The comprehensive tax reform legislation passed by Congress in December 2017 is poised to significantly impact the life sciences industry. The Tax Cuts and Jobs Act (TCJA) affords life sciences companies numerous opportunities to positively impact their bottom line, so it’s critical to develop an understanding of the new tax rules and how they can be applied effectively.
Deducting the cost of new equipment
The cost of equipment can be quite expensive for companies in the research and development business, so receiving an immediate tax write-off for the cost of equipment is extremely beneficial to any company planning to expand its operations or add a new lab or clean room to its current operation. Under the new law, businesses may take 100 percent bonus depreciation on new or used tangible personal property with a recovery period of 20 years or less that is both acquired and placed into service after Sept. 27, 2017 and before Jan.1, 2023.
Property acquired before Sept. 28, 2017 and placed in service on or after Sept. 28, 2017 remains eligible for 50 percent bonus depreciation. Bonus depreciation is phased down 20 percent each year for property acquired and placed in service after Dec. 31, 2022 and before Jan. 1, 2027.
Another expensing provision that may be beneficial is the § 179 expensing allowance. This allows businesses to deduct the cost of qualifying equipment and software placed in service during the tax year. The new law increases the expense limitation to $1 million and the phase-out amount to $2.5 million for property placed in service in taxable years beginning after Dec. 31, 2017.
Both bonus depreciation and § 179 expensing may result in substantial present value tax savings for companies with plans to purchase new or used equipment.
New limitations on deducting business interest
The TCJA also added more rules related to deducting business interest. Under the new rules, most companies would not be allowed an interest deduction for amounts exceeding 30 percent of their adjusted taxable income.
Adjusted taxable income for years beginning before Jan. 1, 2022 is defined as taxable income calculated without regard to depreciation, amortization, business interest expense/income, net operating losses, items of income or loss not allocable to the trade or business and deductions for certain pass-through income.
For tax years beginning on or after Jan. 1, 2022, the definition of adjusted taxable income is the same as previously described, other than the adjustment for depreciation and amortization.
The rule generally doesn’t apply to taxpayers who have less than $25 million of average annual gross receipts for the previous three years. For companies below the gross receipts threshold, the limitation on deducting business interest would not have any impact.
For those companies with average annual gross receipts exceeding $25 million, potential tax planning strategies exist to help reduce the impact of the interest limitation. For example, instead of financing an expansion through additional bank debt, companies may consider adding new equity investors instead. Adding investors would increase cash through equity contributions rather than debt.
Research and development credit opportunities
The TCJA also retained some important tax credits with the potential to favorably impact the bottom line, including the research and development (R&D) credit.
The R&D credit provides companies with an incentive to invest in innovation. The credit is available to companies that develop new products or processes or improve upon existing products or processes. Companies that qualify can claim wages, supplies and contract research costs associated with R&D projects and activities.
Certain start-up life sciences companies may also be eligible for the R&D credit payroll offset that was enacted as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. The R&D credit payroll offset allows eligible small businesses that have little or no income tax liability to offset the R&D credit against payroll taxes instead of incomes taxes. To qualify, a business must have gross receipts of less than $5 million for the current taxable year and no gross receipts for any taxable year preceding the
five-taxable-year period ending with the current taxable year. For example, to be eligible for the R&D credit payroll offset in 2017, a company must have had less than $5 million of gross receipts in 2017 and no gross receipts prior to 2013.
The election to claim the payroll tax credit must be made on a timely filed original tax return (including extensions). Up to $250,000 of annual federal R&D credits can be allocated against payroll tax liability, beginning in the first quarter after the filing of the income tax return.
Twenty percent deduction for certain pass-through income
The TCJA includes a rule allowing individuals, estates and trusts to claim a deduction equal to 20 percent of the domestic qualified business income from a partnership, S corporation or sole proprietorship. The deduction is generally subject to a limit based on either wages paid or wages paid plus a capital element.
This deduction will benefit many small businesses including start-up life sciences companies. Although the calculation appears to be relatively simple, it is an involved computation with many nuances, exceptions and areas where guidance is currently lacking and clarification is needed from Congress or the Treasury Department. As such, consult your tax advisor about how this may benefit your business.
Research and experimentation expenses
Starting in tax years beginning after Dec. 31, 2021, specified research or experimental expenditures (including software development) will be required to be capitalized and amortized ratably over a five-year period for domestic expenses or 15 years for expenses related to research conducted outside the U.S. Currently, companies have an option to deduct those expenses in the current year.
Limitations for non-corporate losses
Many start-up life science companies incur taxable losses for several years before generating taxable income. For non-corporate entities, the new rule regarding limitation of excess business losses may be relevant. An excess business loss is defined as the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer over the sum of aggregate gross income/gain plus a threshold amount ($250,000 single, $500,000 joint). The limitation is applied at the partner or S corporation shareholder level. Excess losses are treated as part of the taxpayer's net operating loss carryforward in subsequent tax years.
Converting to a C corporation
With all the new tax law changes, companies may ask whether they should convert to a C corporation from a pass-through entity (such as a partnership or S corporation). The highest marginal income tax rate for individuals is 37 percent under the new law, while C corporations are taxed at a flat rate of 21 percent. With the revised tax rates, C corporations seem to come out ahead, with lower tax rates than individuals. Whether or not a particular company should switch to a C corporation depends on multiple factors, all of which should be considered carefully.
Among the factors to be considered is the general availability of the 20 percent deduction for pass-through income discussed above. Other considerations, such as the desire to pass through company losses to owners or decisions to make frequent cash distributions, might make converting to a C corporation less advantageous. Additional factors, like continued positive taxable income and a lack of desire to make cash distributions to owners outside of tax distributions, may make converting to a C corporation more desirable. Ultimately, switching entity types is a fact-specific analysis and any final decision is best made after engaging in discussions with a tax advisor.
New hybrid territorial tax regime
C corporations with foreign operations benefitted from the TCJA in the form of a new hybrid territorial tax regime, but at the cost of a one-time transition tax on accumulated foreign earnings. “Territorial” refers to the fact that dividends from greater-than-10 percent owned foreign subsidiaries are now eligible for a 100 percent dividends received deduction by C corporations. However, pass-through entities are not eligible for this benefit. As such, pass-through entities owning foreign subsidiaries may consider the use of a C corporation as a holding vehicle in order to defer taxation on foreign dividends.
The “hybrid” descriptor reflects the TCJA’s imposition of a new anti-deferral rule on low-taxed income earned by greater-than-50 percent owned foreign subsidiaries, also called “Controlled Foreign Corporations” or “CFCs.” Such income is classified as “GILTI,” or “Global Intangible Low-Taxed Income,” which encompasses all CFC income in excess of a 10 percent return on certain tangible depreciable assets. As with the dividend exemption, the GILTI provisions are markedly more onerous for pass-through entities as compared with C corporations, which are availed of both the indirect foreign credit and a 50 percent GILTI deduction. This disparity lends further credibility to the use of a C corporation as a CFC holding vehicle for U.S. entities currently structured as pass-through. Moreover, the GILTI regime should force a reexamination of offshoring strategies, particularly with respect to intangible property, by C corporations and pass-through entities alike.
A final TCJA provision supporting the territorial regime is a 37.5 percent deduction for “Foreign Derived Intangible Income” or ”FDII” earned by C corporations. FDII is computed by determining the foreign source portion of the corporation’s trade or business income (i.e., income from sales to foreign customers), and applying this proportion to the corporation’s “deemed intangible income,” or total trade or business income exceeding a 10 percent return on certain tangible depreciable assets. The FDII regime thus provides another incentive for retaining income-generating assets onshore in keeping with the “territorial” label. Due to the disparate treatment afforded C corporations and pass-through entities, FDII should be considered in the context of C corporation conversions discussed above.
There is no shortage of ways in which life sciences companies can benefit from the recently passed comprehensive tax reform legislation. Possessing a knowledge of the Tax Cuts and Jobs Act and leveraging some of the new rules and measures in place may save companies time and positively impact their bottom line.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.