Three months ago, Congress passed the Tax Cuts and Jobs Act (the Act or TCJA), the most significant tax legislation to be enacted since 1986. The legislative language and related committee reports prompted many questions about the mechanics of the new law, the majority of which remain unanswered. With Treasury expected to issue guidance slowly over the months ahead, taxpayers remain in a quandary about their 2018 tax positions. The Tax Reform Progress Report is our newest publication, a series of regular communications addressing open issues in the new law and providing insight as to which direction the IRS and Treasury may go.
Our first edition will focus on:
- the new rules governing qualified improvement property
- the deductibility of meals and entertainment
- various issues involving the business interest expense limitation
- accounting method rules and unintended consequences for rental real estate
- the IRS guidance on the partial deduction for interest expense related to home equity lines of credit
- the repatriation tax deadlines, including due dates on elections and payments
Qualified improvement property
The legislation attempted to simplify the bonus depreciation rules for qualified improvement property (QIP), but, due to a drafting error, the final statutory language does not reflect the congressional intent. The Act removed QIP from the definition of qualified property for bonus depreciation purposes with the view to make QIP bonus-eligible by virtue of assigning it a 15-year recovery period. While the 15-year recovery period for QIP (as well as the 20-year Alternative Depreciation System (ADS) recovery period) was omitted from the final legislation, it is our understanding that the House Ways and Means Committee recognizes the need for a technical correction. It is uncertain if such a bill can pass Congress as it would require 60 votes in the Senate.
Questions have arisen as to whether QIP can be treated as bonus-eligible based on congressional intent and legislative history.
Discussion: Treasury recently indicated Congress must correct the statute in order for QIP to be depreciated over 15 years. However, the current political climate makes it difficult for a technical corrections bill for the TCJA to pass. It is possible that when the Joint Committee on Taxation issues its description of the bill, known as the “blue book,” some of the law’s confusing provisions will be clarified. A member of the IRS’ Office of Associate Chief Counsel (Income Tax and Accounting) recently said there is currently no statutory authority to say that qualified improvement property is 15-year property, even though the conference report does refer to a 15-year recovery period.
Conclusion: Given the uncertainty regarding any technical corrections legislation, taxpayers should treat QIP acquired and placed in service after Dec. 31, 2017, as 39-year property not eligible for bonus depreciation.
Meals and entertainment
The changes made to section 274(a) have led to some uncertainty about the deductibility of meals with clients or customers. The TCJA eliminated the language that allowed deductions for entertainment, amusement or recreation, unless the taxpayer established that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion, associated with the active conduct of the taxpayer’s trade or business. The purpose of the change was to eliminate the subjective determination of whether such expenses were sufficiently business-related.
At a high level, entertainment expenses are nondeductible while most meals are 50 percent deductible.
The following is a brief outline of common meals-related expenses about which we have received inquiries:
Meals with clients
In order for meals to be 50 percent deductible, business must be discussed during the meal. We suggest documenting on the receipt the nature of the business conversation.
Meals with coworkers
Meals with employees or coworkers where business is discussed are 50 percent deductible. If there are no business conversations, the meal is not deductible. Again, we suggest documenting on the receipt the business purpose of the meal.
Meals while traveling
Meals when traveling for business are 50 percent deductible.
Company activities, such as holiday parties, birthday and anniversary celebrations, picnics, etc., are fully deductible.
No tax deduction is allowed for entertainment, amusement or recreation-related expenses. These include tickets to high school or college sporting events, leased skyboxes for sporting events, transportation to/from sporting events, cover charges, taxes, tips and parking for entertainment events.
Generally, you cannot deduct amounts paid or incurred for membership in any club organized for business, pleasure, recreation or any other social purpose. This includes country clubs, golf and athletic clubs, hotel clubs, sporting clubs, airline clubs and clubs operated to provide meals under circumstances generally considered conducive to business discussions.
Exception: The following organizations are not treated as clubs organized for business, pleasure, recreation or other social purposes unless one of its primary objectives is to conduct entertainment activities for members or their guests, or to provide members or their guests with access to entertainment facilities.
- Boards of trade
- Business leagues
- Chambers of commerce
- Civic or public service organizations
- Professional organizations such as the AICPA, legal bar associations or other state societies
- Trade associations
Interest expense limitations with respect to consolidated returns
The TCJA amends section 163(j) to limit the deductibility of business interest expense to the sum of:
- Business interest income,
- 30 percent of earnings before interest, taxes, depreciation and amortization (depreciation and amortization will be excluded from this calculation for tax years beginning on or after Jan. 1, 2022, and onward), and
- Floor plan financing interest
Disallowed interest can be carried forward indefinitely. The restriction applies to companies with average annual gross receipts of more than $25 million.
Exceptions: The TCJA provides several exceptions for various business:
- The limitation does not apply to floor plan financing interest. For this purpose, floor plan financing interest means indebtedness used to finance motor vehicles held for sale or lease, and secured by such inventory.
- The law allows real property and farming trades or businesses to make an irrevocable election out of the business interest deduction limitation. These businesses must then use the ADS (broadly, a longer cost recovery period) to depreciate property with a recovery period of 10 years or more. Expect guidance from the IRS as to the timing and format of such elections.
Real property trades or businesses include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage services. Grouping of activities is not expected to control the determination of a taxpayer’s real property trades or businesses. Farming trades or businesses include cultivation of land, harvesting of any agricultural or horticultural commodity, operating a nursery or sod farm as well as the raising or harvesting of trees bearing fruits, nuts, other crops or ornamental trees.
- The interest deduction limit does not apply to certain regulated public utilities or to certain electric cooperatives.
For taxpayers filing consolidated returns that include both businesses subject to the limitation and exempted businesses, it is not clear how to compute the interest limitation. Tax committee reports indicate that for consolidated returns the limitation is calculated at the consolidated level. However, a strict interpretation of that language would preclude use of the exceptions contemplated by the changes.
The IRS is currently weighing the applicability of the 2017 tax law’s limits on deductibility of business interest payments to corporations with exempted subsidiaries. An IRS official recently noted that the question is not unique to consolidated returns, in that you can have a single corporation that engages in multiple lines of business, and so you still have a question of allocation from that expense to those businesses.
Related questions include:
- How is consolidated adjusted taxable income determined if the parent is the holding company that incurs the debt for the group?
- How is the interest expense calculation determined if the parent loans funds to a subsidiary?
- Is interest expense limited if all members of a consolidated or affiliated group co-borrow debt of the group?
Unfortunately, there is no timeline as to when the IRS and Treasury will issue guidance to answer these and other questions. We also do not have a clear understanding as to the government’s priorities of areas for immediate guidance. Our view, based on the code, is the ultimate guidance will provide a carve-out for trades or businesses excluded from the business interest limitation rules. We believe interest associated with those businesses will be allowed in full on a consolidated return. How parent company debt will be allocated to business activities remains an unresolved item affected taxpayers should carefully monitor.
Election out of interest expense limitation and change to ADS
Real property businesses can make an election out of the section 163(j) interest limitation. In exchange for being able to make this election, the tradeoff is that electing entities are not eligible for bonus depreciation and must use ADS, resulting in longer recovery periods for certain property. Property that must be depreciated under ADS is not eligible for bonus depreciation; however, as noted above, QIP will not be bonus-eligible without a technical corrections bill. Clearly, this is not much of a tradeoff.
Questions have arisen as to whether the depreciation change and election would be made on Form 3115 (accounting method change) or subject to the “change-in-use” rules.
Discussion: A representative from the Office of Chief Counsel unofficially commented that the election would be treated as a change in use. This is consistent with an initial Senate Finance Committee report to the Senate Budget Committee wherein the former indicated they contemplated it as such. However, neither the final legislation nor the conference committee report addressed this issue. This is significant as the change-in-use rules adjust depreciation on a prospective basis and do not require any recapture of prior depreciation deductions via a section 481 adjustment. For taxpayers placing assets in service between Sept. 28, 2017, and year-end, they should use a Modified Accelerated Cost Recovery System (MACRS) in order to maximize deductions at the presumably higher effective rates without the concern of Form 3115 filings and corresponding section 481 adjustments in 2018.
We believe the ultimate treatment will be to consider the election as a change in use, thereby sparing taxpayers the cost of the 3115 filing and the tax associated with recapturing prior-year depreciation deductions via an accounting method change.
Debt of owners of pass-through entities allocated to contributions or purchases of interests in the entity
Owners of pass-through entities often finance a contribution to the entity or a purchase of an interest in the entity. Under Notice 89-35, the debt proceeds and the associated interest expense are allocated among all of the assets of the entity using any reasonable method. The allowable interest expense is then reported on either Schedule E or Schedule A depending on the type of expenditure to which the interest expense is allocated. For example, interest associated with the purchase of a partnership interest in rental real estate would be deductible on Schedule E (above the line).
As discussed above, the TCJA limits the deductibility of business interest (in general, 30 percent of adjusted taxable income). For pass-through entities (both partnerships and S corporations), the business interest limitation is determined at the entity level. Special carryforward rules apply to partnerships, but not S corporations. For partnerships, any excess taxable income of the partnership may be passed through and used by the partners. In addition, any excess business interest of a partnership is allocated to the partners rather than remaining as a carryforward at the partnership level.
The new limitations on the deductibility of interest under section 163(j) for debt-financed contributions or purchases raise issues that require clarification, particularly for S-corporation shareholders.
- Will such debt-financed expenditures be subject to the limitations? To the extent that the interest expense is allocated as business interest, it would appear that the limitations would apply.
- If the limitations apply at the owner level, how is the adjusted taxable income determined? Keep in mind that adjusted taxable income is determined at the entity level for both partnerships and S corporations; however, partnerships may pass through any excess taxable income. If partners can apply their share of the partnership’s excess taxable income to their own debt-financed contribution or purchase, they may be able to deduct the interest, but S-corporation shareholders would have no such excess taxable income.
- If a partner has both excess business interest allocated from the partnership and a debt-financed contribution or purchase, how will the deduction be allocated between the two types of excess interest when sufficient income is generated to use the deduction?
Treasury stated that section 163(j) guidance would be issued in the coming months, but we have not seen any discussion related to the issues presented here.
We believe guidance will apply the limit on the interest deduction at the partner level based on any excess taxable income allocated from the partnership.
Section 451(b) and unintended consequences for rental real estate
The TCJA amended section 451(b) to require a taxpayer to recognize income no later than the tax year in which the income is taken into account as income on (1) an applicable financial statement (AFS, defined below) or (2) under rules specified by the IRS. This income-recognition timing rule is also referred to as “the AFS conformity rule.”
Specifically, the Act provides that, for an accrual basis taxpayer, the all-events test with respect to any item of gross income (or portion thereof) will not be treated as met any later than when that item (or portion thereof) is taken into account as revenue in:
- an AFS or
- such other financial statement as the IRS may specify for purposes of section 451(b).
As a result, the new law requires a taxpayer to recognize income no later than the tax year in which that income is taken into account as income on an AFS or another financial statement under rules specified by the IRS.
Consequences to lessors of real estate. As a result of this new provision, lessors may have to recognize rents in taxable income before they are received. For financial statement purposes, generally accepted accounting principles (GAAP) recognizes rents using a straight-line method. Straight-line rents essentially ignore rent holidays and accelerate the effects of annual escalations in order to level rents over the period of the lease. This could result in acceleration of rental income on leases not subject to section 467 treatment.
Discussion: We are not certain Congress intended this result in the area of real estate. The conference committee report provides very little detail regarding the amendment to section 451(b), and there is no discussion pertaining to rental real estate. We have attempted to discuss the issue with the chief counsel’s office, but it refused to comment on the matter at this time.
Absent guidance to the contrary, it appears that rental real estate will be covered by this provision.
- If possible, taxpayers should no longer prepare an AFS; instead, consider an income tax-based audit.
An AFS for purposes of section 451(b) is:
- a financial statement which is certified as being prepared in accordance with GAAP and is
- a Form 10-K (or successor form), or annual statement to shareholders, required to be filed by the taxpayer with the U.S. Securities and Exchange Commission (SEC),
- an audited financial statement of the taxpayer which is used for:
- credit purposes
- reporting to shareholders, partners or other proprietors, or to beneficiaries, or
- any other substantial nontax purpose,
- filed by the taxpayer with any other federal agency for purposes other than federal tax purposes, but only if there is no statement of the taxpayer described in items (i) or (ii), above.
- a financial statement using International Financial Reporting Standards (IFRS) and
- filed by the taxpayer with an agency of a foreign government which
- is equivalent to the SEC and
- has reporting standards no less stringent than those required by the SEC, but only if there is no statement of the taxpayer described in item (A), above, or section 451(b)(3)(B).
- filed by the taxpayer with an agency of a foreign government which
- a financial statement filed by the taxpayer with any other regulatory or governmental body specified by IRS, but only if there is no statement of the taxpayer described in items (A) or (B), above.
Clarification on home equity interest deductions
The TCJA revised the home mortgage interest deduction and brought into question the ability to deduct interest on home equity loans. The TCJA maintains the mortgage interest deduction in its current form, but only for existing mortgages. It reduces the deduction for new mortgages to $750,000 from the current $1 million principal cap. For this purpose, a new mortgage is considered debt-incurred after Dec. 15, 2017.
The IRS recently clarified that home equity interest is not fully disallowed as many thought upon passage of the Act. Rather, if the home equity loan is used to improve the residence, and the combined mortgages are under the applicable cap, the interest on the home equity loan will be deductible. However, if the home equity loan is used for other purposes, such as financing a car purchase, paying off credit card debt, etc., the interest will no longer be deductible. Taxpayers should retain records supporting the use of funds obtained through home equity loans in order to substantiate any related interest deduction.
Additional guidance on repatriation tax
As part of the transition to a hybrid territorial tax system, the TCJA enacted section 965, which requires that, for the last taxable year beginning before Jan. 1, 2018, any U.S. shareholder of a specified foreign corporation must include in its income, the pro rata share of the accumulated post-1986 deferred foreign income of the corporation. This newly enacted section requires U.S. shareholders to pay a one-time repatriation tax on the untaxed foreign post-1986 earnings and profits (E&P) of a specified foreign corporation. Since its enactment, Treasury issued administrative guidance in Notice 2018-07 and Notice 2018-13. The latest guidance was recently issued IR-2018-53, on March 13, 2018, in the form of frequently asked questions (FAQ) about the reporting of the repatriation tax and tax liability payments that may arise from the section 965.
The FAQ reiterates that the repatriation tax is imposed on any person that is a U.S. shareholder of a deferred foreign income corporation or any person that is a direct or indirect partner in a domestic partnership, a shareholder in an S corporation or a beneficiary of another pass-through entity that is a U.S. shareholder of a deferred foreign income corporation. Any U.S. shareholder of a specified foreign corporation must include in its income the pro rata share of the accumulated post-1986 deferred foreign income of the corporation. The application of the two-tier rate is accomplished by making a portion of that pro rata share of deferred foreign income deductible, resulting in a reduced tax rate of 15.5 percent for the included deferred foreign income held in liquid form (i.e., cash or cash equivalent assets) and 8 percent for the remaining deferred foreign income (i.e., illiquid assets), determined as of Nov. 2, 2017, or as of Dec. 31, 2017 (measurement dates).
Further, the FAQ provides that individual taxpayers who electronically file their Form 1040 and have not already filed their 2017 tax returns should file on or after April 2, 2018. However, individual taxpayers who file a paper Form 1040 can file their returns at any time. With respect to the reporting of section 965 amounts, the FAQ introduces a new reporting form, the IRC 965 Transition Tax Statement, which provides for specific information that must be included when reporting section 965 amounts to the IRS. It is also important to note that elections under section 965 may be made by the extended due date for filing the relevant tax return. Taxpayers electing to pay the repatriation tax in installments must make the first installment payment by the unextended due date of their return for the inclusion year. Moreover, the FAQ points out that the taxpayers are required to determine their 2017 tax liability, absent section 965, and then, if applicable, calculate the tax liability triggered by the 2017 deemed repatriation. Accordingly, the two federal income tax payments should be remitted by the unextended due date of their inclusion-year tax return. Finally, taxpayers should also be aware of the requirements to file a Form 5471 for each specified foreign corporation with respect to which the taxpayer is a U.S. shareholder. More guidance is expected in the coming days on section 965.
Please visit our Tax Reform Resource Center on our website for additional information.
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.