Business Taxes: The Impact of Reduced Corporate Rates, the Qualified Business Income Deduction, Immediate Expensing and the Interest Deduction Limitation

BUSINESS TAXES

The Impact of Reduced Corporate Rates, the Qualified Business Income Deduction, Immediate Expensing and the Interest Deduction Limitation

Elizabeth McGinley, Partner Steven Lorch, Associate

SPEAKERS

Elizabeth L. McGinley Partner, New York T: 212.508.6173 liz.mcginley@bracewell.com

Steven J. Lorch Associate, New York T: 212.508.6176 steven.lorch@bracewell.com

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REDUCED CORPORATE INCOME TAX RATE • Under prior law, taxable income generated by a corporation was subject to tax at a maximum rate of 35%. • Corporate earnings in the hands of a shareholder generally were subject to a combined maximum effective rate of 48% (35% at the corporate level and 20% on dividend distributions at the individual level). • Under the TCJA, taxable income generated by a corporation is subject to tax at a flat 21% rate. Corporate earnings in the hands of a shareholder generally are subject to a combined effective rate of 36.8% (21% at the corporate level and 20% on dividend distributions at the individual level).

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OTHER PROVISIONS IMPACTING CORPORATE INCOME TAXATION • Under prior law, the corporate alternative minimum tax (AMT) required corporations to pay a minimum tax based on their alternative minimum taxable income, which was computed without certain losses and deductions otherwise permitted for federal income tax purposes. • The TCJA repeals the corporate AMT. • Under prior law, corporate net operating losses (NOLs) could be carried back for two taxable years and carried forward for twenty taxable years and generally were available to offset 100% of federal taxable income in those years. • For NOLs arising in years beginning after 2017, the TCJA eliminates the carryback of NOLs. Such NOLs may be carried forward indefinitely, although the NOL deduction is limited to 80% of federal taxable income for each carryforward year.

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PASS-THROUGH DEDUCTION FOR QUALIFIED BUSINESS INCOME • Under prior law, an individual’s ordinary income, earned directly or indirectly through a pass-through entity, was subject to tax at individual graduated rates (with a maximum rate of 39.6%). • Under the TCJA, individual rates are reduced (maximum of 37%), and an individual engaged in business directly or indirectly through a pass-through entity may be eligible for a deduction of up to 20% of his/her qualified business income (QBI) from such business. • QBI is taxable income derived from certain U.S. businesses and is determined separately for each business (with the QBI deduction capped at 100% of combined QBI). • QBI generally excludes capital gains, dividends, interest income and compensation for services performed by the individual, including guaranteed payments.

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EFFECTIVE RATE ON QBI AND KEY LIMITATIONS • The reduced individual rates and QBI deduction cause the maximum effective rate imposed on QBI to fall to 29.6%, subject to the following limitations on the QBI deduction. • The first limitation caps the individual’s QBI deduction with respect to a business, other than a business conducted by an MLP, at the greater of two amounts: ‒ 50% of the individual’s share of W-2 wages for the business, and ‒ 25% of the individual’s share of W-2 wages for the business plus 2.5% of the individual’s share of the tax basis of depreciable property used in the business. • The second limitation eliminates the QBI deduction for certain service businesses. • These limitations apply only if the individual’s taxable income for the year is equal to or greater than $315,000, with a phase-in up to $415,000 (married filing jointly), or $157,500, with a phase-in up to $207,500 (single and married filing separately).

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COMPARISON OF PASS-THROUGH AND CORPORATE RATES • The maximum effective rate on pass-through income, assuming the QBI deduction would not apply (37%), approximates the combined effective rate on corporate earnings in the hands of a shareholder (36.8%). • We expect oil and gas businesses currently operating in pass-through form to continue to do so, particularly if the QBI deduction is available. • The QBI deduction for individuals earning income from oil and gas businesses operated as pass-through entities, other than MLPs, may be reduced by the wage limitation, particularly if significant services are provided by independent contractors.

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EXPIRATION OF CERTAIN RATES UNDER THE TCJA • The reduced corporate income rate is not scheduled to expire. • The reduced rates for individuals and the QBI deduction, however, are scheduled to expire after 2025. • If the individual rate reduction and QBI deduction are not extended, the combined effective rate on distributed corporate earnings (36.8%) would fall slightly below the maximum individual rate applicable to pass-through income (39.6%) after 2025. • Accordingly, after 2025, operating as a corporation rather than a pass-through entity could be preferable, particularly if distributions to shareholders are delayed, thereby deferring the application of the shareholder level of tax.

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NEW OPPORTUNITY FOR IMMEDIATE EXPENSING • Under prior law, taxpayers could claim a special depreciation deduction for qualified property (generally, MACRS property with useful life of 20 years or less first used by the taxpayer) in the year the property was placed in service. The deduction was equal to 50% of the cost of qualified property in 2017 with a phase down through 2020, subject to certain limitations. • Under the TCJA, a 100% deduction is available for the cost of property placed in service after September 27, 2017 and before January 1, 2023. Thereafter, the available deduction is reduced 20% each year through the end of 2026. • Under the TCJA, qualified property generally is property with a useful life of 20 years or less and includes used property acquired by the taxpayer in an arm’s length transaction. • Taxpayers may elect not to apply the new special depreciation deduction for any class of property placed in service in any taxable year. • Immediate expensing is not available for property used in the trade or business of furnishing or sale of electrical energy or gas through a local distribution system, or transportation of gas by pipeline, if the rates have been established or approved by a state or federal authority.

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LIMITATIONS ON THE DEDUCTIBILITY OF INTEREST • Before the TCJA, corporate interest deductions were limited under the Code Section 163(j) earnings stripping rules. The TCJA eliminates that provision. • Under the TCJA, a taxpayer’s yearly interest deduction is limited to the taxpayer’s business interest plus 30% of the taxpayer’s adjusted taxable income, which generally is taxable income computed, until the end of 2021, without deduction for depreciation, amortization or depletion. • A taxpayer’s limitation is calculated at the entity level for corporations and pass-through entities. Partners, however, can deduct additional interest expense up to their distributive share of the partnership’s excess taxable income. • Interest expense in excess of the new limitation may be carried forward indefinitely. Partnerships allocate such excess interest expense to their partners, and partners may deduct such interest in future years to the extent of their share of the partnership’s excess taxable income. • The limitation on interest deductions does not apply to regulated electrical power or gas companies which, for this purpose, are defined in the same manner as for the exclusion from immediate expensing.

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