The Tax Cuts and Jobs Act (TCJA), which was signed into law on Dec. 22, 2017, was overwhelmingly favorable to businesses. There were, however, elements to TCJA that have a detrimental impact on businesses and could get much worse if the economy slows. With interest rates at historic lows over much of the past decade, many businesses have taken on significant amounts of debt. For those companies, the new interest deduction limitation could have a negative effect. Should we have a recession, as many economists are now predicting in 2020, it would likely drive income down and subject more businesses than expected to the limit on interest deductions. A recession would also undoubtedly cause more businesses to experience losses. For those companies, new limits on net operating losses (NOLs), will slow their ability to recover those losses for tax purposes after the economy improves. Following is a summary of those two provisions and a table of key business deductions or benefits eliminated by TCJA.
Interest deduction limitation
The TCJA limits the deduction for net business interest in excess in interest income to 30% of adjusted taxable income for tax years beginning after Dec. 31, 2017. Adjusted taxable income is defined as taxable income computed without interest expense, interest income, NOL deductions, and the 20% deduction for certain qualified business income under Section 199A. For tax years beginning before Jan. 1, 2022, adjusted taxable income also excludes depreciation, amortization, and depletion. So for the first four years, the calculation is similar to earnings before interest, taxes, depreciation and amortization (EBITDA), and then becomes more similar to “EBIT.” Any disallowed interest expense is carried forward indefinitely. Investment interest income and expense are not affected by the provision.
The limit does not apply to regulated public utilities and businesses with average annual gross receipts of $25 million or less for the three prior taxable years. Certain real property and farming trades or businesses can make an irrevocable election to forgo certain depreciation methods (including bonus depreciation) and be exempt from the limit. The definitions of real property trade or business is broad and includes property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. In addition, interest related to debt used to finance motor vehicles that are held for sale or lease is exempt. However, these businesses are not eligible for bonus depreciation and there is some question as to whether they could elect to forgo the interest exception and claim bonus depreciation instead.
There are special rules that apply the limit to partnerships. First, the limit applies at the entity level to determine the deduction of business interest with respect to the partnership’s non-separately stated interest expense. If there is excess adjusted taxable income for the partnership, a partner can increase its own adjusted taxable income by its share of such excess in determining such partner’s business interest deduction. If business interest is disallowed at the partnership level in a taxable year, such disallowed interest is allocated to the partners and may only be deducted by a partner against excess business interest income and excess adjusted taxable income allocated to the partner from such partnership in a succeeding year. Similar rules apply to an S corporation and its shareholders.
Grant Thornton Insight: Because the limit is based on a proportion of income, it becomes much harsher if an economic downturn temporarily suppresses the incomes of businesses, especially as this is often when many businesses need to increase debt to stay afloat.
Corporate AMT and NOLs
The conference agreement repeals the corporate AMT effective for tax years beginning after Dec. 31, 2017. Taxpayers with unused AMT credits can claim 50% of the remaining credits after liability is reduced to zero as refundable in each of the years 2018, 2019 and 2020, with all remaining credits claimed as refundable in 2021. In addition, Treasury has just determined that the sequestration will not reduce these refundable payments.
The repeal of the corporate AMT is undermined by new limits on NOLs. Formerly, the most common corporate AMT trigger was the limit on the NOL deductions to 90% of taxable income. Although the AMT is repealed, an even harsher new NOL limit is imposed outside of the AMT. Under the new law, NOL deductions can only offset up to 80% of taxable income. The bill also repeals NOL carry-backs but allows indefinite carry-forwards. Property and casualty insurance companies retain the current two-year carry-back and 20-year carry-forward provisions, and certain farming losses retain a two-year carry-back. The 80% limit applies to NOLs arising from tax years beginning after Dec. 31, 2017, and the new carry-forward period applies to NOLs arising in tax years ending after Dec. 31, 2017. The different effective date for the carry-forward changes appears to be an error based on the legislative history. A technical correction in this area is possible.
Grant Thornton Insight: A recession can drive many businesses into loss positions. When the economy recovers, it is critical for these businesses to use the temporary losses to reduce taxable income so they use more of their cash to regrow their business as the markets recover. The new limit on the ability use NOLs could make the recovery more painful.
Key deductions and businesses benefits repealed
In addition to the interest deduction and NOL limitations, TCJA repeals or limits many other business credits, deductions and incentives. Following is brief summary.
Overall, TCJA has been a boon for businesses, but, with an increasing likelihood of a recession looming on the horizon, businesses should consider how a contraction could impact their tax posture. Read our broader discussion of TCJA
and consult your Grant Thornton tax professional with any questions.
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