election to apply 50 percent expensing for the first tax year ending after Sept. 27, 2017.
Repeal of Section 199 Deductions
The Tax Act eliminates the domestic production deduction (Section 199), which allows, in some cases, a several-point tax rate reduction for many companies. The tax-affected benefit for 2017 is about 3 percent of net qualified income. The repeal provision is effective for tax years beginning after Dec. 31, 2017.
As many companies are aware, Section 199 has been an ongoing focus of IRS examination activity, which has resulted in several cases pending in a variety of federal courts. Because of the provision in the new Tax Act that eliminates Section 199 for tax years beginning after Dec. 31, 2017, it is unclear how the IRS will examine and litigate Section 199 claims for tax years beginning before 2018.
New Requirements for the Research Credit
The Tax Act maintains the research credit, but it introduces a new requirement to amortize all research and development expenditures over five years, effective for tax years beginning after 2021. Section 174 will require taxpayers to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years in the case of foreign research). The Tax Act modifies Section 174 to require that all software development costs be treated as research or experimental expenditures. In addition, any capitalized research and experimental expenditures relating to property that is disposed of, retired, or abandoned during the amortization period must continue to be amortized throughout the remainder of the period. Generally, purchased software may be amortized over just 36 months pursuant to Section 167(f)(1), so the Tax Act puts taxpayers that develop their own software in a tax position that is less favorable than taxpayers who acquire it.
It had been common practice for companies to adopt a method of immediate expensing for software development costs under Revenue Procedure 2000-50. The new provision eliminates the expensing method for such costs, as all costs related to software development will constitute research and experimental expenditures.
Special Rules for Income Inclusion
The income inclusion provision modifies the recognition of income rules by requiring a taxpayer to recognize income no later than the tax year in which the income is taken into account as income on an applicable financial statement or another financial statement under rules provided by the Secretary of the Treasury. However, in the case of a contract that contains multiple performance obligations, the provision allows the taxpayer to allocate the transaction price in accordance with the allocation made in the taxpayer’s applicable financial statement.
Additionally, the provision codifies the deferral method of accounting for advance payments for goods and services contained in Revenue Procedure 2004-34. Under that method, taxpayers are permitted to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if the income is deferred for financial statement purposes.
This provision generally results in an earlier accrual of income to the extent amounts are accrued earlier for financial statement purposes than currently required under Section 451. Taxpayers should consider this provision in conjunction with their ASC 606 adoption, as the potential for an acceleration of taxable income exists. The exception for certain advance payments of income is an important one, preserving the current, widely applied favorable federal income tax treatment for such items. Advance payments governed by Revenue Procedure 2004-34 include amounts received for services; the sale of goods; the use of intellectual property (by license or lease, for example); the occupancy or use of property if ancillary to the provision of services; the sale, lease, or license of computer software; certain ancillary guarantee or warranty contracts; and eligible subscriptions and memberships.
Modification to Net Operating Loss
Before the changes made to Section 172 by the Tax Act, taxpayers could carry back a net operating loss (NOL) arising in a tax year for two years and carry forward the NOL for 20 years to offset taxable income. Generally, an NOL is the excess of the taxpayer’s business deductions over its gross income. Section 172 provides special provisions modifying the carryback period for specific types of losses or losses arising in particular years. Included in these special provisions is Section 172(f), which allows a 10-year carryback of losses arising from specified liabilities, such as certain losses attributable to product liability or expenses incurred in investigating, opposing, or settling claims against the taxpayer on account of product liability. The alternative minimum tax (AMT) rules do not allow a taxpayer’s NOL deduction to reduce the taxpayer’s AMT income by more than 90 percent.
The Tax Act modifies the rules for NOLs under Section 172. For losses arising in tax years beginning after 2017, the NOL deduction is limited to 80 percent of taxable income. Further, the carryback provisions are repealed, except in certain limited situations. Additionally, for many taxpayers, an indefinite carryforward is now allowed.
There are certain tax planning opportunities companies may consider taking now regarding the timing of their deductions and income recognition. Such planning would cause minimal disruption to the business, but could create permanent tax savings given the reduction in the corporate income tax rate.
Changing the timing of deductions would necessitate an application for change in accounting method (that is Form 3115). For fiscal-year taxpayers, nonautomatic accounting method changes must be filed on or before the last day of the tax year to be effective for that tax year. For calendar-year taxpayers, automatic accounting method changes are still available and must be filed on or before Oct. 15, 2018 (the extended due date of the tax return) to be effective for the 2017 calendar tax year.
Brendan P. Cox, CPA, is a partner in the Philadelphia office of EY and serves on the EY Center for Tax Policy, where he provides guidance on legislative procedure, modeling, and planning. He is a member of the PICPA Federal Taxation Committee and can be reached at firstname.lastname@example.org.
For more PICPA coverage of the Tax Cuts and Jobs Act, be sure to read the Federal Tax Reform Guide
presented by the Pennsylvania CPA Journal
. The issue focuses entirely on the new tax law and opportunities for CPAs.