The $1.5 trillion new tax law represents the most sweeping change to tax code in a generation. Tax reform of this magnitude will have broad implications for government contractors. While accountants and tax departments wade through the 185-page legislation, here are the top 10 things government contractors need to know:
1. The corporate tax rate was permanently reduced from 35 percent to 21 percent.
The top corporate tax rate has been permanently reduced from 35 percent to a flat rate of 21 percent, beginning in 2018. Unlike all other provisions in the new law, including tax breaks for individuals, the new corporate tax rate provision does not expire.
2. There’s a tax break for owners of pass-through entities.
The new law provides owners of pass-through businesses—which include individuals, estates, and trusts—with a deduction of up to 20 percent of their domestic qualified business income, whether it is attributable to income earned through an S corporation, partnership, sole proprietorship, or disregarded entity. Without the new deduction, taxpayers would pay 2018 taxes on their share of qualified earnings at rates up to 37 percent. With the new 20 percent deduction, the tax rate on such income could be as low as 29.6 percent. It should again be noted that certain service industries are excluded from the preferential rate, unless taxable income is below $207,500 (for single filers) and $415,000 (for joint filers), under which the benefit of the deduction is phased out.
3. There might be huge tax benefits to changing your company’s current choice of entity.
Taxpayers should consider evaluating the choice of entity used to operate their businesses. The 21 percent reduced corporate tax rate may increase the popularity of corporations. However, factors such as the new 20 percent deduction for pass-through income, expected use of after-tax cash earnings, and potential exit values will significantly complicate these analyses. The potential after-tax cash benefits ultimately realized by owners could make choice-of-entity determinations one of the most important decisions taxpayers will now make.
4. There have been significant changes to the international tax system.
In connection with these changes, certain U.S. shareholders who own stock in certain foreign corporations will have to pay a one-time “transition tax” on their share of accumulated overseas earnings. Other changes include a “participation exemption,” which is a 100 percent dividend-received deduction that permits certain domestic C corporations to receive dividends from their foreign subsidiaries without being taxed on such dividends when certain conditions are satisfied. There is also a new requirement that certain U.S. shareholders of controlled foreign corporations (CFCs) include in income their share of the “global intangible low-taxed income” of such CFCs. Finally, there are new measures to deter base erosion and promote U.S. production.
5. The corporate AMT and DPAD are dead, but Research Tax Credits live on.
The law repeals the Section 199 Domestic Production Activities Deduction (DPAD) and the corporate Alternative Minimum Tax (AMT) for tax years beginning after 2017. The Research Tax Credit was retained and is now more valuable given the reduction of the corporate tax rate from 35 percent to 21 percent.
6. They’ve scrapped NOL carrybacks and limited the use of carryforwards.
Previously, businesses were able to offset current taxable income by claiming net operating losses (NOLs), generally eligible for a two-year carryback and 20-year carryforward. Now NOLs for tax years ending after 2017 cannot be carried back, but can be indefinitely carried forward. In addition, NOLs for tax years beginning in 2018 will be subject to an 80 percent limitation. Companies will have to track their NOLs in different buckets and consider cost-recovery strategy on depreciable assets in applying the 80 percent limitation.
7. Tax reform’s impact on accounting methods may change when revenue is recognized, but new provisions could also lead to temporary and permanent tax benefits.
Under the new law, accrual basis taxpayers must now recognize income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement.
However, new provisions also provide favorable methods of accounting that were not previously available. That, coupled with the reduction in tax rates, creates a favorable and unique environment for filing accounting method changes.
There are many method changes still available for the 2017 tax year. Taxpayers should evaluate current accounting methods to identify any actionable opportunities to accelerate deductions and defer income for the 2017 tax year, which could result in significant tax savings.
8. There are new rules for bonus depreciation and full expensing on new and used property.
The new tax law allows a 100 percent first-year deduction—up from 50 percent—for the adjusted basis of qualifying assets placed in service after Sept. 27, 2017, and before Jan. 1, 2023, with a gradual phase down in subsequent years before sunsetting after 2026. The definition of qualifying property was also expanded to include used property purchased in an arm’s-length transaction. Businesses should pay close attention to any qualifying asset acquisitions made during the fourth quarter of 2017, as the full expensing can be taken on the 2017 return if the property was acquired and placed in service after Sept. 27, 2017.
Additionally, under new tax law, taxpayers may now deduct up to $1 million under Section 179 for properties placed in service beginning in 2018 — double the previous allowable amount. The phase-out threshold is increased to $2.5 million and will be indexed for inflation in future years and the types of qualifying property has been expanded.
9. The availability of the cash method of accounting expanded for small businesses.
Beginning in 2018, the average annual gross receipts threshold for businesses to use the cash method increases from $5 million to $25 million. Additionally, small businesses who meet the $25 million gross receipts threshold are not required to account for inventories and are exempt from the uniform capitalization rules. The $25 million is indexed for inflation for tax years beginning after 2018.
10. Now is the time to assess total rewards strategies.
Tax reform significantly impacts various components of an employer’s total compensation program—namely the expansion of the $1 million deduction cap on pay to covered employees; disallowed deductions for transportation fringe benefits provided to employees; income inclusion for employer-paid moving expenses; further deduction limitations on certain meal and entertainment expenses; and a two-year tax credit for employer-paid family and medical leave programs. As the IRS releases guidance, employers must immediately modify their payroll systems to reflect tax reform changes impacting individual taxpayers.
For questions related to matters discussed above, please contact:
Compliments of BDO United States, a member of the EACCNY