The Tax Cuts and Jobs Act (TCJA or Tax Reform) of 2017 contains a multitude of new provisions that were passed in record time. The magnitude of the changes coupled with the speed at which it passed resulted in many questions that remain unanswered. These uncertainties and gray areas make it difficult for taxpayers and their tax advisors to fully understand the application of a rather substantial portion of the law’s language and intent. Critical and much-needed guidance from the IRS should surface this summer. Here are some key provisions in the tax reform law that we are expecting guidance on:
Qualified Opportunity Funds
The Opportunity Zones program was established by Congress in the TCJA as an innovative approach to spurring long-term private sector investments in low-income urban and rural communities nationwide. The program allows investors with capital gain tax liabilities to receive favorable tax treatment for investing in Opportunity Funds that are certified by the US Treasury Department. The Opportunity Funds use the capital invested to make equity investments in qualifying businesses and real estate in Opportunity Zones designated by each state.
The Opportunity Zones program allows individual and corporate taxpayers to defer capital gains on the sale of stock, business assets or any other property (whether or not the asset sold was located in or related to a low-income community) by investing the proceeds in an Opportunity Fund within 180 days of the sale or exchange, in an amount equal to the gain to be deferred. In addition to the deferral of capital gains, the Opportunity Zones program includes holding period benchmarks that result in greater tax benefits. Additional guidance and regulations are expected in the coming weeks and months to provide further clarification on this new incentive program.
Capital Gain Deferral Election
A new addition to the TCJA includes a deferral election for employees receiving stock-based compensation from privately held corporations. The new Section 83(i) election allows employees to defer the recognition of income attributable to stock received on exercise of an option or settlement of a restricted stock unit (RSUs), for a maximum of five years. The election is only permitted with respect to a transfer of “qualified stock” to a “qualified employee” of an “eligible corporation.” This election will benefit employees who receive stock-based compensation; however additional guidance is needed from the IRS to assist practitioners, employers and employees in complying with the election. You can read more about this new deferral election here.
20% Deduction Under New Section 199A
Section 199A was added to the TCJA to give sole proprietors and pass-through entities (partnerships, S corporations, etc.) a deduction of up to 20% of their qualified business income. However, some taxpayers that are engaged in a “specified trade or business” may be ineligible for the deduction. The extent of which businesses qualify will largely remain an uncertainty until the IRS issues additional guidance that is expected in late July.
The law currently states that if a trade or business involves the performance of services in various fields (including health, law, accounting, consulting, etc.), the deduction is not available to taxpayers exceeding certain income thresholds. For example, if a healthcare practice provides normal treatment to patients but has an affiliate or subsidiary that sells medical supplies, is that considered a service provided in the field of health? Rulings under other section of tax law suggest that if a service is considered a commodity, it is not considered a service even if it is in one of the fields referenced above.
Similarly, the law states that the new 20% pass-through deduction would not be made available where the principal asset of the trade or business is the reputation or skill of its employee(s) or owner(s). This definition could be broadly interpreted. Will there be an objective test an entity will have to meet in order to avoid this pitfall? Further guidance from the IRS and Treasury will hopefully answer many of these questions.
Carried interests are ownership interests in a partnership that share in the partnership’s net profits, often taxed at capital gains rates instead of ordinary rates. In the days leading up to tax reform, many experts assumed that the carried interest “loophole” would be repealed altogether. Instead of an outright repeal, the new tax reform law effectively extended the capital gains holding period from one year to three years for “applicable partnership interests.” There is uncertainty regarding the law’s language on the types of entities that are exempt from the new treatment. Section 1061(c)(4)(A) says that an applicable partnership interest does not include a partnership interest held by a corporation. Thus utilizing an S corporation would seemingly be a way to circumvent these new holding period requirements. However, IRS Notice 2018-18 announced that there will be new regulations issued stating the IRS does not intend that the term “corporation” include an S corporation.
Another point of uncertainty surrounds the start of the three-year holding period. Lawmakers have not established a firm answer to this question, nor do any regulations currently speak to it. Until authoritative guidance is provided, taxpayers must look to the facts and circumstances of their individual situations to help answer this question.
Prior to the new tax reform law, the tax code categorized building improvements into different classes which can have differing treatment with respect to depreciation depending on the type and structure of a particular improvement. Under prior law, these classes included Qualified Leasehold Improvement Property, Qualified Restaurant Property and Qualified Retail Improvement Property. While most building improvements are generally depreciable over 39 years, improvements meeting these category definitions were eligible for a 15-year cost recovery period. Assets with lives of 20 years or less are eligible for bonus depreciation, which allowed for an immediate 50% deduction under the prior law. Additionally, the PATH Act of 2015 created another category, Qualified Improvement Property (QIP), which allowed bonus depreciation to be taken on qualifying interior building improvements that were still subject to the general 39 year recovery period.
Under the TCJA, an effort was made to simplify and consolidate these different classes of improvements under a newly defined Qualified Improvement Property (QIP) designation. Based on the conference agreement and committee reports, this new QIP category was intended to have a 15 year recovery period, therefore qualifying the assets for 100% bonus depreciation which results in a full write-off in the year placed in service. However, due to an oversight in drafting the final bill, the legislation did not include the stated 15 year recovery period for QIP, which made the assets not eligible for 100% bonus depreciation. As a result, the current law treatment for QIP is actually less advantageous than under prior law. It is widely anticipated that a legislative fix will be issued to address this issue. However, it is currently unknown when or if the fix will be issued.
As we await guidance on these issues from the IRS, there are ways that you can prepare yourself and your business to adjust to the IRS’s guidance once it becomes available. William Dow, CPA, Member of the Firm and Leader of Warren Averett’s Tax Division advises companies who are ready to take action: “Lack of guidance in many of these areas has been a hindrance in planning for their applicability to certain taxpayers. It is not uncommon to see guidance from the IRS and Treasury, as well as Technical Corrections Bills to help interpret legislation and fix drafting errors and oversights. Do not wait for all question to be answered. Start planning with the law based on the spirit of the legislation.” Contact your Warren Averett advisor to learn what industry-specific steps your business can take to start planning today for tax reform guidance.