The inability of Congress to include key tax extenders in the Consolidated Appropriations Act of 2023, signed into law on December 29, 2022, will increase the federal income tax bill for the majority of U.S. businesses. Coming into the new year, business owners likely breathed a sigh of relief that no major tax legislation was passed. However, significant tax law changes embedded in the Tax Cuts and Jobs Act (TCJA) are impacting the 2022 and 2023 taxable years, leaving many business owners scratching their heads trying to understand why their cash tax payments are so high.
Due to the limited majority of Republicans at the time the TCJA passed in December of 2017, the tax legislation could only be passed via a budget reconciliation process, which requires only a simple majority. Under the budget reconciliation process a bill cannot increase the deficit beyond a 10-year budget window. Therefore, the TCJA includes various sunset provisions or set expiration dates for many of the individual income tax legislation benefits.
Most of the TCJA sunset provisions relate to individual taxation ending in the 2025 taxable year, including decreased income tax rates, the 199A deduction (often referred to as the pass-through entity deduction), and an increased estate and gift tax exemption amount. While most business provisions were made permanent, significant adjustments were included to also decrease the TCJA revenue costs. Starting in the 2022 taxable year, capitalization of research and experimental expenditures was mandated and the ability to deduct business interest expense was drastically modified. In addition, beginning in the 2023 taxable year, bonus depreciation decreased to 80%, and is less than 100% for the first time since 2018.
Some will try to argue that these changes merely result in timing differences, which generally do not impact tax financial statement disclosures. However, the amount of cash investment needed to be in compliance with these temporary federal income tax provisions could force some businesses to make tough decisions to stay afloat.
Bonus Depreciation (Section 168(k)
Following enactment of the TCJA it was expected that bonus depreciation would start to decrease in the 2023 taxable year. However, much like with R&E capitalization, few people expected Congress to allow bonus depreciation to decrease below 100%. After all, isn’t this all just part of a budget gimmick for the budget reconciliation process? Apparently not. For any qualified property placed in service in the 2023 taxable year, bonus depreciation will be limited to 80%. And it does not get better after that. Based on the current legislation, bonus depreciation will continue to decrease by 20% each year until it is no longer available starting in the 2027 taxable year.
If a company is looking to make significant qualified property purchases, the sooner the better. However, the ability to deduct business interest expense to finance those property purchases could be limited based on the current law as well (see below). Modeling is encouraged to strike a proper balance to identify when qualified property should be bonused versus the utilization of MACRS which could potentially allow for more interest expense to be deducted.
The potential cash impact of purchasing or improving property may be offset by the clean energy credits and accelerated deductions that were included as part of the Inflation Reduction Act (“IRA”) passed in August of 2022. The federal government has provided significant credits for many clean energy purchases, including commercial vehicles, charging stations, and solar panels. In addition, the IRA expanded the ability to receive an immediate deduction for certain energy improvements. Many states are also providing grants, rebates, and credit incentives for similar types of investment. Companies should be strategic when identifying what property to purchase or improve.
To learn more about these federal clean energy initiatives, click here:
Companies should evaluate the ability to immediately deduct certain property purchases under Section 179. While some may not have focused on Section 179 previously due to 100% bonus depreciation, it is important to remember that the TCJA broadened the types of real property eligible under Section 179. Roofs, HVAC property, fire property, and alarm security systems are eligible for Section 179 treatment, as well as certain improvements made to nonresidential property made to the interior of a building. For the 2023 taxable year, up to $1,160,000 of expensing may be available under Section 179.
Business Interest Expense Limitation (Section 163(j))
With interest expense rates increasing, and a substantial modification to the limitation of interest expense taking effect in the 2022 taxable year, it has become harder for businesses to benefit fully from a business interest expense deduction. The TCJA implemented Section 163(j), limiting the amount of business interest expense based on the amount of business interest income, 30% of adjusted taxable income, and floor plan financing interest.
For taxable years beginning before January 1, 2022, taxpayers were allowed to add back depreciation, amortization, and depletion when determining the amount of adjusted taxable income for purposes of Section 163(j). This provided a broader base to apply the 30% limitation, thereby increasing the amount of allowable business interest expense. However, starting in the 2022 taxable year, the addback of depreciation, amortization, and depletion is no longer available. This change creates a smaller base, and potentially further limits the allowable business interest expense deduction.
Assume a taxpayer has preliminary taxable income of $300,000 during the taxable year, including $200,000 of business interest expense, and depreciation of $500,000. Before the change in the depreciation, amortization, and depletion addback for the 2022 taxable year, the full amount of business interest expenses would have been an allowable deduction. However, as depreciation can no longer be added back as of 2022, the allowable business interest expense deduction will only be $150,000, or 75% of the overall business interest expense incurred. The disallowed business interest expense can be carried forward indefinitely, but generally cannot be utilized unless the entity creates excess taxable income or income above what is needed for the current year’s business interest expense to be absorbed.
Provided the taxpayer does not file a consolidated return, all intercompany pricing agreements should be reviewed, including rent payments and management fees, to ensure amounts accurately reflect arm’s length arrangements. For example, it is not uncommon for operations to be placed in a separate business entity from real estate operations. Oftentimes, real estate operations are engaged in financing arrangements to purchase the property. If the interest rate is increasing, then intercompany rent payments should be reviewed and appropriately adjusted to reflect the economics of the arrangements. The rent increase would likely increase preliminary taxable income, allowing more business interest expense to be deducted.
Taxpayers should analyze whether the best strategy moving forward is to take bonus depreciation on all eligible asset classes. Starting in the 2022 taxable year, bonus depreciation will lower the adjusted taxable income, or tax base, that is utilized to determine the amount of business interest expense limitation. If there is a concern that a taxpayer will not be able to utilize disallowed interest expense in the future, the utilization of bonus depreciation on qualified asset classes should be analyzed. The ability to depreciate a fixed asset depends on the asset class life, and the time the asset is placed in service. In other words, unlike the utilization of disallowed business interest expense, excess taxable income is not required to receive a depreciation deduction. Therefore, taxpayers may benefit from electing out -of -bonus depreciation for 3 or 5-year assets and instead utilize MACRS depreciation to ensure business interest expense is deductible in a timely fashion.
Analyze the small business exemption and real property trade or business exception to see if the business interest expense limitation rules can be ignored.
As part of the TCJA, entities can claim the small business exemption and avoid application of the interest expense limitation rules for a particular tax year, provided certain requirements are met. The small business exemption is available if the taxpayer’s previous three years’ average annual gross receipts are under $27,000,000 ($29,000,00,0 for the 2023 taxable year) and the entity is not considered to be a tax shelter.. When determining the gross receipts test, the aggregation rules of Section 52(a) and (b), as well as Section 414(m) and (o) apply. The small business exemption test should be calculated on an annual basis. An additional advantage of qualifying under the small business exemption is that any previously disallowed interest expense is allowed as a deduction in the qualifying year.
Alternatively, if the small business exemption is unavailable, the real property trade or business exception should be evaluated. The real property trade or business exception is for any trade or business that is considered to conduct a real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. It should be noted that the election into the real property trade or business exception is an irrevocable election. If the election is made, the entity must convert all property with a 15-year life or above to the Alternative Depreciation System (ADS). Property with less than a 15-year life does not have to be converted and would still be eligible for bonus depreciation. Under ADS, 15-year property (including Qualified Improvement Property) will be considered to have a 20-year life and will no longer qualify for bonus depreciation. However, based on the current tax law, bonus depreciation will be decreasing dramatically over the next five years and therefore, the impact of making a real estate trade or business exception may not be as significant. Lastly, if a real property trade or business election is made, any excess interest expense carryforward before the election is trapped and will not be allowed to be utilized in succeeding taxable years, regardless of whether excess taxable income is generated.
Caution: Tax professionals should be aware that if a taxpayer has significant floor plan financing and their business interest expense amount exceeds both business interest income and 30% of the entity’s adjusted taxable income, none of the property purchased during that taxable year will be considered qualified property for purposes of bonus depreciation.
Capitalization of Research and Experimental Expenditures (Section 174)
Businesses will also be forced to capitalize and amortize research and experimental expenditures over 5 years or 15 years if attributable to foreign research starting in the 2022 taxable year. The denial of immediate expensing for R&E expenditures could result in an increase to federal taxable income for many industries, including technology and life sciences. To better understand the dramatic impact on the United States’ ability to compete globally for new companies involved in research and innovation by the absence of Congressional legislation, click here: Will Congress Restore The Tax Incentive For Research Spending? (forbes.com). Nevertheless, companies are now forced to identify, track, and create reasonable allocation methodologies for R&E expenditures, in addition to tracking R&D credit and ASC 740 book R&D expenses.
While taxpayers may start the R&E capitalization process by reviewing R&E expenses utilized in computing their R&D credit and ASC 730 book R&D expense, additional steps will be required to identify and capitalize R&E expenditures properly. The definition of R&E expenditures under the capitalization policy is much broader than those identified for the R&D credit or ASC 730. R&E expenditures generally include all costs incidental to the development or improvement of a product. Examples include costs of obtaining a patent, attorney fees, wages, utilities (i.e., heat, light, and power), overhead, patent expense, materials, rent, depreciation, and software development costs, regardless of whether they are for the taxpayer’s own use or held for sale to others.
Properly analyze net operating loss rules to understand the impact to taxable income as a result of R&E capitalization. While net operating losses incurred in taxable years before December 31, 2017 will fully offset taxable income, the TCJA made significant changes to the ability to utilize net operating losses incurred after December 31, 2017. Under the TCJA amendment, net operating losses that were incurred after December 31, 2017, and applied to taxable years after December 31, 2020, can only offset up to 80% of taxable income, leaving 20% of taxable income subject to federal income tax.
It is required that any R&E expenditures utilized for credit purposes be included for purposes of R&E capitalization. Therefore, it will be important to reconcile R&D credit and R&E expenditures to ensure the R&D credit will not be inadvertently decreased.
If R&E capitalization does create taxable income, additional tax planning should be reviewed to lower taxable income, which could necessitate an R&D credit study.
To learn more regarding different steps to prepare for R&E capitalization, please visit Steps-to-prepare-for-2022-re-capitalization-requirement/.
The lack of Congressional movement regarding these key business tax provisions, in addition to a slowing economy, is a concern for many businesses. Even though Republicans have indicated a desire to implement certain tax extenders in the 2023 taxable year, Democrats are holding firm that they will not engage in serious discussions without an expanded child tax credit. With the two Congressional houses divided, bipartisan legislation is becoming increasingly more problematic. Even worse, could this reflect the inability to pass future tax extenders? Will the significant individual income tax expiration provisions included in the TCJA, currently scheduled to phase out starting in 2025, be allowed to sunset? The significance of these TCJA provisions will require business leaders to remain active and diligent in working with Congressional leaders to address these issues.