We are fast approaching the five-year anniversary of the Tax Cuts and Jobs Act (TCJA), which was signed into law on December 22, 2017. The law was a signature accomplishment of the Trump administration, and while it was not a complete rewrite of the Internal Revenue Code, it significantly changed the landscape of both business and individual taxation.
While many of the provisions from TCJA became effective in 2018, some of them came with a time-delayed fuse before taking effect. Accordingly, it is possible that some folks may have overlooked or do not remember these changes, particularly over the past couple of years with the litany of new tax legislation that emerged as a result of the Covid-19 pandemic. This article will take a look at two of these newly effective provisions from the TCJA, which taxpayers and practitioners alike need to be aware of.
Limitation of Business Interest Expense under IRC Section 163(j)
One of the most significant changes in the TCJA involved the limitation of deductible business interest expense. In a nutshell, a business that is subject to these rules can only deduct business interest expense that is less than or equal to 30 percent of its adjusted taxable income (ATI). This provision effectively increased the cost of borrowing funds for businesses, by way of reducing the amount of business interest expense a company can deduct in a given tax year.
Through the end of 2021, ATI was equal to a company’s taxable income without regard to deductions for interest, taxes, depreciation or amortization expense (commonly referred to as EBITDA). However, for tax years beginning after 2021, ATI is now equivalent to a company’s taxable income without regard to deductions for interest or taxes (commonly referred to as EBIT). Depreciation and amortization expense are no longer included in the computation of ATI, which means a much smaller portion of a company’s business interest expense will be deductible in 2022 versus 2021, with all other things remaining constant.
Qualified real property and farming trades or businesses still have the ability to make the election to not have the interest limitation rules apply (if such an election has not already been made), in exchange for depreciating the company’s property over a longer period of time. While some analysis is needed, it is more often than not beneficial for a company to take a haircut on their annual depreciation deductions, in exchange for being able to deduct the interest expense without limitation. In addition, businesses whose aggregate gross receipts for the prior three tax years fall under $27 million for 2022 are generally not required to limit their business interest expense. Businesses must use caution in determining whether they qualify for this small business exception, particularly in years where there are losses. Regardless of gross receipts or common control, the limitation on business interest expense is required for any passthrough entity that is not an electing real property or farming trade or business that allocates more than 35% of their losses to limited partners and limited entrepreneurs in a given tax year (commonly referred to as the syndicate rule).
Requirement to Capitalize and Amortize Research Expenses
Previously, the tax code allowed for research and experimental expenditures to be expensed as they are incurred. This, in conjunction with the tax credit for increasing research activities (commonly referred to as the R&D Tax Credit), incentivized businesses to make significant investments in developing new products and processes. The R&D tax credit was also enhanced by the Protecting Americans from Tax Hikes (PATH) Act of 2015, in two meaningful ways. One, the credit was made a permanent part of the tax code, after being perpetually extended by Congress for several years. In addition, small businesses and startup companies gained the option to take the credit against payroll taxes, as a way to give them a more immediate benefit from the credit.
However, for tax years that begin after December 31, 2021, these R&D expenditures must now be capitalized and amortized over a five-year period, with a fifteen-year amortization period required for foreign research expenditures. For purposes of determining the currently deductible amount of such expenditures, taxpayers must assume that the eligible expenditures paid or incurred during the tax year were incurred at the midpoint of each relevant year. This effectively imposes a half-year convention on the amortization of the expenditures, similar to how fixed assets are depreciated for tax purposes.
Consider the following example – a manufacturing company incurs qualified research expenditures of $400,000 for 2021, and $400,000 for 2022. While they are able to deduct $400,000 of such expenditures for 2021, the allowable deduction for 2022 is only $80,000. The end result for this company, all other things held constant, is a net increase to their taxable income of $320,000 from 2021 to 2022.
One possible silver lining is that taxpayers may be able to utilize carryovers that otherwise might continue to be suspended. For instance, corporations whose charitable donations are limited to 10% of modified taxable income each year will be able to use more of their charitable contributions carryforward if their taxable income is higher from having to capitalize the R&D expenditures. In addition, the business interest expense limitation, as discussed earlier in this article, should be lower for a company that must capitalize and amortize their research expenditures, given that their adjusted taxable income will be higher.
Under the TCJA, this change is treated as a change in accounting method and applied on the cutoff method for qualified expenditures that are paid or incurred for tax years beginning after December 31, 2021. This will require taxpayers to file Form 3115, Application for Change in Accounting Method, with their 2022 income tax returns.
What Business Owners and Taxpayers Should Do to Prepare
Many folks have been hopeful that Congress would pass a bill to delay the implementation of these law changes. Unfortunately, the possibility of such a bill being passed gets bleaker with every passing day.
These two changes to the law will require businesses and their trusted tax advisors to do more careful tax planning each year, including planning that spans multiple years. And while nobody has a perfect crystal ball, taxpayers who are unprepared may unknowingly encounter late payment penalties and interest for failing to pay in the proper amount of tax during the year, as well as with any extensions that are filed.
If you have any questions or are interested in learning more about this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts today.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.