Tech companies in South Florida can benefit from the Tax Cuts and Jobs Act (“TCJA”), as long as they proactively plan for the new tax changes. Otherwise, opportunities to maximize tax savings could quickly morph into more expensive tax bills.
South Florida businesses in the technology, health and life sciences, and industrial sectors (or “THInc” businesses for short) have several decisions to make as they compare new options for deductions, expensing, and tax rates, based on variables, such as their size, maturity, and entity type.
Here’s what South Florida THinc companies need to know about tax reform.
Assessing benefits of corporations and pass-throughs: New provisions for pass-through entities and C corporations have owners and shareholders re-examining their choice of business entity (i.e., S corporation, partnership, etc.). For some entities, the lower corporate tax rate of 21 percent (previously 35 percent) and the potential to partially exclude gains of certain small business stock from taxable income under the section 1202 rules may ultimately make it worthwhile to incorporate as a C corporation. Conversely, C corporations aren’t eligible for the new section 199A deduction of 20 percent of domestic qualified business income (“QBI”). Other factors include the maturity of the business and plans for how profits will be used (e.g., investments versus shareholder distributions).
The reduced corporate tax rate will have a negative impact on tech companies’ financial statements, because deferred tax assets will need to be revalued as of Dec. 31, 2017. Net operating losses (“NOLs”) can no longer be carried back and going forward are limited to 80 percent of taxable income.
These new provisions will affect businesses in different ways, which is why it’s important to consult with your tax services provider.
Qualified business income deduction: The section 199A deduction for QBI is one of the more complex provisions of the new law. In brief, a non-corporate taxpayer may deduct up to 20 percent of domestic QBI from a partnership, S corporation or sole proprietorship. This deduction can effectively lower the top individual tax rate from 37 percent to 29.6 percent on pass-through business income.
There are limits on the QBI deduction. Income from specified service businesses where the principal asset of the company is based on the reputation and skill of its employees or owners (e.g., health, law, accounting, performing arts, etc.) aren’t eligible. There are also limits on calculating the 20 percent QBI deduction derived from W-2 wages and the costs of depreciable tangible property.
Enhancements and limits to business deductions: Beginning in 2018, interest expense is limited to 30 percent of adjusted taxable income. Through December 31, 2021, adjusted taxable income will include add-backs of interest, depreciation, amortization, and depletion. Any interest expense that is not deductible in the current year can be carried forward indefinitely. The analysis to determine how much of the interest is limited takes place the entity level.
Some experts have concerns that the limit on deducting business interest may impact the borrowing businesses use for investments and capital purchases. However, through Dec. 31, 2022, businesses can claim bonus depreciation that will allow them to write-off as much as 100 percent of eligible tangible property purchases instead of depreciating the asset over several years. After 2022, the deduction starts to phase out by 20 percent annually until it expires at the end of 2026. Businesses will need to compare their tax savings between these two deductions to see which works best for their long-term capital spending plan.
Simpler accounting methods: Businesses with less than $25 million in average annual gross receipts over the three prior taxable years are allowed to use the cash method of accounting, simplified inventory accounting methods and the completed contract accounting method for long-term contracts. These tax accounting methods can create more flexibility in tax planning and provide for easier record-keeping and reporting requirements while not negatively impacting the company’s financial statements provided to lenders. Businesses with less than $25 million in gross receipts will not be subject to the 30 percent limit on business interest expense deductions.
Research and Development (“R&D”) credit: The R&D credit made permanent in 2015 survived the tax overhaul. Given the focus many THInc sectors have on inventing, innovating and developing new products, services and processes, retaining the R&D credit is a big win.
One significant change to R&D expense deductions is that for tax years beginning after Dec. 31, 2021, specified research and experimentation expenses must now be capitalized and amortized ratably over a five-year period. For research conducted outside the U.S., the amortization period is extended to 15 years.
Software development expenses are among the activities that qualify for the credit. Many THInc companies invest heavily in internal IT projects that improve their individual processes. These expenditures may qualify for the R&D credit.
Patents: Under prior law, patents, inventions, models and designs, secret formulas and processes (whether patented or not) were considered capital assets. The proceeds from their sale received the beneficial capital gains rates. Under the TCJA, these proceeds are recognized as ordinary income. Inventors whose income is based solely on the creation and sale of intellectual property (“IP”) may now find themselves treated the same way as professionals in specified service businesses who pay the individual tax rate on income generated by fees.
How will the TCJA impact future deal pricing or entity structuring? Will sellers push for stock sales to get long-term capital gain benefits? Or will buyers insist on an asset sale to benefit from 15-year amortization of the acquired patent?
Purchase price allocations will be even more critical going forward. Companies will have to decide if the sale is designated as goodwill, workforce, or client list versus self-created IP. There’s uncertainty surrounding these terms. Therefore, asset purchase agreements will be modified to finalize the purchase price allocation at the time of sale versus several months down the road. It may also impact which party will be responsible for the allocation. Hopefully the IRS will provide clarification soon.
Lourdes De Los Santos is a tax partner at Cherry Bekaert’s South Florida practice and a member of the firm’s South Florida THInc® practice. She specializes in serving the middle market focused in real estate, construction, trade and logistics industries.