[JPRT 115-1-18]
[From the U.S. Government Publishing Office]
[JOINT COMMITTEE PRINT]
GENERAL EXPLANATION OF
PUBLIC LAW 115-97
----------
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
DECEMBER 2018
JCS-1-18
[JOINT COMMITTEE PRINT]
GENERAL EXPLANATION OF
PUBLIC LAW 115-97
__________
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
DECEMBER 2018
______
U.S. GOVERNMENT PUBLISHING OFFICE
33-137 WASHINGTON : 2018 JCS-1-18
JOINT COMMITTEE ON TAXATION
115th Congress, 2d Session
------
SENATE HOUSE
ORRIN G. HATCH, Utah, KEVIN BRADY, Texas,
Chairman Vice Chairman
CHUCK GRASSLEY, Iowa SAM JOHNSON, Texas
MIKE CRAPO, Idaho DEVIN NUNES, California
RON WYDEN, Oregon RICHARD NEAL, Massachusetts
DEBBIE STABENOW, Michigan JOHN LEWIS, Georgia
Thomas A. Barthold, Chief of Staff
Robert Harvey, Deputy Chief of Staff
David Lenter, Deputy Chief of Staff
C O N T E N T S
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Page
INTRODUCTION..................................................... 1
TITLE I.......................................................... 3
SUBTITLE A--INDIVIDUAL TAX REFORM................................ 3
PART I--TAX RATE REFORM.......................................... 3
A. Modification of Rates (sec. 11001 of the Act and
sec. 1 of the Code)................................ 3
B. Inflation Adjustments Based On Chained CPI (sec.
11002 of the Act and sec. 1(f) of the Code)........ 9
PART II--DEDUCTION FOR QUALIFIED BUSINESS INCOME OF PASS-THRU
ENTITIES....................................................... 11
A. Deduction for Qualified Business Income (sec. 11011
of the Act and sec. 199A of the Code).............. 11
B. Limitation on Losses for Taxpayers Other Than
Corporations (sec. 11012 of the Act and sec. 461(l)
of the Code)....................................... 38
PART III--TAX BENEFITS FOR FAMILIES AND INDIVIDUALS.............. 42
A. Increase in Standard Deduction (sec. 11021 of the
Act and sec. 63 of the Code)....................... 42
B. Increase in and Modification of Child Tax Credit
(sec. 11022 of the Act and sec. 24 of the Code).... 43
C. Modifications to the Deduction for Charitable
Contributions (secs. 11023, 13704, and 13705 of the
Act and sec. 170 of the Code)...................... 46
D. Increased Contributions to ABLE Accounts (sec.
11024 of the Act and secs. 25B and 529A of the
Code).............................................. 52
E. Rollovers to ABLE Programs from 529 Programs (sec.
11025 of the Act and secs. 529 and 529A of the
Code).............................................. 54
F. Treatment of Certain Individuals Performing
Services in the Sinai Peninsula of Egypt (sec.
11026 of the Act and secs. 2, 112, 692, 2201, 3401,
4253, 6013, and 7508 of the Code).................. 55
G. Temporary Reduction in Medical Expense Deduction
Floor (sec. 11027 of the Act and sec. 213 of the
Code).............................................. 56
H. Relief for 2016 Disaster Areas (sec. 11028 of the
Act and secs. 72(t), 165, 401-403, 408, 457, and
3405 of the Code).................................. 57
PART IV--EDUCATION............................................... 61
A. Treatment of Student Loans Discharged on Account of
Death or Disability (sec. 11031 of the Act and sec.
108 of the Code)................................... 61
B. 529 Account Funding for Elementary and Secondary
Education (sec. 11032 of the Act and sec. 529 of
the Code).......................................... 62
PART V--DEDUCTIONS AND EXCLUSIONS................................ 65
A. Suspension of Deduction for Personal Exemptions
(sec. 11041 of the Act and sec. 151 of the Code)... 65
B. Limitation on Deduction for State and Local, etc.
Taxes (sec. 11042 of the Act and sec. 164 of the
Code).............................................. 67
C. Limitation on Deduction for Qualified Residence
Interest (sec. 11043 of the Act and sec. 163(h) of
the Code).......................................... 69
D. Modification of Deduction for Personal Casualty
Losses (sec. 11044 of the Act and sec. 165 of the
Code).............................................. 71
E. Suspension of Miscellaneous Itemized Deductions
(sec. 11045 of the Act and secs. 62, 67 and 212 of
the Code).......................................... 72
F. Suspension of Overall Limitation on Itemized
Deductions (sec. 11046 of the Act and sec. 68 of
the Code).......................................... 74
G. Suspension of Exclusion for Qualified Bicycle
Commuting Reimbursement (sec. 11047 of the Act and
sec. 132(f) of the Code)........................... 75
H. Suspension of Exclusion for Qualified Moving
Expense Reimbursement (sec. 11048 of the Act and
sec. 132(g) of the Code)........................... 76
I. Suspension of Deduction for Moving Expenses (sec.
11049 of the Act, and sec. 217 of the Code)........ 77
J. Limitation on Wagering Losses (sec. 11050 of the
Act and sec. 165(d) of the Code)................... 78
K. Repeal of Deduction for Alimony Payments (sec.
11051 of the Act and secs. 61, 71, 215, and 682 of
the Code).......................................... 78
PART VI--INCREASE IN ESTATE AND GIFT TAX EXEMPTION............... 80
A. Increase in Estate and Gift Tax Exemption (sec.
11061 of the Act and secs. 2001 and 2010 of the
Code).............................................. 80
PART VII--EXTENSION OF TIME LIMIT FOR CONTESTING IRS LEVY........ 90
A. Extension of Time Limit for Contesting IRS Levy
(sec. 11071 of the Act and secs. 6343 and 6532 of
the Code).......................................... 90
PART VIII--INDIVIDUAL MANDATE.................................... 91
A. Elimination of Shared Responsibility Payment for
Individuals Failing to Maintain Minimum Essential
Coverage (sec. 11081 of the Act and sec. 5000A of
the Code).......................................... 91
SUBTITLE B--ALTERNATIVE MINIMUM TAX.............................. 92
A. Repeal of Tax for Corporations; Credit for Prior
Year Minimum Tax Liability of Corporations;
Increased Exemption for Individuals (secs. 12001-
12003 of the Act and secs. 53 and 55-59 of the
Code).............................................. 92
SUBTITLE C--BUSINESS-RELATED PROVISIONS.......................... 99
PART I--CORPORATE PROVISIONS..................................... 99
A. 21-Percent Corporate Tax Rate (sec. 13001 of the
Act and sec. 11 of the Code)....................... 99
B. Reduction in Dividends-Received Deduction to
Reflect Lower Corporate Income Tax Rates (sec.
13002 of the Act and sec. 243 of the Code)......... 103
PART II--SMALL BUSINESS REFORMS.................................. 104
A. Modifications of Rules for Expensing Depreciable
Business Assets (sec. 13101 of the Act and sec. 179
of the Code)....................................... 104
B. Small Business Accounting Method Reform and
Simplification (sec. 13102 of the Act and secs.
263A, 448, 460, and 471 of the Code)............... 107
PART III--COST RECOVERY AND ACCOUNTING METHODS................... 115
SUBPART A--COST RECOVERY......................................... 115
A. Temporary 100-Percent Expensing for Certain
Business Assets (sec. 13201 of the Act and sec.
168(k) of the Code)................................ 115
B. Modifications to Depreciation Limitations on Luxury
Automobiles and Personal Use Property (sec. 13202
of the Act and sec. 280F of the Code).............. 128
C. Modifications of Treatment of Certain Farm Property
(sec. 13203 of the Act and sec. 168 of the Code)... 130
D. Applicable Recovery Period for Real Property (sec.
13204 of the Act and sec. 168 of the Code)......... 133
E. Use of Alternative Depreciation System for Electing
Farming Businesses (sec. 13205 of the Act and sec.
168 of the Code)................................... 139
F. Amortization of Research and Experimental
Expenditures (sec. 13206 of the Act and sec. 174 of
the Code).......................................... 142
G. Expensing of Certain Costs of Replanting Citrus
Plants Lost by Reason of Casualty (sec. 13207 of
the Act and sec. 263A of the Code)................. 145
SUBPART B--ACCOUNTING METHODS.................................... 148
A. Certain Special Rules for Taxable Year of Inclusion
(sec. 13221 of the Act and sec. 451 of the Code)... 148
PART IV--BUSINESS-RELATED EXCLUSIONS AND DEDUCTIONS.............. 172
A. Limitation on Deduction for Interest (sec. 13301 of
the Act and sec. 163(j) of the Code)............... 172
B. Modification of Net Operating Loss Deduction (sec.
13302 of the Act and sec. 172 of the Code)......... 180
C. Like-Kind Exchanges of Real Property (sec. 13303 of
the Act and sec. 1031 of the Code)................. 182
D. Limitation on Deduction by Employers of Expenses
for Fringe Benefits (sec. 13304 of the Act and sec.
274 of the Code)................................... 185
E. Repeal of Deduction for Income Attributable to
Domestic Production Activities (sec. 13305 of the
Act and former sec. 199 of the Code)............... 191
F. Denial of Deduction for Certain Fines, Penalties,
and Other Amounts (sec. 13306 of the Act and sec.
162 of the Code)................................... 193
G. Denial of Deduction for Settlements Subject to
Nondisclosure Agreements Paid in Connection with
Sexual Harassment or Sexual Abuse (sec. 13307 of
the Act and sec. 162 of the Code).................. 195
H. Repeal of Deduction for Local Lobbying Expenses
(sec. 13308 of the Act and sec. 162 of the Code)... 195
I. Recharacterization of Certain Gains in the Case of
Partnership Profits Interests Held in Connection
with Performance of Investment Services (sec. 13309
of the Act and sec. 1061 of the Code).............. 197
J. Prohibition on Cash, Gift Cards, and Other
Nontangible Personal Property as Employee
Achievement Awards (sec. 13310 of the Act and secs.
74(c) and 274(j) of the Code)...................... 204
K. Elimination of Deduction for Living Expenses
Incurred by Members of Congress (sec. 13311 of the
Act and sec. 162 of the Code)...................... 204
L. Certain Contributions by Governmental Entities Not
Treated as Contributions to Capital (sec. 13312 of
the Act and sec. 118 of the Code).................. 205
M. Repeal of Rollover of Publicly Traded Securities
Gain into Specialized Small Business Investment
Companies (sec. 13313 of the Act and former sec.
1044 of the Code).................................. 206
N. Certain Self-Created Property Not Treated as a
Capital Asset (sec. 13314 of the Act and sec.
1221(a)(3) of the Code)............................ 206
PART V--BUSINESS CREDITS......................................... 209
A. Modification of Orphan Drug Credit (sec. 13401 of
the Act and secs. 45C and 280C of the Code)........ 209
B. Rehabilitation Credit Limited to Certified Historic
Structures (sec. 13402 of the Act and sec. 47 of
the Code).......................................... 210
C. Employer Credit for Paid Family and Medical Leave
(sec. 13403 of the Act and new sec. 45S of the
Code).............................................. 211
D. Repeal of Tax Credit Bonds (sec. 13404 of the Act
and former secs. 54A, 54B, 54C, 54D, 54E, 54F and
6431 of the Code).................................. 214
PART VI--PROVISIONS RELATED TO SPECIFIC ENTITIES AND INDUSTRIES.. 218
SUBPART A--PARTNERSHIPS PROVISIONS............................... 218
A. Treatment of Gain or Loss of Foreign Persons from
Sale or Exchange of Interests in Partnerships
Engaged in Trade or Business Within the United
States (sec. 13501 of the Act and secs. 864(c) and
1446 of the Code).................................. 218
B. Modify Definition of Substantial Built-in Loss in
the Case of Transfer of Partnership Interest (sec.
13502 of the Act and sec. 743(d) of the Code)...... 221
C. Charitable Contributions and Foreign Taxes Taken
into Account in Determining Limitation on Allowance
of Partner's Share of Loss (sec. 13503 of the Act
and sec. 704 of the Code).......................... 222
D. Repeal of Technical Termination of Partnerships
(sec. 13504 of the Act and sec. 708(b) of the Code) 224
SUBPART B--INSURANCE REFORMS..................................... 225
A. Net Operating Losses of Life Insurance Companies
(sec. 13511 of the Act and sec. 805 of the Code)... 225
B. Repeal of Small Life Insurance Company Deduction
(sec. 13512 of the Act and former sec. 806 of the
Code).............................................. 226
C. Adjustment for Change in Computing Reserves (sec.
13513 of the Act and sec. 807(f) of the Code)...... 227
D. Repeal of Special Rule for Distributions to
Shareholders from Pre-1984 Policyholders Surplus
Account (sec. 13514 of the Act and former sec. 815
of the Code)....................................... 228
E. Modification of Proration Rules for Property and
Casualty Insurance Companies (sec. 13515 of the Act
and sec. 832(b) of the Code)....................... 230
F. Repeal of Special Estimated Tax Payments (sec.
13516 of the Act and former sec. 847 of the Code).. 231
G. Computation of Life Insurance Tax Reserves (sec.
13517 of the Act and sec. 807 of the Code)......... 233
H. Modification of Rules for Life Insurance Proration
for Purposes of Determining the Dividends Received
Deduction (sec. 13518 of the Act and sec. 812 of
the Code).......................................... 237
I. Capitalization of Certain Policy Acquisition
Expenses (sec. 13519 of the Act and sec. 848 of the
Code).............................................. 240
J. Tax Reporting for Life Settlement Transactions and
Clarification of Tax Basis of Life Insurance
Transactions, and Exception to Transfer for
Valuable Consideration Rules (secs. 13520-13522 of
the Act and secs. 101 and 1016(a) and new sec.
6050Y of the Code)................................. 241
K. Modification of Discounting Rules for Property and
Casualty Insurance Companies (sec. 13523 of the Act
and sec. 846(c) of the Code)....................... 245
SUBPART C--BANKS AND FINANCIAL INSTRUMENTS....................... 247
A. Limitation on Deduction for FDIC Premiums (sec.
13531 of the Act and sec. 162 of the Code)......... 247
B. Repeal of Advance Refunding Bonds (sec. 13532 of
the Act and sec. 149 of the Code).................. 250
SUBPART D--S CORPORATIONS........................................ 251
A. Expansion of Qualifying Beneficiaries of an
Electing Small Business Trust (sec. 13541 of the
Act and sec. 1361(c) of the Code).................. 251
B. Charitable Contribution Deduction for Electing
Small Business Trusts (sec. 13542 of the Act and
sec. 641(c) of the Code)........................... 252
C. Modification of Treatment of S Corporation
Conversions to C Corporations (sec. 13543 of the
Act and secs. 481 and 1371 of the Code)............ 253
PART VII--EMPLOYMENT............................................. 257
SUBPART A--COMPENSATION.......................................... 257
A. Modification of Limitation on Excessive Employee
Remuneration (sec. 13601 of the Act and sec. 162(m)
of the Code)....................................... 257
B. Excise Tax on Excess Tax-Exempt Organization
Executive Compensation (sec. 13602 of the Act and
new sec. 4960 of the Code)......................... 263
C. Treatment of Qualified Equity Grants (sec. 13603 of
the Act and new sec. 83(i) of the Code)............ 266
D. Increase in Excise Tax Rate for Stock Compensation
of Insiders in Expatriated Corporations (sec. 13604
of the Act and sec. 4985 of the Code).............. 276
SUBPART B--RETIREMENT PLANS...................................... 282
A. Repeal of Special Rule Permitting
Recharacterization of Roth Conversions (sec. 13611
of the Act and sec. 408A(d) of the Code)........... 282
B. Modification of Rules Applicable to Length of
Service Award Plans (sec. 13612 of the Act and sec.
457(e) of the Code)................................ 285
C. Extended Rollover Period for Plan Loan Offset
Amounts (sec. 13613 of the Act and sec. 402(c) of
the Code).......................................... 286
PART VIII--EXEMPT ORGANIZATIONS.................................. 288
A. Excise Tax Based on Investment Income of Private
Colleges and Universities (sec. 13701 of the Act
and new sec. 4968 of the Code)..................... 288
B. Unrelated Business Taxable Income Separately
Computed for Each Trade or Business Activity (sec.
13702 of the Act and sec. 512(a) of the Code)...... 291
C. Unrelated Business Taxable Income Increased by
Amount of Certain Fringe Benefit Expenses for which
Deduction is Disallowed (sec. 13703 of the Act and
sec. 512 of the Code).............................. 294
PART IX--OTHER PROVISIONS........................................ 297
SUBPART A--CRAFT BEVERAGE MODERNIZATION AND TAX REFORM........... 297
A. Production Period for Beer, Wine, and Distilled
Spirits (sec. 13801 of the Act and sec. 263A(f) of
the Code).......................................... 297
B. Reduced Rate of Excise Tax on Beer (sec. 13802 of
the Act and sec. 5051(a) of the Code).............. 299
C. Transfer of Beer Between Bonded Facilities (sec.
13803 of the Act and sec. 5414 of the Code)........ 301
D. Reduced Rate of Excise Tax on Certain Wine (sec.
13804 of the Act and sec. 5041(c) of the Code)..... 302
E. Adjustment of Alcohol Content Level for Application
of Excise Tax Rates (sec. 13805 of the Act and sec.
5041(b) of the Code)............................... 304
F. Definition of Mead and Low Alcohol by Volume Wine
(sec. 13806 of the Act and sec. 5041 of the Code).. 306
G. Reduced Rate of Excise Tax on Certain Distilled
Spirits (sec. 13807 of the Act and sec. 5001 of the
Code).............................................. 307
H. Bulk Distilled Spirits (sec. 13808 of the Act and
sec. 5212 of the Code)............................. 308
SUBPART B--MISCELLANEOUS PROVISIONS.............................. 309
A. Modification of Tax Treatment of Alaska Native
Corporations and Settlement Trusts (sec. 13821 of
the Act and secs. 646 and 6039H and new secs. 139G
and 247 of the Code)............................... 309
B. Amounts Paid for Aircraft Management Services (sec.
13822 of the Act and sec. 4621(e) of the Code)..... 313
C. Opportunity Zones (sec. 13823 of the Act and new
secs. 1400Z-1 and 1400Z-2 of the Code)............. 316
SUBTITLE D--INTERNATIONAL TAX PROVISIONS......................... 322
PRIOR LAW........................................................ 322
A. General Overview of International Principles of
Taxation........................................... 322
1. Source and residence principles................ 323
2. Origin and destination principles.............. 323
3. Resolving overlapping or conflicting
jurisdiction to tax............................ 324
4. International principles as applied in the U.S.
tax system..................................... 325
B. Principles Common to Inbound and Outbound Taxation. 326
1. Residence...................................... 326
2. Entity classification.......................... 327
3. Source of income rules......................... 327
4. Intercompany transfers......................... 330
C. U.S. Tax Rules Applicable to Nonresident Aliens and
Foreign Corporations (Inbound)..................... 331
1. Gross-basis taxation of U.S.-source income..... 331
2. Net-basis taxation of U.S.-source income....... 333
3. Special rules.................................. 336
D. U.S. Tax Rules Applicable to Foreign Activities of
U.S. Persons (Outbound)............................ 338
1. In general..................................... 338
2. Anti-deferral regimes.......................... 339
3. Foreign tax credit............................. 343
4. Special rules.................................. 345
PART I--OUTBOUND TRANSACTIONS.................................... 348
SUBPART A--ESTABLISHMENT OF PARTICIPATION EXEMPTION SYSTEM FOR
TAXATION OF FOREIGN INCOME..................................... 348
A. Deduction for Foreign-Source Portion of Dividends
Received by Domestic Corporations from Specified
10-Percent Owned Foreign Corporations (sec. 14101
of the Act and sec. 904(b) and new sec. 245A of the
Code).............................................. 348
B. Special Rules Relating to Sales or Transfers
Involving Specified 10-Percent Owned Foreign
Corporations (sec. 14102 of the Act and secs.
367(a)(3), 961, 964(e), and 1248 and new sec. 91 of
the Code).......................................... 351
C. Treatment of Deferred Foreign Income Upon
Transition to Participation Exemption System of
Taxation and Deemed Repatriation at Two-Tier Rate
(sec. 14103 of the Act and secs. 78, 904, 907, and
965 of the Code)................................... 355
SUBPART B--RULES RELATED TO PASSIVE AND MOBILE INCOME............ 368
A. Current Year Inclusion of Global Intangible Low-
Taxed Income by U.S. Shareholders (sec. 14201 of
the Act and sec. 78 and new secs. 951A and 960(d)
of the Code)....................................... 368
B. Deduction for Foreign-Derived Intangible Income and
Global Intangible Low-Taxed Income (sec. 14202 of
the Act and new sec. 250 of the Code).............. 377
C. Repeal of Treatment of Foreign Base Company Oil
Related Income as Subpart F Income (sec. 14211 of
the Act and sec. 954(a) of the Code)............... 383
D. Repeal of Inclusion Based on Withdrawal of
Previously Excluded Subpart F Income from Qualified
Investment (sec. 14212 of the Act and sec. 955 of
the Code).......................................... 383
E. Modification of Stock Attribution Rules for
Determining Status as a Controlled Foreign
Corporation (sec. 14213 of the Act and secs. 318
and 958 of the Code)............................... 384
F. Modification of Definition of United States
Shareholder (sec. 14214 of the Act and sec. 951 of
the Code).......................................... 385
G. Elimination of Requirement that Corporation Must Be
Controlled for 30 Days Before Subpart F Inclusions
Apply (sec. 14215 of the Act and sec. 951(a)(1) of
the Code).......................................... 386
H. Limitations on Income Shifting Through Intangible
Property Transfers (sec. 14221 of the Act and secs.
367 and 482 of the Code)........................... 386
I. Certain Related Party Amounts Paid or Accrued in
Hybrid Transactions or With Hybrid Entities (sec.
14222 of the Act and sec. 267A of the Code)........ 389
J. Shareholders of Surrogate Foreign Corporations Not
Eligible for Reduced Rate on Dividends (sec. 14223
of the Act and sec. 1(h)(11)(C)(iii) of the Code).. 391
SUBPART C--MODIFICATIONS RELATED TO FOREIGN TAX CREDIT SYSTEM.... 392
A. Repeal of Section 902 Indirect Foreign Tax Credits;
Determination of Section 960 Credit on Current Year
Basis (sec. 14301 of the Act and secs. 902, 960,
and 78 of the Code)................................ 392
B. Separate Foreign Tax Credit Limitation Basket for
Foreign Branch Income (sec. 14302 of the Act and
sec. 904 of the Code).............................. 394
C. Source of Income from Sales of Inventory Determined
Solely on Basis of Production Activities (sec.
14303 of the Act and sec. 863(b) of the Code)...... 396
D. Election to Increase Percentage of Domestic Taxable
Income Offset by Overall Domestic Loss Treated as
Foreign Source (sec. 14304 of the Act and sec.
904(g) of the Code)................................ 397
PART II--INBOUND TRANSACTIONS.................................... 399
A. Base Erosion and Anti-Abuse Tax (sec. 14401 of the
Act and sec. 6038A and new sec. 59A of the Code)... 399
PART III--OTHER PROVISIONS....................................... 410
A. Restriction on Insurance Business Exception to the
Passive Foreign Investment Company Rules (sec.
14501 of the Act and sec. 1297 of the Code)........ 410
B. Repeal of Fair Market Value Method of Interest
Expense Apportionment (sec. 14502 of the Act and
sec. 864 of the Code).............................. 412
APPENDIX: TECHNICAL EXPLANATION OF MODIFICATION OF DEDUCTION FOR
QUALIFIED BUSINESS INCOME OF A COOPERATIVE AND ITS PATRONS
(ENACTED MARCH 23, 2018, PUB. L. NO. 115-141).................. 413
ESTIMATED BUDGET EFFECTS OF TAX LEGISLATION ENACTED IN PUBLIC LAW
115-97......................................................... 433
INTRODUCTION
This document,\1\ prepared by the staff of the Joint
Committee on Taxation in consultation with the staffs of the
House Committee on Ways and Means, the Senate Committee on
Finance, and the Treasury Department's Office of Tax Policy,
provides an explanation of Public Law No. 115-97 (also referred
to as the ``Act'' throughout).\2\ The explanation of the
provisions follows the order of the Act.
---------------------------------------------------------------------------
\1\ This document may be cited as follows: Joint Committee on
Taxation, General Explanation of Public Law No. 115-97 (JCS-1-18),
December 2018.
\2\ Pub. L. No. 115-97, 31 Stat. 2054.
---------------------------------------------------------------------------
For each provision, the document includes a description of
prior law, an explanation of the provision, and the effective
date. The prior law section describes the law in effect
immediately prior to enactment and does not reflect changes to
the law made by the provision or by subsequent legislation. For
contemporaneous legislative history related to the Act, please
see the relevant House Ways and Means Committee report,\3\ the
reconciliation recommendations submitted by the Senate Budget
Committee,\4\ and the Conference Report.\5\ This document
includes citations to some, but not necessarily all,
regulations and other administrative guidance issued as of the
time of publication of the document. These citations are
included strictly as reference tools for readers.
---------------------------------------------------------------------------
\3\ Report of the Committee on Ways and Means on H.R. 1, the ``Tax
Cuts and Jobs Act,'' H. Rep. No. 115-409, November 13, 2017.
\4\ Reconciliation Recommendations Pursuant to H. Con. Res. 71, S.
Prt. 115-20, December 2017.
\5\ Conference Report to Accompany H.R. 1, the ``Tax Cuts and Jobs
Act'', Rep. No. 115-466, December 15, 2017.
---------------------------------------------------------------------------
Section references are to the Internal Revenue Code of
1986, as amended, (the ``Code'') unless otherwise indicated.
TITLE I
SUBTITLE A--INDIVIDUAL TAX REFORM
PART I--TAX RATE REFORM
A. Modification of Rates (sec. 11001 of the Act and sec. 1 of the Code)
Prior Law
In general
To determine regular tax liability, an individual taxpayer
generally must apply the tax rate schedules (or the tax tables)
to his or her taxable income. The rate schedules are broken
into several ranges of income, known as income brackets, and
the marginal tax rate increases as a taxpayer's income
increases.
Tax rate schedules
Separate rate schedules apply based on an individual's
filing status. For 2017, the regular individual income tax rate
schedules are as follows:
TABLE 1.--FEDERAL INDIVIDUAL INCOME TAX RATES FOR 2017 \6\
------------------------------------------------------------------------
If taxable income is: Then income tax equals:
------------------------------------------------------------------------
Single Individuals
Not over $9,325........................ 10% of the taxable income
Over $9,325 but not over $37,950....... $932.50 plus 15% of the excess
over $9,325
Over $37,950 but not over $91,900...... $5,226.25 plus 25% of the
excess over $37,950
Over $91,900 but not over $191,650..... $18,713.75 plus 28% of the
excess over $91,900
Over $191,650 but not over $416,700.... $46,643.75 plus 33% of the
excess over $191,650
Over $416,700 but not over $418,400.... $120,910.25 plus 35% of the
excess over $416,700
Over $418,400.......................... $121,505.25 plus 39.6% of the
excess over $418,400
------------------------------------------------------------------------
Heads of Households
Not over $13,350....................... 10% of the taxable income
Over $13,350 but not over $50,800...... $1,335 plus 15% of the excess
over $13,350
Over $50,800 but not over $131,200..... $6,952.50 plus 25% of the
excess over $50,800
Over $131,200 but not over $212,500.... $27,052.50 plus 28% of the
excess over $131,200
Over $212,500 but not over $416,700.... $49,816.50 plus 33% of the
excess over $212,500
Over $416,700 but not over $444,550.... $117,202.50 plus 35% of the
excess over $416,700
Over $444,550.......................... $126,950 plus 39.6% of the
excess over $444,550
------------------------------------------------------------------------
Married Individuals Filing Joint Returns and Surviving Spouses
Not over $18,650....................... 10% of the taxable income
Over $18,650 but not over $75,900...... $1,865 plus 15% of the excess
over $18,650
Over $75,900 but not over $153,100..... $10,452.50 plus 25% of the
excess over $75,900
Over $153,100 but not over $233,350.... $29,752.50 plus 28% of the
excess over $153,100
Over $233,350 but not over $416,700.... $52,222.50 plus 33% of the
excess over $233,350
Over $416,700 but not over $470,700.... $112,728 plus 35% of the excess
over $416,700
Over $470,700.......................... $131,628 plus 39.6% of the
excess over $470,700
------------------------------------------------------------------------
Married Individuals Filing Separate Returns
Not over $9,325........................ 10% of the taxable income
Over $9,325 but not over $37,950....... $932.50 plus 15% of the excess
over $9,325
Over $37,950 but not over $76,550...... $5,226.25 plus 25% of the
excess over $37,950
Over $76,550 but not over $116,675..... $14,876.25 plus 28% of the
excess over $76,550
Over $116,675 but not over $208,350.... $26,111.25 plus 33% of the
excess over $116,675
Over $208,350 but not over $235,350.... $56,364 plus 35% of the excess
over $208,350
Over $235,350.......................... $65,814 plus 39.6% of the
excess over $235,350
------------------------------------------------------------------------
Estates and Trusts
Not over $2,550........................ 15% of the taxable income
Over $2,550 but not over $6,000........ $382.50 plus 25% of the excess
over $2,550
Over $6,000 but not over $9,150........ $1,245 plus 28% of the excess
over $6,000
Over $9,150 but not over $12,500....... $2,127 plus 33% of the excess
over $9,150
Over $12,500........................... $3,232.50 plus 39.6% of the
excess over $12,500
------------------------------------------------------------------------
Unearned income of children
Special rules (generally referred to as the ``kiddie tax'')
apply to the net unearned income of certain children.\7\
Generally, the kiddie tax applies to a child if: (1) the child
has not reached the age of 19 by the close of the taxable year,
or the child is a full-time student under the age of 24, and
either of the child's parents is alive at such time; (2) the
child's unearned income exceeds. $2,100 (for 2017); and (3) the
child does not file a joint return.\8\ The kiddie tax applies
regardless of whether the child may be claimed as a dependent
by either or both parents. For children above age 17, the
kiddie tax applies only to children whose earned income does
not exceed one-half of the amount of their support.
---------------------------------------------------------------------------
\6\ Rev. Proc. 2016-55, 2016-45 I.R.B. 707, Sec. 3.01.
\7\ Sec. 1(g).
\8\ Sec. 1(g)(2).
---------------------------------------------------------------------------
Under these rules, the net unearned income of a child (for
2017, unearned income over $2,100) is taxed at the parents' tax
rates if the parents' tax rates are higher than the tax rates
of the child.\9\ The remainder of a child's taxable income
(i.e., earned income, plus unearned income up to $2,100 (for
2017), less the child's standard deduction) is taxed at the
child's rates, regardless of whether the kiddie tax applies to
the child. For these purposes, unearned income is income other
than wages, salaries, professional fees, other amounts received
as compensation for personal services actually rendered, and
distributions from qualified disability trusts.\10\ In general,
a child is eligible to use the preferential tax rates for
qualified dividends and capital gains.\11\
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\9\ Special rules apply for determining which parent's rate applies
where a joint return is not filed.
\10\ Sec. 1(g)(4) and sec. 911(d)(2).
\11\ Sec. 1(h).
---------------------------------------------------------------------------
The kiddie tax is calculated by computing the ``allocable
parental tax.'' This involves adding the net unearned income of
the child to the parent's income and then applying the parent's
tax rate. A child's ``net unearned income'' is the child's
unearned income less the sum of (1) the minimum standard
deduction allowed to dependents ($1,050 for 2017 \12\), and (2)
the greater of (a) such minimum standard deduction amount or
(b) the amount of allowable itemized deductions that are
directly connected with the production of the unearned
income.\13\
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\12\ Sec. 3.02 of Rev. Proc. 2016-55, supra.
\13\ Sec. 1(g)(4).
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The allocable parental tax equals the hypothetical increase
in tax to the parent that results from adding the child's net
unearned income to the parent's taxable income.\14\ If the
child has net capital gains or qualified dividends, these items
are allocated to the parent's hypothetical taxable income
according to the ratio of net unearned income to the child's
total unearned income. If a parent has more than one child
subject to the kiddie tax, the net unearned income of all
children is combined, and a single kiddie tax is calculated.
Each child is then allocated a proportionate share of the
hypothetical increase, based upon the child's net unearned
income relative to the aggregate net unearned income of all of
the parent's children subject to the tax.
---------------------------------------------------------------------------
\14\ Sec. 1(g)(3).
---------------------------------------------------------------------------
Generally, a child must file a separate return to report
his or her income.\15\ The parents' tax is not affected by the
child's income, and the total tax due from the child is the
greater of:
---------------------------------------------------------------------------
\15\ Sec. 1(g)(6). See Form 8615, Tax for Certain Children Who Have
Unearned Income.
---------------------------------------------------------------------------
1. The sum of (a) the tax payable by the child on the
child's earned income and unearned income up to $2,100
(for 2017), plus (b) the allocable parental tax on the
child's unearned income, or
2. The tax on the child's income without regard to
the kiddie tax provisions.\16\
---------------------------------------------------------------------------
\16\ Sec. 1(g)(1).
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If a child's gross income is only from interest and
dividends and the amount of the gross income (in 2017) is
greater than $1,050, and less than $10,500, the parents may
elect to report the child's gross income on the parents' return
and the child is treated as having no gross income. A tax at
the rate of 10 percent is imposed on up to $1,050 of the
child's gross income included on the parents' return.
Capital gains rates
In the case of an individual, estate, or trust, adjusted
net capital gain is taxed at rates of 0, 15, and 20 percent.
The amount taxed at a zero rate is the amount that would
otherwise be taxed at a 0-, 10-, or 15-percent rate if the gain
were ordinary income; the amount taxed at a 15-percent rate is
the amount that would otherwise be taxed at a 25-, 28-, 33-, or
35-percent rate if the gain were ordinary income; and the
amount taxed at a 20-percent rate is the amount that would
otherwise be taxed at a 39.6-percent rate if the gain were
ordinary income. The same rates applicable to adjusted net
capital gain under the regular tax apply to the alternative
minimum tax.
The maximum rate on unrecaptured section 1250 gain is 25
percent, and the maximum rate on net collectibles gain and
certain gain from the sale of small business stock is 28
percent.
The ``adjusted net capital gain'' of an individual is the
net capital gain reduced (but not below zero) by the gain (if
any) taxed at maximum rates of 25 and 28 percent. The net
capital gain is reduced by the amount of gain that the
individual treats as investment income for purposes of
determining the investment interest limitation. Net capital
gain is increased by the amount of qualified dividend income.
In addition, a tax is imposed on net investment income in
the case of an individual, estate, or trust. In the case of an
individual, the tax is 3.8 percent of the lesser of net
investment income, which includes gains and dividends, or the
excess of modified adjusted gross income over the threshold
amount. The threshold amount is $250,000 in the case of a joint
return or surviving spouse, $125,000 in the case of a married
individual filing a separate return, and $200,000 in the case
of any other individual.
Explanation of Provision
The provision temporarily replaces the existing rate
structure with a new rate structure.
TABLE 2.--FEDERAL INDIVIDUAL INCOME TAX RATES FOR 2018
------------------------------------------------------------------------
If taxable income is: Then income tax equals:
------------------------------------------------------------------------
Single Individuals
Not over $9,525........................ 10% of the taxable income
Over $9,525 but not over $38,700....... $952.50 plus 12% of the excess
over $9,525
Over $38,700 but not over $82,500...... $4,453.50 plus 22% of the
excess over $38,700
Over $82,500 but not over $157,500..... $14,089.50 plus 24% of the
excess over $82,500
Over $157,500 but not over $200,000.... $32,089.50 plus 32% of the
excess over $157,500
Over $200,000 but not over $500,000.... $45,689.50 plus 35% of the
excess over $200,000
Over $500,000.......................... $150,689.50 plus 37% of the
excess over $500,000
------------------------------------------------------------------------
Heads of Households
Not over $13,600....................... 10% of the taxable income
Over $13,600 but not over $51,800...... $1,360 plus 12% of the excess
over $13,600
Over $51,800 but not over $82,500...... $5,944 plus 22% of the excess
over $51,800
Over $82,500 but not over $157,500..... $12,698 plus 24% of the excess
over $82,500
Over $157,500 but not over $200,000.... $30,698 plus 32% of the excess
over $157,500
Over $200,000 but not over $500,000.... $44,298 plus 35% of the excess
over $200,000
Over $500,000.......................... $149,298 plus 37% of the excess
over $500,000
------------------------------------------------------------------------
Married Individuals Filing Joint Returns and Surviving Spouses
Not over $19,050....................... 10% of the taxable income
Over $19,050 but not over $77,400...... $1,905 plus 12% of the excess
over $19,050
Over $77,400 but not over $165,000..... $8,907 plus 22% of the excess
over $77,400
Over $165,000 but not over $315,000.... $28,179 plus 24% of the excess
over $165,000
Over $315,000 but not over $400,000.... $64,179 plus 32% of the excess
over $315,000
Over $400,000 but not over $600,000.... $91,379 plus 35% of the excess
over $400,000
Over $600,000.......................... $161,379 plus 37% of the excess
over $600,000
------------------------------------------------------------------------
Married Individuals Filing Separate Returns
Not over $9,525........................ 10% of the taxable income
Over $9,525 but not over $38,700....... $952.50 plus 12% of the excess
over $9,525
Over $38,700 but not over $82,500...... $4,453.50 plus 22% of the
excess over $38,700
Over $82,500 but not over $157,500..... $14,089.50 plus 24% of the
excess over $82,500
Over $157,500 but not over $200,000.... $32,089.50 plus 32% of the
excess over $157,500
Over $200,000 but not over $300,000.... $45,689.50 plus 35% of the
excess over $200,000
Over $300,000.......................... $80,689.50 plus 37% of the
excess over $300,000
------------------------------------------------------------------------
Estates and Trusts
Not over $2,550........................ 10% of the taxable income
Over $2,550 but not over $9,150........ $255 plus 24% of the excess
over $2,550
Over $9,150 but not over $12,500....... $1,839 plus 35% of the excess
over $9,150
Over $12,500........................... $3,011.50 plus 37% of the
excess over $12,500
------------------------------------------------------------------------
The provision's rate structure does not apply to taxable
years beginning after December 31, 2025.
Under the provision, the brackets applicable to single
filers, married taxpayers filing separately, and heads of
household are rounded down to the nearest $25, while other
brackets are rounded down to the nearest $50.\17\
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\17\ A technical correction may be needed in order to round the
bracket breakpoints applicable to heads of household down to the
nearest $25. The correction would retain uniformity between those
bracket breakpoints and the bracket breakpoints for single filers,
which are intended to be identical for the 32-, 35-, and 37-percent
brackets.
---------------------------------------------------------------------------
Simplification of tax on unearned income of children
The provision temporarily simplifies the ``kiddie tax'' by
separating the child's tax from the tax situation of the
child's parent or of any sibling. It is intended that the net
unearned income (both ordinary income and net capital gain) of
a child to whom the provision applies is taxed according to the
tax table applicable to a trust, while earned taxable income
\18\ of a child is taxed according to the tax table applicable
to the child (normally the table applicable to unmarried
individuals).\19\
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\18\ For this purpose, earned taxable income means taxable income
reduced (but not below zero) by net unearned income. Sec. 1(j)(4)(D).
\19\ A technical correction may be necessary for the ``kiddie tax''
to fully reflect this intent. As currently enacted, a child to whom the
``kiddie tax'' applies uses modified unmarried and estates and trusts
brackets to calculate tax on income. The brackets are modified so that
the total amount taxed at a given rate does not exceed the amount that
would be taxed at that rate in the case of an individual to whom the
kiddie tax does not apply.
The following examples illustrate how the tax for a child to whom
the ``kiddie tax'' applies may be calculated, by applying the estates
and trusts brackets to net unearned income and applying modified
unmarried brackets to earned taxable income.
Example 1.--Assume a child to whom the ``kiddie tax'' applies is a
dependent of another taxpayer and has interest income of $8,000 and no
other income for taxable year 2018. The child is allowed a standard
deduction of $1,050 (section 63(c)(5)(A) limits the basic standard
deduction in the case of certain dependents to the greater of, for
2018, (i) $1,050 or (ii) the sum of $350 and the child's earned income)
and thus the child's taxable income is $6,950. The child's net unearned
income is $8,000 less $2,100 (section 1(g)(4)(A) provides for a
reduction in the amount of net unearned income by twice the basic
standard deduction, which for 2018 is $1,050, if the child does not
itemize deductions), which is $5,900. The child's earned taxable income
is $1,050 ($6,950 less $5,900).
The tax on the net unearned income of $5,900 may be calculated by
computing the tax on a trust with that amount of taxable income. The
tax is $255 plus 24 percent of the excess over $2,550, which is $1,059
($255 plus $804). Next, the tax brackets for unmarried taxpayers are
reduced by any net unearned income taxed at that same rate. $2,550 of
unearned income is taxed at 10 percent, so the top of the 10-percent
bracket is reduced to $6,975 ($9,525 less $2,550). $3,350 of unearned
income is taxed at 24 percent, so the top of the 24-percent bracket is
reduced to $154,150 ($157,500 less $3,350). No changes are made to the
top of the 12-,
22-, 32-, and 35-percent brackets.
The tax on $1,050 of earned taxable income is subject to this
revised rate schedule. Thus, the tax on this income is $105 ($1,050 at
10 percent). The child's total tax liability is $1,164 ($1,059 plus
$105). Note that in this example, a portion of the child's income is
subject to tax under a rate schedule other than the estates and trusts
rate schedule, notwithstanding that the taxpayer has only unearned
income. This is a result of reducing unearned income by two standard
deductions to arrive at net unearned income.
Example 2.--Assume a child to whom the ``kiddie tax'' applies is a
dependent of another taxpayer and has interest income of $18,000 and
wages of $18,000 for the taxable year 2018. The child is allowed a
standard deduction of $12,000 (which is less than the sum of $18,000
plus $350) and thus the child's taxable income is $24,000. The child's
net unearned income is $15,900 ($18,000 less $2,100). The child's
earned taxable income is $8,100 ($24,000 less $15,900).
The tax on the net unearned income of $15,900 may be calculated by
computing the tax on a trust with that amount of taxable income. The
tax is $3,011.50 plus 37 percent of the excess over $12,500, which is
$4,269.50 ($3,011.50 plus $1,258). Next, the tax brackets for unmarried
taxpayers are reduced by any net unearned income taxed at that same
rate. $2,550 of net unearned income is taxed at 10 percent, so the top
of the 10-percent bracket is reduced to $6,975 ($9,525 less $2,550).
$6,600 of net unearned income is taxed at 24 percent, so the top of the
24-percent bracket is reduced to $150,900 ($157,500 less $6,600).
$3,400 of net unearned income is taxed at 35 percent, so the top of the
35-percent bracket is reduced to $496,600 ($500,000 less $3,400). No
changes are made to the endpoints of the 12-, 22-, or 32-percent
brackets.
The tax on $8,100 of earned taxable income is subject to this
revised rate schedule. Thus the tax on this income is $832.50 ($6,975
at 10 percent and $1,125 at 12 percent). The child's total tax
liability is $5,102 ($4,269.50 plus $832.50).
---------------------------------------------------------------------------
The provision's simplification of the ``kiddie tax'' does
not apply to taxable years beginning after December 31, 2025.
Maximum rates on capital gains and qualified dividends
The provision generally retains the prior-law maximum rates
on net capital gain and qualified dividends. The breakpoints
between the zero- and 15-percent rates (``15-percent
breakpoint'') and the 15- and 20-percent rates (``20-percent
breakpoint'') are based on the same amounts as the breakpoints
under prior law, except the breakpoints are indexed using the
Chained Consumer Price Index in taxable years beginning after
2017. Thus, for 2018, the 15-percent breakpoint is $77,200 for
joint returns and surviving spouses (one-half of this amount
for married taxpayers filing separately), $51,700 for heads of
household, $2,600 for estates and trusts, and $38,600 for other
unmarried individuals. The 20-percent breakpoint is $479,000
for joint returns and surviving spouses (one-half of this
amount for married taxpayers filing separately), $452,400 for
heads of household, $12,700 for estates and trusts, and
$425,800 for other unmarried individuals.
Therefore, in the case of an individual (including an
estate or trust) with adjusted net capital gain, to the extent
the gain would not result in taxable income exceeding the 15-
percent breakpoint, the gain is not taxed. Generally, any
adjusted net capital gain that would result in taxable income
exceeding the 15-percent breakpoint but not exceeding the 20-
percent breakpoint is taxed at 15 percent.\20\ The remaining
adjusted net capital gain is taxed at 20 percent.
---------------------------------------------------------------------------
\20\ In certain circumstances adjusted net capital gain in this
range may be taxed at different rates due to the fact that the 15-
percent breakpoints ($38,600, $51,700, and $77,200 for unmarried, head
of household, and married filing jointly respectively) are $100 or $200
less than the top of the 12-percent ordinary bracket ($38,700, $51,800,
and $77,400 for unmarried, head of household, and married filing
jointly respectively).
---------------------------------------------------------------------------
Unrecaptured section 1250 gain generally is taxed at a
maximum rate of 25 percent, and net collectibles gain and
certain gain from the sale of small business stock is taxed at
a maximum rate of 28 percent.
Paid preparer due diligence requirement for head of household status
The provision directs the Secretary of the Treasury to
promulgate due diligence requirements for paid preparers in
determining eligibility for a taxpayer to file as head of
household. For 2018, a penalty of $520 is imposed for each
failure to meet these requirements.\21\
---------------------------------------------------------------------------
\21\ This amount is indexed for inflation. Sec. 6695(h).
---------------------------------------------------------------------------
The Treasury Department has provided guidance addressing
Federal income tax withholding for 2018.\22\
---------------------------------------------------------------------------
\22\ See Internal Revenue Service, Publication 15, (Circular E),
Employer's Tax Guide 2018, pp. 21-25 and the IRS withholding calculator
available at irs.gov/W4App.
---------------------------------------------------------------------------
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
B. Inflation Adjustments Based On Chained CPI (sec. 11002 of the Act
and sec. 1(f) of the Code)
Prior Law
Many dollar amounts in the Code are adjusted for inflation
to protect taxpayers from the effects of rising prices. Under
prior law, most of the adjustments are based on annual changes
in the level of the Consumer Price Index for All Urban
Consumers (``CPI-U''). The CPI-U is an index that measures
prices paid by typical urban consumers on a broad range of
goods and services, and is developed and published by the
Department of Labor. Generally, the Code adjusts applicable
calendar year amounts for cost of living by using the
percentage by which the price index for the preceding calendar
year exceeds the price index for a base calendar year.\23\ The
IRS annually issues a publication setting forth the inflation-
adjusted amounts for taxable years beginning in the next
calendar year.
---------------------------------------------------------------------------
\23\ Sec. 1(f). Under prior law, the indexing base calendar year is
the year referenced in section 1(f)(3)(B) as modified.
---------------------------------------------------------------------------
Among the inflation-indexed individual income tax amounts
are the following: (1) the regular income tax brackets; (2) the
basic standard deduction; (3) the additional standard deduction
for the aged and blind; (4) the personal exemption amount; (5)
the thresholds for the overall limitation on itemized
deductions and the personal exemption phase-out; (6) the phase-
in and phase-out thresholds of the earned income credit; (7)
IRA contribution limits and deductible amounts; and (8) the
saver's credit.
Explanation of Provision
The provision requires the use of the Chained Consumer
Price Index for All Urban Consumers (``C-CPI-U'') to adjust
amounts currently indexed by the CPI-U. The C-CPI-U, like the
CPI-U, is a measure of the average change over time in prices
paid by urban consumers. It is developed and published by the
Department of Labor, but differs from the CPI-U in accounting
for the ability of individuals to alter their consumption
patterns in response to relative price changes.\24\ Another
notable difference is that, unlike the CPI-U, initially
released C-CPI-U index values are subject to a quarterly
schedule of revisions until finalized in the following
year.\25\
---------------------------------------------------------------------------
\24\ The C-CPI-U accomplishes this by allowing for consumer
substitution between item categories in the collection of consumer
goods and services that make up the index, while the CPI-U only allows
for modest substitution within item categories.
\25\ Bureau of Labor Statistics, CPI Detailed Report--June 2017,
Table 1C.
---------------------------------------------------------------------------
The values of C-CPI-U used for cost-of-living adjustments
for any given calendar are the latest values published as of
the date on which the initial C-CPI-U index is published for
the month of August for the preceding year.\26\ Generally, this
date is in September of such preceding year.
---------------------------------------------------------------------------
\26\ Sec. 1(f)(6)(A).
---------------------------------------------------------------------------
Under the provision, indexed amounts in the Code use the C-
CPI-U and the CPI-U or solely the C-CPI-U in taxable years
beginning after December 31, 2017. In the case of applicable
dollar amounts with a base calendar year \27\ prior to 2016,
the provision indexes these amounts as if the CPI-U applies
through 2017 and the C-CPI-U applies for years thereafter; the
provision does not index these applicable amounts from their
base years using only the C-CPI-U. However, amounts with cost-
of-living adjustment base years of 2016 and later are indexed
using solely the C-CPI-U. Therefore, amounts that are reset for
2018 (and given indexing base years of 2017) \28\ are indexed
by the C-CPI-U in taxable years beginning after December 31,
2018.
---------------------------------------------------------------------------
\27\ Under the provision, the indexing base calendar year is the
year referenced in section 1(f)(3)(A)(ii) as modified.
\28\ For example, the basic standard deduction. Sec. 63(c)(7).
The Treasury Department has published cost-of-living
adjustments for 2018 and 2019.\29\
---------------------------------------------------------------------------
\29\ Rev. Proc. 2018-18, 2018-10 I.R.B. 392 (March 2, 2018); Rev.
Proc. 2018-57, 2018-49 I.R.B. 827 (Nov. 15, 2018).
---------------------------------------------------------------------------
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
PART II--DEDUCTION FOR QUALIFIED BUSINESS INCOME OF PASS-THRU ENTITIES
A. Deduction for Qualified Business Income (sec. 11011 of the Act and
sec. 199A of the Code)
Prior Law
Individual income tax rates
To determine regular tax liability, an individual taxpayer
generally applies the tax rate schedules (or the tax tables) to
his or her taxable income. The rate schedules are broken into
several ranges of income, known as income brackets, and the
taxpayer's marginal tax rate increases as income increases.
Separate rate schedules apply based on an individual's filing
status (i.e., single, head of household, married filing
jointly, or married filing separately). For 2017, the regular
individual income tax rate schedule provides rates of 10, 15,
25, 28, 33, 35, and 39.6 percent.
Partnerships
Partnerships generally are treated for Federal income tax
purposes as passthrough entities not subject to tax at the
entity level.\30\ Items of income (including tax-exempt
income), gain, loss, deduction, and credit of the partnership
are taken into account by the partners in computing their
income tax liability based on the partnership's method of
accounting and regardless of whether the income is distributed
to the partners.\31\ A partner's deduction for partnership
losses is limited to the partner's adjusted basis in its
partnership interest.\32\ Losses not allowed as a result of
that limitation generally are carried forward to the next year.
A partner's adjusted basis in a partnership interest generally
equals (1) the sum of (a) the amount of money and the adjusted
basis of property contributed to the partnership, or the amount
paid for the partnership interest, (b) the partner's
distributive share of partnership income, and (c) the partner's
share of partnership liabilities, reduced by (2) the sum of (a)
the partner's distributive share of losses allowed as a
deduction and certain nondeductible expenditures, and (b) any
partnership distributions to the partner.\33\ Partners
generally may receive distributions of partnership property
without recognition of gain or loss, subject to some
exceptions.\34\
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\30\ Sec. 701.
\31\ Sec. 702(a).
\32\ Sec. 704(d). In addition, passive loss and at-risk limitations
limit the extent to which certain types of income can be offset by a
partner's share of partnership deductions (secs. 469 and 465). These
limitations do not apply to corporate partners, except certain closely-
held corporations.
\33\ Sec. 705.
\34\ Sec. 731. Gain or loss may nevertheless be recognized, for
example, on the distribution of money or marketable securities in
excess of basis, distributions with respect to contributed property, or
in the case of disproportionate distributions (which can result in
ordinary income).
---------------------------------------------------------------------------
Partnerships may allocate items of income, gain, loss,
deduction, and credit among the partners, provided the
allocations have substantial economic effect.\35\ In general,
an allocation has substantial economic effect to the extent the
partner to which the allocation is made receives the economic
benefit or bears the economic burden of such allocation and the
allocation substantially affects the dollar amounts to be
received by the partners from the partnership independent of
tax consequences.\36\
---------------------------------------------------------------------------
\35\ Sec. 704(b)(2).
\36\ Treas. Reg. sec. 1.704-1(b)(2).
---------------------------------------------------------------------------
State laws of every State provide for the establishment of
limited liability companies \37\ (``LLCs''), which are neither
partnerships nor corporations under applicable State law, but
which are generally treated as partnerships for Federal tax
purposes.\38\
---------------------------------------------------------------------------
\37\ The first LLC statute was enacted in Wyoming in 1977. All
States (and the District of Columbia) now have an LLC statute, though
the tax treatment of LLCs for State tax purposes may differ.
\38\ Any domestic nonpublicly traded unincorporated entity with two
or more members generally is treated as a partnership for Federal
income tax purposes, while any single-member domestic unincorporated
entity generally is treated as disregarded for Federal income tax
purposes (i.e., treated as not separate from its owner). Instead of the
applicable default treatment, however, an LLC may elect to be treated
as a corporation for Federal income tax purposes. Treas. Reg. sec.
301.7701-3 (known as the ``check-the-box'' regulations).
---------------------------------------------------------------------------
A publicly traded partnership generally is treated as a
corporation for Federal tax purposes.\39\ For this purpose, a
publicly traded partnership means any partnership if interests
in the partnership are traded on an established securities
market or interests in the partnership are readily tradable on
a secondary market (or the substantial equivalent thereof).\40\
An exception from corporate treatment is provided for certain
publicly traded partnerships, 90 percent or more of whose gross
income comprises one or more types of qualifying income.\41\
---------------------------------------------------------------------------
\39\ Sec. 7704(a).
\40\ Sec. 7704(b).
\41\ Sec. 7704(c)(2). Qualifying income is defined to include
interest, dividends, and gains from the disposition of a capital asset
(or of property described in section 1231(b)) that is held for the
production of income that is qualifying income. Sec. 7704(d).
Qualifying income also includes rents from real property, gains from
the sale or other disposition of real property, and income and gains
from the exploration, development, mining or production, processing,
refining, transportation (including pipelines transporting gas, oil, or
products thereof), or the marketing of any mineral or natural resource
(including fertilizer, geothermal energy, and timber), industrial
source carbon dioxide, or the transportation or storage of certain fuel
mixtures, alternative fuel, alcohol fuel, or biodiesel fuel. It also
includes income and gains from commodities (not described in section
1221(a)(1)) or futures, options, or forward contracts with respect to
such commodities (including foreign currency transactions of a
commodity pool) where a principal activity of the partnership is the
buying and selling of such commodities, futures, options, or forward
contracts. However, the exception for partnerships with qualifying
income does not apply to any partnership resembling a mutual fund
(i.e., that would be described in section 851(a) if it were a domestic
corporation), which includes a corporation registered under the
Investment Company Act of 1940 (Pub. L. No. 76-768 (1940)) as a
management company or unit investment trust. Sec. 7704(c)(3).
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S corporations
An S corporation \42\ generally is not subject to Federal
income tax at the corporate level.\43\ Items of income
(including tax-exempt income), gain, loss, deduction, and
credit of the S corporation are taken into account by the S
corporation shareholders in computing their income tax
liabilities (based on the S corporation's method of accounting
and regardless of whether the income is distributed to the
shareholders). A shareholder's deduction for corporate losses
is limited to the sum of the shareholder's adjusted basis in
its S corporation stock and the indebtedness of the S
corporation to such shareholder. Losses not allowed as a result
of that limitation generally are carried forward to the next
year. A shareholder's adjusted basis in the S corporation stock
generally equals (1) the sum of (a) the shareholder's capital
contributions to the S corporation and (b) the shareholder's
pro rata share of S corporation income, reduced by (2) the sum
of (a) the shareholder's pro rata share of losses allowed as a
deduction and certain nondeductible expenditures, and (b) any S
corporation distributions to the shareholder.\44\
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\42\ An S corporation is so named because its Federal tax treatment
is governed by subchapter S of the Code.
\43\ Secs. 1363 and 1366.
\44\ Sec. 1367. If any amount that would reduce the adjusted basis
of a shareholder's S corporation stock exceeds the amount that would
reduce that basis to zero, the excess is applied to reduce (but not
below zero) the shareholder's basis in any indebtedness of the S
corporation to the shareholder. If, after a reduction in the basis of
such indebtedness, there is an event that would increase the adjusted
basis of the shareholder's S corporation stock, such increase is
instead first applied to restore the reduction in the basis of the
shareholder's indebtedness. Sec. 1367(b)(2).
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In general, an S corporation shareholder is not subject to
tax on corporate distributions unless the distributions exceed
the shareholder's basis in the stock of the corporation.
Electing S corporation status
To be eligible to elect S corporation status, a corporation
may not have more than 100 shareholders and may not have more
than one class of stock.\45\ Only individuals (other than
nonresident aliens), certain tax-exempt organizations, and
certain trusts and estates are permitted shareholders of an S
corporation.
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\45\ Sec. 1361. For this purpose, a husband and wife and all
members of a family are treated as one shareholder. Sec. 1361(c)(1).
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Sole proprietorships
Unlike a C corporation, partnership, or S corporation, a
business conducted as a sole proprietorship is not treated as
an entity distinct from its owner for Federal income tax
purposes.\46\ Rather, the business owner is taxed directly on
business income, and files Schedule C (sole proprietorships
generally), Schedule E (rental real estate and royalties), or
Schedule F (farms) with his or her individual tax return.
Furthermore, transfer of a sole proprietorship is treated as a
transfer of each individual asset of the business. Nonetheless,
a sole proprietorship is treated as an entity separate from its
owner for employment tax purposes,\47\ for certain excise
taxes,\48\ and certain information reporting requirements.\49\
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\46\ A single-member unincorporated entity is disregarded for
Federal income tax purposes, unless its owner elects to be treated as a
C corporation. Treas. Reg. sec. 301.7701-3(b)(1)(ii). Sole
proprietorships often are conducted through legal entities for nontax
reasons. While sole proprietorships generally may have no more than one
owner, a married couple that files a joint return and jointly owns and
operates a business may elect to have that business treated as a sole
proprietorship under section 761(f).
\47\ Treas. Reg. sec. 301.7701-2(c)(2)(iv).
\48\ Treas. Reg. sec. 301.7701-2(c)(2)(v).
\49\ Treas. Reg. sec. 301.7701-2(c)(2)(vi).
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Trade or business
For Federal income tax purposes, a taxpayer conducting
activities giving rise to income or loss must evaluate whether
its activities rise to the level of constituting a trade or
business, and if so, how many trades or businesses the taxpayer
has.
Many areas of Federal income tax law require a taxpayer to
make a threshold determination of whether its activities rise
to the level of constituting a trade or business. For example,
expenses are deductible under section 162 if they are incurred
``in carrying on any trade or business,'' \50\ the passive
activity loss limitation of section 469 can limit losses from
an activity that ``involves the conduct of any trade or
business,'' \51\ and research and experimental expenditures are
eligible for deduction under section 174 if they are paid or
incurred ``in connection with [a] trade or business.'' \52\
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\50\ Sec. 162(a).
\51\ Sec. 469(c)(1)(A). A passive activity generally is one in
which the taxpayer does not materially participate, and additional
rules apply.
\52\ Sec. 174(a). Another example outside the domestic context is
that a foreign corporation may be subject to U.S. corporate income tax
rules if it is engaged in the ``conduct of a trade or business within
the United States.'' These examples are not exhaustive.
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Courts have held that for an activity to rise to the level
of constituting a trade or business, ``the taxpayer must be
involved in the activity with continuity and regularity and . .
. the taxpayer's primary purpose for engaging in the activity
must be for income or profit.'' \53\ In order to meet this
standard, the taxpayer must satisfy two requirements: (1)
regular and continuous conduct of the activity; \54\ and (2) a
primary purpose to earn a profit.\55\ Whether a taxpayer's
activities meet these factors depends on the facts and
circumstances of each case.\56\ While most activities
determined to be trades or businesses are so treated because
the taxpayer offers goods or services to the public, a trade or
business may also include other activities if such activities
are the source of the taxpayer's livelihood.\57\
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\53\ Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).
\54\ This first factor depends on the extent of the taxpayer's
activities. For example, a taxpayer who devoted 60 to 80 hours per week
to gambling on dog races was determined to have engaged in the activity
regularly and continuously such that the gambling activity rose to the
level of constituting a trade or business. See Commissioner v.
Groetzinger, 480 U.S. 23 (1987). As another example, a taxpayer who
executed a total of 372 securities trades in a year, with at least one
trade taking place on 110 days of the year, was determined not to have
engaged in securities trading on a regular or continuous basis. See
Holsinger v. Commissioner, T.C. Memo 2008-191. As a third example, a
married couple who owned two homes, one of which they lived in and
renovated while monitoring the home market with an eye toward potential
sale, and the other of which they rented out but eventually planned to
occupy, were held to have neither engaged in the activity with
sufficient frequency nor possessed the required profit motive necessary
to meet the standard for being engaged in a trade or business. See
Ohana v. Commissioner, T.C. Memo 2014-83.
\55\ This second factor depends on the taxpayer's state of mind.
The taxpayer must have a good faith intention to make a profit from the
activity, and not be engaged in it ``merely for pleasure, exhibition,
or social diversion.'' See Doggett v. Burnet, 65 F.2d 191 (D.C. Cir.
1933), rev'g 23 B.T.A. 744 (1931).
\56\ See, e.g., Higgins v. Commissioner, 61 S. Ct. 475 (1941).
\57\ Commissioner v. Groetzinger, 480 U.S. 23, at 34-35 (1987).
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Once a taxpayer has made the threshold determination that
its activities rise to the level of constituting a trade or
business, the taxpayer must determine whether it is carrying on
a single unified trade or business (involving one or more
activities) or multiple separate trades or businesses. The
determination of whether the taxpayer is conducting one, or
multiple, trades or businesses is relevant to the taxpayer's
choices of methods of accounting used to compute taxable income
(e.g., the cash method or an accrual method, and various
special methods of accounting for certain items).\58\ Under
section 446, a taxpayer with multiple separate trades or
businesses may use different overall methods of accounting (and
different special methods of accounting for an item, if
applicable) to compute taxable income for each trade or
business.\59\ However, a taxpayer with a single unified trade
or business must use the same overall method of accounting for
the activities (and the same special method of accounting, if
applicable) within that trade or business.\60\ A taxpayer
filing its first return may adopt any permissible method of
accounting in connection with each separate trade or
business.\61\
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\58\ Sec. 446(c) and Treas. Reg. sec. 1.446-1(c)(1).
\59\ Sec. 446(d) and Treas. Reg. sec. 1.446-1(d)(1). For example, a
taxpayer may account for a personal service trade or business using the
cash method and may account for a manufacturing business on an accrual
method if such activities constitute separate trades or businesses. For
a discussion of trades or businesses eligible to use the cash method
and an accrual method, including changes to such rules by the Act, see
discussion of section 13102 of the Act (Small Business Accounting
Method Reform).
\60\ For example, a taxpayer with a single trade or business that
includes both manufacturing and service activities generally must
account for such trade or business using an accrual method. See, e.g.,
Thompson Electric, Inc. v. Commissioner, T.C. Memo. 1995-292. For a
discussion of trades or businesses eligible to use the cash method and
an accrual method, including changes to such rules by the Act, see
discussion of section 13102 of the Act (Small Business Accounting
Method Reform).
\61\ Treas. Reg. sec. 1.446-1(e)(1). See also, Rev. Rul. 90-38,
1990-1 C.B. 57 (holding that a taxpayer adopts a method of accounting
(1) when it uses a permissible method of accounting on a single tax
return, or (2) when it uses the same impermissible method of accounting
on two or more consecutive tax returns). Except as otherwise provided,
section 446(e) requires taxpayers to secure the consent of the
Secretary before changing a method of accounting, including any change
in method of accounting attributable to a taxpayer's redetermination of
how many separate trades or businesses it has.
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Treasury regulations provide that activities are not
considered separate and distinct trades or businesses unless
they each keep a complete and separable set of books and
records.\62\ Courts evaluating whether activities are separate
and distinct trades or businesses have looked to factors such
as the existence of common management, use of shared office
space (or lack thereof), use of shared employees (or the lack
thereof), and the nature of each business.\63\ The IRS has
ruled that an entity that is disregarded for Federal income tax
purposes, and thus treated as a separate division of its owner
(e.g., a single-member limited liability company or a qualified
subchapter S subsidiary); may constitute a separate trade or
business under section 446 depending on the taxpayer's facts
and circumstances.\64\
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\62\ Treas. Reg. sec. 1.446-1(d)(2).
\63\ Two cases addressing activities involving chicken farming and
other related activities illustrate the nature of the analysis. First,
in Peterson Produce, Inc. v. United States, 313 F.2d 609 (8th Cir.
1963), aff'g 205 F. Supp. 229 (W.D. Ark. 1962), the court upheld a U.S.
district court determination that the taxpayer's newly-formed chicken
farming division was not separate and distinct from the taxpayer's feed
and hatchery trade or business because the existing business primarily
sold chicks to the new division and the taxpayer did not keep separate
books and records for the two activities. In Burgess Poultry Mkt., Inc.
v. United States, 64-2 USTC 9515 (E.D. Tex. 1964), however, the court
held that the taxpayer's two divisions, one of which raised chicks and
the other of which processed broiler chickens, were separate and
distinct trades or businesses because they kept separate books and
records, had separate employees, and did substantial business with
third parties. See also Rev. Rul. 74-270, 1974-1 C.B. 109 (ruling that
a bank's commercial banking division and trust division were separate
trades or businesses where they had separate books and records,
separate employees, separate office space, and separate management).
\64\ See, e.g., Sections 9.01 and 15.07(4)(b) of Rev. Proc. 2018-1,
2018-1 I.R.B. 1 (and its predecessors). See also CCA 201430013, July
25, 2014.
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Cooperatives and their patrons
Certain corporations are eligible to be treated as
cooperatives and taxed under the special rules of subchapter T
of the Code.\65\ In general, the subchapter T rules apply to
any corporation operating on a cooperative basis (except mutual
savings banks, insurance companies, most tax-exempt
organizations, and certain utilities).
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\65\ Secs. 1381-1388.
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For Federal income tax purposes, a cooperative subject to
the cooperative tax rules of subchapter T generally computes
its income as if it were a taxable corporation, except that, in
determining its taxable income, the cooperative does not take
into account amounts paid for the taxable year as (1) patronage
dividends, to the extent paid in money, qualified written
notices of allocation, or other property (except nonqualified
written notices of allocation) with respect to patronage
occurring during such taxable year, and (2) per-unit retain
allocations, to the extent paid in money, qualified per-unit
retain certificates, or other property (except nonqualified
per-unit retain certificates) with respect to marketing
occurring during such taxable year.\66\
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\66\ Secs. 1382 (determination of taxable income) and 1388
(definitions).
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Patronage dividends are amounts paid to a patron (1) on the
basis of quantity or value of business done with or for such
patron, (2) under an obligation of the cooperative to pay such
amount that existed before the cooperative received the amount
so paid, and (3) which are determined by reference to the net
earnings of the cooperative from business done with or for its
patrons.\67\ Per-unit retain allocations are allocations to a
patron with respect to products marketed for him, the amount of
which is fixed without reference to the net earnings of the
organization pursuant to an agreement between the organization
and the patron.\68\
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\67\ Sec. 1388(a).
\68\ Sec. 1388(f).
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Because a patron of a cooperative that receives patronage
dividends or per-unit retain allocations generally must include
such amounts in gross income,\69\ excluding patronage dividends
and per-unit retain allocations paid by the cooperative from
the cooperative's taxable income in effect allows the
cooperative to be a conduit with respect to profits derived
from transactions with its patrons.
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\69\ Sec. 1385(a)(1) and (3).
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Treatment of taxpayers with domestic production activities income under
section 199 \70\
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\70\ For a discussion of the repeal of section 199, see the
description of section 13305 of the Act (Repeal of Deduction for Income
Attributable to Domestic Production Activities).
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In general
Section 199 provides a deduction from taxable income (or,
in the case of an individual, adjusted gross income \71\) that
is equal to nine percent of the lesser of the taxpayer's
qualified production activities income or taxable income
(determined without regard to the section 199 deduction) for
the taxable year.\72\ The amount of the deduction for a taxable
year is limited to 50 percent of the W-2 wages paid by the
taxpayer and properly allocable to domestic production gross
receipts during the calendar year that ends in such taxable
year.\73\ W-2 wages are the total wages subject to wage
withholding,\74\ elective deferrals,\75\ and deferred
compensation\76\ paid by the taxpayer with respect to
employment of its employees during the calendar year ending
during the taxable year of the taxpayer.\77\ W-2 wages do not
include any amount that is not properly allocable to domestic
production gross receipts as a qualified item of deduction.\78\
In addition, W-2 wages do not include any amount that was not
properly included in a return filed with the Social Security
Administration on or before the 60th day after the due date
(including extensions) for such return.\79\
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\71\ For this purpose, adjusted gross income is determined after
application of sections 86, 135, 137, 219, 221, 222, and 469, and
without regard to the section 199 deduction. Sec. 199(d)(2).
\72\ Sec. 199(a).
\73\ Sec. 199(b).
\74\ Defined in sec. 3401(a).
\75\ Within the meaning of sec. 402(g)(3).
\76\ Deferred compensation includes compensation deferred under
section 457, as well as the amount of any designated Roth contributions
(as defined in section 402A).
\77\ Sec. 199(b). In the case of a taxpayer with a short taxable
year that does not contain a calendar year ending during such short
taxable year, the following amounts are treated as the W-2 wages of the
taxpayer for the short taxable year: (1) wages paid during the short
taxable year to employees of the qualified trade or business; (2)
elective deferrals (within the meaning of section 402(g)(3)) made
during the short taxable year by employees of the qualified trade or
business; and (3) compensation actually deferred under section 457
during the short taxable year with respect to employees of the
qualified trade or business. Amounts that are treated as W-2 wages for
a taxable year are not treated as W-2 wages of any other taxable year.
See Treas. Reg. sec. 1.199-2(b). In addition, in the case of a taxpayer
who is an individual with otherwise qualified production activities
income from sources within the commonwealth of Puerto Rico, if all the
income for the taxable year is taxable under section 1 (income tax
rates for individuals), the determination of W-2 wages with respect to
the taxpayer's trade or business conducted in Puerto Rico is made
without regard to any exclusion under the wage withholding rules (as
provided in section 3401(a)(8)) for remuneration paid for services in
Puerto Rico. See sec. 199(d)(8)(B).
\78\ Sec. 199(b)(2)(B).
\79\ Sec. 199(b)(2)(C).
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In the case of oil related qualified production activities
income, the deduction is reduced by three percent of the least
of the taxpayer's oil related qualified production activities
income, qualified production activities income, or taxable
income (determined without regard to the section 199 deduction)
for the taxable year.\80\ For this purpose, oil related
qualified production activities income for any taxable year is
the portion of qualified production activities income
attributable to the production, refining, processing,
transportation, or distribution of oil, gas, or any primary
product thereof \81\ during the taxable year.
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\80\ Sec. 199(d)(9).
\81\ Within the meaning of sec. 927(a)(2)(C) as in effect before
its repeal.
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In general, qualified production activities income is equal
to domestic production gross receipts reduced by the sum of:
(1) the cost of goods sold that are allocable to those
receipts;\82\ and (2) other expenses, losses, or deductions
which are properly allocable to those receipts.\83\ Domestic
production gross receipts generally are gross receipts of a
taxpayer that are derived from: (1) any sale, exchange, or
other disposition, or any lease, rental, or license, of
qualifying production property \84\ that was manufactured,
produced, grown, or extracted by the taxpayer in whole or in
significant part within the United States; \85\ (2) any sale,
exchange, or other disposition, or any lease, rental, or
license, of any qualified film \86\ produced by the taxpayer;
(3) any sale, exchange, or other disposition, or any lease,
rental, or license, of electricity, natural gas, or potable
water produced by the taxpayer in the United States; (4)
construction of real property performed in the United States by
a taxpayer in the ordinary course of a construction trade or
business; or (5) engineering or architectural services
performed in the United States by the taxpayer for the
construction of real property in the United States.\87\
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\82\ For this purpose, any item or service brought into the United
States is treated as acquired by purchase, and its cost is treated as
not less than its value immediately after it entered the United States.
A similar rule applies in determining the adjusted basis of leased or
rented property where the lease or rental gives rise to domestic
production gross receipts. In addition, for any property exported by
the taxpayer for further manufacture, the increase in cost or adjusted
basis may not exceed the difference between the value of the property
when exported and the value of the property when brought back into the
United States after the further manufacture. See sec. 199(c)(3)(A) and
(B).
\83\ Sec. 199(c)(1). In computing qualified production activities
income, the domestic production activities deduction itself is not an
allocable deduction. Sec. 199(c)(1)(B)(ii). See also Treas. Reg. secs.
1.199-1 through -9 for rules regarding the proper allocation of items
of income, deduction, expense, and loss for purposes of determining
qualified production activities income.
\84\ Qualifying production property generally includes any tangible
personal property, computer software, and sound recordings. Sec.
199(c)(5).
\85\ When used in the Code in a geographical sense, the term
``United States'' generally includes only the States and the District
of Columbia. Sec. 7701(a)(9). A special rule for determining domestic
production gross receipts, however, provides that for taxable years
beginning after December 31, 2005, and before January 1, 2017, in the
case of any taxpayer with gross receipts from sources within the
Commonwealth of Puerto Rico, the term ``United States'' includes the
Commonwealth of Puerto Rico, but only if all of the taxpayer's Puerto
Rico-sourced gross receipts are taxable under the Federal income tax
for individuals or corporations for such taxable year. See sections
199(d)(8)(A) and (C). Such special rule was extended to taxable years
beginning before January 1, 2018, by the Bipartisan Budget Act of 2018,
Pub. L. No. 115-123, February 9, 2018. In computing the 50-percent wage
limitation, the taxpayer is permitted to take into account wages paid
to bona fide residents of Puerto Rico for services performed in Puerto
Rico. Sec. 199(d)(8)(B).
\86\ Qualified film includes any motion picture film or videotape
(including live or delayed television programming, but not including
certain sexually explicit productions) if 50 percent or more of the
total compensation relating to the production of the film (including
compensation in the form of residuals and participations) constitutes
compensation for services performed in the United States by actors,
production personnel, directors, and producers. Sec. 199(c)(6).
\87\ Sec. 199(c)(4)(A).
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Domestic production gross receipts do not include any gross
receipts of the taxpayer derived from property leased,
licensed, or rented by the taxpayer for use by any related
person.\88\ In addition, domestic production gross receipts do
not include gross receipts which are derived from: (1) the sale
of food and beverages prepared by the taxpayer at a retail
establishment; (2) the transmission or distribution of
electricity, natural gas, or potable water; or (3) the lease,
rental, license, sale, exchange, or other disposition of
land.\89\
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\88\ Sec. 199(c)(7). For this purpose, a person is treated as
related to another person if such persons are treated as a single
employer under subsection (a) or (b) of section 52 or subsection (m) or
(o) of section 414, except that determinations under subsections (a)
and (b) of section 52 are made without regard to section 1563(b).
\89\ Sec. 199(c)(4)(B).
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Special rules
All members of an expanded affiliated group \90\ are
treated as a single corporation and the deduction is allocated
among the members of the expanded affiliated group in
proportion to each member's respective amount, if any, of
qualified production activities income. In addition, for
purposes of determining domestic production gross receipts, if
all of the interests in the capital and profits of a
partnership are owned by members of a single expanded
affiliated group at all times during the taxable year of such
partnership, the partnership and all members of such group are
treated as a single taxpayer during such period.\91\
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\90\ For this purpose, an expanded affiliated group is an
affiliated group as defined in section 1504(a) determined (i) by
substituting ``more than 50 percent'' for ``more than 80 percent'' each
place it appears, and (ii) without regard to paragraphs (2) and (4) of
section 1504(b). See sec. 199(d)(4)(B).
\91\ Sec. 199(d)(4)(D).
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For a tax-exempt taxpayer subject to tax on its unrelated
business taxable income by section 511, the section 199
deduction is determined by substituting unrelated business
taxable income for taxable income where applicable.\92\
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\92\ Sec. 199(d)(7).
---------------------------------------------------------------------------
The section 199 deduction is determined by only taking into
account items that are attributable to the actual conduct of a
trade or business.\93\
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\93\ Sec. 199(d)(5).
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Partnerships and S corporations
With regard to the domestic production activities income of
a partnership or S corporation, the deduction is determined at
the partner or shareholder level. Each partner or shareholder
generally takes into account such person's allocable share of
the components of the calculation (including domestic
production gross receipts; the cost of goods sold allocable to
such receipts; and other expenses, losses, or deductions
allocable to such receipts) from the partnership or S
corporation, as well as any items relating to the partner or
shareholder's own qualified production activities income, if
any.\94\
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\94\ Sec. 199(d)(1)(A).
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In applying the W-2 wage limitation, each partner or
shareholder is treated as having been allocated wages from the
partnership or S corporation in an amount that is equal to such
person's allocable share of W-2 wages.\95\
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\95\ In the case of a trust or estate, the components of the
calculation are apportioned between (and among) the beneficiaries and
the fiduciary. See sec. 199(d)(1)(B) and Treas. Reg. sec. 1.199-5(d)
and (e).
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Specified agricultural and horticultural cooperatives
In general.--With regard to specified agricultural and
horticultural cooperatives, section 199 provides the same
treatment of qualified production activities income derived
from agricultural or horticultural products that are
manufactured, produced, grown, or extracted by such
cooperatives \96\ as it provides for qualified production
activities income of other taxpayers, including non-specified
cooperatives (i.e., the cooperative may claim a deduction for
qualified production activities income). The cooperative is
treated as having manufactured, produced, grown, or extracted
in whole or significant part any qualifying production property
marketed by the cooperative if such items were manufactured,
produced, grown, or extracted in whole or significant part by
the cooperative's patrons.\97\ In addition, the cooperative is
treated as having manufactured, produced, grown, or extracted
agricultural products with respect to which the cooperative
performs storage, handling, or other processing activities
(other than transportation activities) within the United States
related to the sale, exchange, or other disposition of such
products, provided the products are consumed in connection with
or incorporated into the manufacturing, production, growth, or
extraction of qualifying production property (whether or not by
the cooperative).\98\ Finally, for purposes of determining the
cooperative's section 199 deduction, qualified production
activities income and taxable income are determined without
regard to any deduction allowable under section 1382(b) and (c)
(relating to patronage dividends, per-unit retain allocations,
and nonpatronage distributions) for the taxable year.\99\
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\96\ For this purpose, agricultural or horticultural products also
include fertilizer, diesel fuel, and other supplies used in
agricultural or horticultural production that are manufactured,
produced, grown, or extracted by the cooperative. See Treas. Reg. sec.
1.199-6(f).
\97\ Sec. 199(d)(3)(D) and Treas. Reg. sec. 1.199-6(d).
\98\ See Treas. Reg. sec. 1.199-3(e)(1).
\99\ See sec. 199(d)(3)(C) and Treas. Reg. sec. 1.199-6(c).
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Definition of a specified agricultural or horticultural
cooperative.--A specified agricultural or horticultural
cooperative is an organization to which part I of subchapter T
applies that is engaged in (a) the manufacturing, production,
growth, or extraction in whole or significant part of any
agricultural or horticultural product, or (b) the marketing of
agricultural or horticultural products that the cooperative's
patrons have so manufactured, produced, grown, or
extracted.\100\
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\100\ Sec. 199(d)(3)(F).
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Allocation of the cooperative's deduction to patrons.--Any
patron that receives a qualified payment from a specified
agricultural or horticultural cooperative is allowed as a
deduction for the taxable year in which such payment is
received an amount equal to the portion of the cooperative's
deduction for qualified production activities income that is
(a) allowed with respect to the portion of the qualified
production activities income to which such payment is
attributable, and (b) identified by the cooperative in a
written notice mailed to the patron during the payment period
described in section 1382(d).\101\ A qualified payment is any
amount that (a) is described in paragraph (1) or (3) of section
1385(a) (i.e., patronage dividends and per-unit retain
allocations), (b) is received by an eligible patron from a
specified agricultural or horticultural cooperative, and (c) is
attributable to qualified production activities income with
respect to which a deduction is allowed to such
cooperative.\102\
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\101\ Sec. 199(d)(3)(A) and Treas. Reg. sec. 1.199-6(a). The
written notice must be mailed by the cooperative to patrons no later
than the 15th day of the ninth month following the close of the taxable
year. The cooperative must report the amount of the patron's section
199 deduction on Form 1099-PATR, ``Taxable Distributions Received From
Cooperatives,'' issued to the patron. Treas. Reg. sec. 1.199-6(g).
\102\ Sec. 199(d)(3)(E). For this purpose, patronage dividends and
per-unit retain allocations include any advances on patronage and per-
unit retains paid in money during the taxable year. Treas. Reg. sec.
1.199-6(e).
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The cooperative cannot reduce its income under section 1382
for any deduction allowable to its patrons under this rule
(i.e., the cooperative must reduce its deductions allowed for
certain payments to its patrons in an amount equal to the
section 199 deduction allocated to its patrons).\103\
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\103\ Sec. 199(d)(3)(B) and Treas. Reg. sec. 1.199-6(b).
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Explanation of Provision
In general
The provision reflects Congress's belief that a reduction
in the corporate income tax rate does not completely address
the Federal income tax burden on businesses. While the
corporate tax is a tax on capital income, the tax on income
from noncorporate businesses may fall on both labor income and
capital income. Treating corporate and noncorporate business
income more similarly to each other under the Federal income
tax requires distinguishing labor income from capital income in
a noncorporate business.
Taxpayers with qualified business income
For taxable years beginning after December 31, 2017, and
before January 1, 2026, an individual taxpayer generally may
deduct 20 percent of qualified business income with respect to
a partnership, S corporation, or sole proprietorship, as well
as 20 percent of aggregate qualified REIT dividends, qualified
cooperative dividends,\104\ and qualified publicly traded
partnership income.\105\ Eligible taxpayers also generally
include fiduciaries and beneficiaries of trusts and estates
with qualified business income. Special rules apply to
specified agricultural or horticultural cooperatives. A
limitation based on W-2 wages, or W-2 wages and capital
investment (as applicable), phases in above a threshold amount
of taxable income.\106\ A disallowance of the deduction on
income of specified service trades or businesses also phases in
above the same threshold amount of taxable income.
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\104\ The treatment of income relating to specified agricultural
and horticultural cooperatives (both the cooperative itself and
payments received by patrons from the cooperative) under section 199A
(as originally enacted December 22, 2017) was modified by the
Consolidated Appropriations Act, 2018, Pub. L. No. 115-141, enacted
March 23, 2018, effective as if included in section 11011 of Pub. L.
No. 115-97. The description of the modification was originally
published as Joint Committee on Taxation, Technical Explanation of the
Revenue Provisions of the House Amendment to the Senate Amendment to
H.R. 1625 (Rules Committee Print 115-66) (JCX-6-18), March 22, 2018,
pp. 5-27, which is reproduced in the Appendix.
\105\ Sec. 199A.
\106\ For purposes of the provision, taxable income is computed
without regard to the 20-percent deduction. Sec. 199A(e)(1).
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Qualified business income
Qualified business income is separately determined for each
qualified trade or business of the taxpayer. For any taxable
year, qualified business income (or qualified business loss
\107\) means the net amount of qualified items of income, gain,
deduction, and loss with respect to the qualified trade or
business of the taxpayer. Qualified items of income or
deduction \108\ are taken into account to determine qualified
business income only to the extent they are included in taxable
income for the year under the methods of accounting of the
qualified trade or business.\109\ For example, in a taxable
year, if a qualified trade or business has $100,000 of ordinary
income from inventory sales and makes an expenditure of $25,000
that is required to be capitalized and amortized over five
years under applicable Federal income tax rules, the qualified
business income is $100,000 minus $5,000 (current-year ordinary
amortization deduction), or $95,000. The qualified business
income is not reduced by the entire amount of the capital
expenditure, but rather only by the amount allowed as a
deduction in determining taxable income for the year under the
qualified trade or business's method of accounting.
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\107\ A qualified business loss from a qualified trade or business
may not be combined with or netted against qualified business income
from other qualified trades or businesses prior to applying the W-2
wage limit or W-2 wage and capital limit, described below.
Specifically, section 199A(b)(2) applies the W-2 wage limit or W-2 wage
and capital limit to each respective qualified trade or business prior
to the combination of the deductible amounts from each qualified trade
or business in section 199A(b)(1)(A). See secs. 199A(b)(1)(A) and
(b)(2). Examples below illustrate these rules.
\108\ Business expenses deductible from gross income of a business
generally only include the ordinary and necessary expenditures directly
connected with or pertaining to such business. See Treas. Reg. sec.
1.162-1(a).
\109\ See, e.g., secs. 162, 166, 167, 168, 197, 263, 263A, and
subchapter E of Chapter 1 (secs. 441-483).
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Qualified items of gain or loss are taken into account to
determine qualified business income or qualified business loss
only to the extent included or allowed in the determination of
taxable income for the year. \110\ For example, assume a
qualified trade or business has a passive loss that is not
allowable by reason of section 469 for taxable year 2017 in the
amount of $50,000, and that the loss is attributable to a
qualified trade or business. Assume further that $20,000 of the
loss is allowed for the taxable year 2018. The $20,000 loss
allowed in 2018 is taken into account in determining the
taxpayer's qualified business income from the qualified trade
or business in 2018.
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\110\ Generally, net operating loss carryovers and carrybacks
determined under section 172 are not qualified items of deduction or
loss with respect to a trade or business. However, a carryover may be
treated as such a qualified item to the extent that any portion of a
net operating loss carryover or carryback is attributable to a loss
that was not allowed in the prior year in which it was incurred (e.g.,
an excess business loss that was not allowed under section 461(l), as
enacted by the Act). Consistent with this, the loss that was not
allowed in the prior year is included in qualified business income in
the taxable year in which the net operating loss carryover or carryback
of which it is a part is deducted. For a discussion of the excess
business loss rules enacted by the Act, see the description of section
11012 of the Act (Limitation on Losses for Taxpayers Other Than
Corporations).
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Domestic business
Items are treated as qualified items of income, gain,
deduction, and loss only to the extent they are effectively
connected with the conduct of a trade or business within the
United States.\111\ In the case of an individual with qualified
business income from sources within the Commonwealth of Puerto
Rico, if all such income for the taxable year is taxable under
section 1 (income tax rates for individuals), then the term
``United States'' is considered to include the Commonwealth of
Puerto Rico for purposes of determining the individual's
qualified business income.\112\
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\111\ For this purpose, section 864(c) is applied by substituting
``qualified trade or business (within the meaning of section 199A)''
for ``nonresident alien individual or a foreign corporation'' or for
``foreign corporation,'' each place they appear. Sec. 199A(c)(3)(A). A
clerical correction may be needed to correct statutory references with
respect to this substitution.
\112\ Sec. 199A(f)(1)(C).
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Reasonable compensation and guaranteed payments
Qualified business income of the taxpayer does not include
any amount paid by an S corporation that is treated as
reasonable compensation of the taxpayer.\113\ Similarly,
qualified business income does not include any guaranteed
payment for services rendered with respect to the trade or
business,\114\ and, to the extent provided in regulations, does
not include any amount paid or incurred by a partnership to a
partner, acting other than in his or her capacity as a partner,
for services.\115\
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\113\ Sec. 199A(c)(4).
\114\ Described in sec. 707(c).
\115\ Described in sec. 707(a).
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Treatment of certain investment items
Certain items are not taken into account as qualified items
of income, gain, deduction, or loss.\116\ Specifically,
qualified items of income, gain, deduction, or loss do not
include (1) any item taken into account in determining net
capital gain or net capital loss, (2) dividends, income
equivalent to a dividend, or payments in lieu of dividends, (3)
interest income other than that which is properly allocable to
a trade or business, (4) the excess of gain over loss from
commodities transactions other than those entered into (i) in
the normal course of the trade or business or (ii) with respect
to stock in trade or property held primarily for sale to
customers in the ordinary course of the trade or business,
property used in the trade or business, or supplies regularly
used or consumed in the trade or business, (5) the excess of
foreign currency gains over foreign currency losses from
section 988 transactions other than transactions directly
related to the business needs of the business activity, (6) net
income from notional principal contracts other than clearly
identified hedging transactions that are treated as ordinary
(i.e., not treated as capital assets), and (7) any amount
received from an annuity that is not received in connection
with the trade or business. Qualified items also do not include
any item of deduction or loss properly allocable to any of the
preceding items.
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\116\ See sec. 199A(c)(3)(B).
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Qualified business loss carryover
If the net amount of qualified business income from all
qualified trades or businesses during the taxable year is a
loss, the qualified business loss is carried over for purposes
of calculating the deduction under section 199A and in the next
taxable year is treated as a loss from a qualified trade or
business.\117\ The qualified business loss carryover continues
to carry forward, reduced by any qualified business income in
subsequent years, until the taxpayer has a taxable year with
net qualified business income. In the first succeeding taxable
year in which the taxpayer has net qualified business income
from all qualified trades or businesses, the taxpayer takes the
qualified business loss carryover under section 199A(c)(2) into
account in calculating the sum of the deductible amounts for
its trades or businesses under section 199A(b)(1)(A).
Specifically, the sum of the deductible amounts for its
qualified trades or businesses for the taxable year is reduced,
but not below zero,\118\ by 20 percent of any qualified
business loss carryover under section 199A(c)(2) when
determining the combined qualified business income amount for
that subsequent year.
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\117\ Sec. 199A(c)(2). Like a current year qualified business loss,
a qualified business loss carryover is not associated with a particular
qualified trade or business of the taxpayer. Like a qualified business
loss, a qualified business loss carryover may not be aggregated with or
netted against qualified business income in a subsequent year prior to
applying the W-2 wage limit or W-2 wage and capital limit, described
below, to each qualified trade or business. See below for examples
illustrating the application of the W-2 wage limit or W-2 wage and
capital limit in taxable years in which there is a qualified business
loss carryover.
\118\ A technical correction may be needed to carry out this
intent.
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For example, in year one, Taxpayer has qualified business
income of $20,000 from qualified business A and a qualified
business loss of $50,000 from qualified business B. In year
two, Taxpayer has qualified business income of $20,000 from
qualified business A and qualified business income of $50,000
from qualified business B. (Neither business is subject to the
W-2 wage, or W-2 wage and capital, limitations described
below.) Under section 199A(c)(2), Taxpayer's $30,000 net
qualified business loss from year one carries forward and is
treated as a $30,000 loss from a qualified trade or business in
year 2. To determine the deduction for year two, Taxpayer
combines 20 percent of the qualified business income of
businesses A and B in year 2 with 20 percent of the $30,000
loss carryover from year 1 for a total deduction of
$8,000.\119\
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\119\ ($70,000 * 20 percent)-($30,000 * 20 percent) = $14,000 -
$6,000 = $8,000. This simple example is intended to illustrate the
operation of this rule alone. For more comprehensive examples showing
interaction among various rules of the provision, see the additional
examples below, in particular, example 3.
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Qualified trade or business \120\
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\120\ The provision does not alter the meaning of the term trade or
business, which retains its ordinary meaning for Federal income tax
purposes. See prior law, above, for a description of how to determine
under prior and present law whether an activity rises to the level of a
trade or business, and whether trades or businesses are treated as
separate and distinct from each other for Federal income tax purposes.
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A qualified trade or business means any trade or business
other than a specified service trade or business and other than
the trade or business of performing services as an
employee.\121\
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\121\ Sec. 199A(d)(1).
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An activity that is treated as a trade or business for all
relevant Federal income tax purposes (and that keeps a complete
and separable set of books and records) may be treated as a
qualified trade or business. For example, assume that an
individual owns a rental building in which the ground floor
space is rented to three unrelated commercial establishments (a
coffee shop, a drycleaner, and a newsstand) and the upper
floors hold apartments rented to residential tenants. For
Federal tax purposes, the individual accounts for the rental
activities with respect to the entire building using a single
set of books and records. Assume further that the individual
materially participates in the rental activity, cost recovery
deductions under section 168 are allowable with respect to the
building, and deductions for expenses with respect to operating
and maintaining the building are allowable under section 162.
Because a complete and separable set of books and records is
kept with respect to the entire building (including the both
the commercial and residential rentals), and because deductions
under section 162 are allowable, the real estate rental trade
or business is a qualified trade or business for purposes of
section 199A.
Whether one or more trade or business activities or rental
activities may be treated as a single activity for purposes of
section 469 \122\ is not determinative of a separate and
distinct trade or business for purposes of section 199A.
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\122\ Sec. 469(c) and Treas. Reg. sec. 1.469-4.
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Specified service trade or business
The provision identifies some service businesses that
generally give rise to income from labor services, that is,
labor income, and excludes those businesses from the provision
(subject to a phase-in). A specified service trade or business
means any trade or business involving the performance of
services in the fields of health,\123\ law, accounting,
actuarial science, performing arts,\124\ consulting,\125\
athletics, financial services, brokerage services, or any trade
or business where the principal asset of such trade or business
is the reputation or skill of one or more of its employees or
owners, or which involves the performance of services that
consist of investing and investment management, trading, or
dealing in securities, partnership interests, or
commodities.\126\ For example, a trade or business in which the
taxpayer works as an independent contractor for various
unrelated businesses, where the business generally holds
minimal tangible and intangible property, is a specified
service trade or business if the principal asset of such trade
or business is the reputation or skill of its owner.
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\123\ A similar list of service trades or business is provided in
section 448(d)(2)(A) and Treas. Reg. sec. 1.448-1T(e)(4)(i). For
purposes of section 448, Treasury regulations provide that the
performance of services in the field of health means the provision of
medical services by physicians, nurses, dentists, and other similar
healthcare professionals. The performance of services in the field of
health does not include the provision of services not directly related
to a medical field, even though the services may purportedly relate to
the health of the service recipient. For example, the performance of
services in the field of health does not include the operation of
health clubs or health spas that provide physical exercise or
conditioning to their customers. See Treas. Reg. sec. 1.448-
1T(e)(4)(ii).
\124\ For purposes of the similar list of services in section 448,
Treasury regulations provide that the performance of services in the
field of the performing arts means the provision of services by actors,
actresses, singers, musicians, entertainers, and similar artists in
their capacity as such. The performance of services in the field of the
performing arts does not include the provision of services by persons
who themselves are not performing artists (e.g., persons who may manage
or promote such artists, and other persons in a trade or business that
relates to the performing arts). Similarly, the performance of services
in the field of the performing arts does not include the provision of
services by persons who broadcast or otherwise disseminate the
performance of such artists to members of the public (e.g., employees
of a radio station that broadcasts the performances of musicians and
singers). See Treas. Reg. sec. 1.448-1T(e)(4)(iii).
\125\ For purposes of the similar list of services in section 448,
Treasury regulations provide that the performance of services in the
field of consulting means the provision of advice and counsel. The
performance of services in the field of consulting does not include the
performance of services other than advice and counsel, such as sales or
brokerage services, or economically similar services. For purposes of
the preceding sentence, the determination of whether a person's
services are sales or brokerage services, or economically similar
services, shall be based on all the facts and circumstances of that
person's business. Such facts and circumstances include, for example,
the manner in which the taxpayer is compensated for the services
provided (e.g., whether the compensation for the services is contingent
upon the consummation of the transaction that the services were
intended to effect). See Treas. Reg. sec. 1.448-1T(e)(4)(iv).
\126\ Sec. 199A(d)(2). For this purpose a security and a commodity
have the meanings provided in the rules for the mark to market
accounting method for dealers in securities. See secs. 475(c)(2) and
(e)(2).
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A specified service trade or business involving the
performance of services that consist of investing and
investment management, trading, or dealing is intended to
include any trade or business primarily engaged in providing
financial markets services (i.e., investing, investment
management, trading, or dealing services with respect to
financial instruments) to customers, as well as any trade or
business that primarily involves investing and managing its own
invested capital. For example, a trade or business engaged in
providing portfolio management services to institutional and
individual customers is a specified service trade or business.
However, a trade or business primarily engaged in the purchase
and sale of a physical commodity (so that it might be viewed as
engaged in trading or dealing in commodities), and that
regularly takes physical possession of the commodity in the
ordinary course of its trade or business at a location or
facility operated by the business, is not a specified service
trade or business because its trade or business does not
involve the performance of financial markets services.
Phase-in of specified service trade or business limitation
above threshold amount
The exclusion from the definition of a qualified trade or
business for specified service trades or businesses phases in
for a taxpayer with taxable income \127\ in excess of a
threshold amount. The threshold amount is $157,500 ($315,000 in
the case of a joint return) (together, the ``threshold
amount''), adjusted for inflation in taxable years beginning
after 2018.\128\ The exclusion from the definition of a
qualified trade or business for specified service trades or
businesses is fully phased in for a taxpayer with taxable
income in excess of the threshold amount plus $50,000 ($100,000
in the case of a joint return).\129\ Thus, the range over which
the phase-in of the specified service trade or business
limitation \130\ applies is taxable income of $157,500 to
$207,500 ($315,000 to $415,000 in the case of a joint return).
A taxpayer whose taxable income exceeds the top of that range
is not entitled to any deduction under section 199A with
respect to a specified service trade or business.
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\127\ For this purpose, taxable income is determined without regard
to the section 199A deduction.
\128\ Sec. 199A(e)(2).
\129\ See sec. 199A(d)(3).
\130\ The limitation based on W-2 wages, or W-2 wages and capital,
described below, is also phased in above the threshold amount.
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For a taxpayer with taxable income within the phase-in
range, the computation of qualified business income with
respect to a specified service trade or business takes into
account only the applicable percentage of qualified items of
income, gain, deduction, or loss, and of allocable W-2 wages,
or of W-2 wages and capital. The applicable percentage with
respect to any taxable year is 100 percent reduced (but not
below zero) by the percentage equal to the ratio that the
excess of the taxable income of the taxpayer for the taxable
year over the threshold amount bears to $50,000 ($100,000 in
the case of a joint return).
Tentative deductible amount for a qualified trade or business
Taxpayers with taxable income below threshold amount
For a taxpayer with taxable income at or below the
threshold amount, the deductible amount for each qualified
trade or business is equal to 20 percent of the qualified
business income with respect to the trade or business.\131\
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\131\ Sec. 199A(b)(3).
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Limitation based on W-2 wages, or W-2 wages and capital
For a taxpayer with taxable income above the threshold
amount, the taxpayer is allowed a deductible amount for each
qualified trade or business \132\ equal to the lesser of (1) 20
percent of the qualified business income with respect to such
trade or business, or (2) the greater of (a) 50 percent of the
W-2 wages paid with respect to the qualified trade or business,
or (b) the sum of 25 percent of the W-2 wages paid with respect
to the qualified trade or business plus 2.5 percent of the
unadjusted basis, immediately after acquisition, of all
qualified property of the qualified trade or business.\133\ The
threshold amount is $157,500 ($315,000 in the case of a joint
return), adjusted for inflation in taxable years beginning
after 2018.\134\
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\132\ A qualified trade or business does not include a specified
service trade or business (with a phase-in above the threshold amount)
and does not include the trade or business of performing services as an
employee, as described above.
\133\ Sec. 199A(b)(2). The W-2 wage, or W-2 wage and capital,
limitation applies to a qualified trade or business regardless of
whether the business has qualified business income or qualified
business loss for the current taxable year. For examples illustrating
the interaction among various rules of the provision, see the
additional examples below.
\134\ Sec. 199A(e)(2). A phase-in for a taxpayer with taxable
income above the threshold amount also applies with respect to the
exclusion from the definition of a qualified trade or business in the
case of a specified service trade or business (as described above).
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Phase-in of limitation based on W-2 wages, or W-2 wages and
capital
The W-2 wage, or W-2 wage and capital, limitation phases in
for a taxpayer with taxable income in excess of the threshold
amount.\135\ The limitation applies fully for a taxpayer with
taxable income in excess of the threshold amount plus $50,000
($100,000 in the case of a joint return).
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\135\ Sec. 199A(b)(3)(B). For this purpose, taxable income is
determined without regard to the section 199A deduction.
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Meaning of W-2 wages and qualified property
W-2 wages are the total wages subject to wage
withholding,\136\ elective deferrals,\137\ and deferred
compensation \138\ paid by the qualified trade or business with
respect to employment of its employees during the calendar year
ending during the taxable year of the taxpayer.\139\ In the
case of a taxpayer who is an individual with otherwise
qualified business income from sources within the Commonwealth
of Puerto Rico, if all the income for the taxable year is
taxable under section 1 (income tax rates for individuals), the
determination of W-2 wages with respect to the taxpayer's
qualified trade or business conducted in Puerto Rico is made
without regard to any exclusion under the wage withholding
rules \140\ for remuneration paid for services in Puerto Rico.
W-2 wages do not include any amount that is not properly
allocable to qualified business income as a qualified item of
deduction.\141\ In addition, W-2 wages do not include any
amount that was not properly included in a return filed with
the Social Security Administration on or before the
60th day after the due date (including extensions)
for the return.\142\
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\136\ Defined in sec. 3401(a).
\137\ Within the meaning of sec. 402(g)(3).
\138\ Deferred compensation includes compensation deferred under
section 457, as well as the amount of any designated Roth contributions
(as defined in section 402A).
\139\ Sec. 199A(b)(4). In the case of a taxpayer with a short
taxable year that does not contain a calendar year ending during such
short taxable year, the following amounts are treated as the W-2 wages
of the taxpayer for the short taxable year: (1) wages paid during the
short taxable year to employees of the qualified trade or business; (2)
elective deferrals (within the meaning of section 402(g)(3)) made
during the short taxable year by employees of the qualified trade or
business; and (3) compensation actually deferred under section 457
during the short taxable year with respect to employees of the
qualified trade or business. Amounts that are treated as W-2 wages for
a taxable year are not treated as W-2 wages of any other taxable year.
\140\ As provided in sec. 3401(a)(8).
\141\ Sec. 199A(b)(4)(B).
\142\ Sec. 199A(b)(4)(C).
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Qualified property means, with respect to a qualified trade
or business for a taxable year, tangible property of a
character subject to depreciation under section 167 that is
held by, and available for use in, the qualified trade or
business at the close of the taxable year, that is used at any
point during the taxable year in the production of qualified
business income, and for which the depreciable period has not
ended before the close of the taxable year.\143\ The
depreciable period with respect to qualified property of a
taxpayer means the period beginning on the date the property
was first placed in service by the taxpayer and ending on the
later of (a) the date that is 10 years after that date, or (b)
the last day of the last full year in the applicable recovery
period that would apply to the property under section 168
(determined without regard to the alternative depreciation
system under section 168(g)).\144\
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\143\ Sec. 199A(b)(6).
\144\ The applicable recovery period for an asset is determined in
part by statute and in part by historic Treasury guidance. Exercising
authority granted by Congress, the Secretary issued Rev. Proc. 87-56,
1987-2 C.B. 674, laying out the framework of recovery periods for
enumerated classes of assets. The Secretary clarified and modified the
list of asset classes in Rev. Proc. 88-22, 1988-1 C.B. 785. In November
1988, Congress revoked the Secretary's authority to modify the class
lives of depreciable property. Rev. Proc. 87-56, as modified, remains
in effect except to the extent that Congress has, since 1988,
statutorily modified the recovery period for certain depreciable
assets, effectively superseding any administrative guidance with regard
to such property. For a discussion of the changes to applicable
recovery periods made by the Act, see the discussion of sections 13203
(Modifications of Treatment of Certain Farm Property) and 13204
(Applicable Recovery Period for Real Property).
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Examples
For example,\145\ a taxpayer (a single individual) has
taxable income of $187,500, of which $100,000 is attributable
to an accounting sole proprietorship after paying wages of
$80,000 to employees. The accounting sole proprietorship pays
W-2 wages of $80,000, and has no qualifying property. The
taxpayer has an applicable percentage of 40 percent.\146\ In
determining qualified business income, the taxpayer takes into
account 40 percent of $100,000, or $40,000. In determining W-2
wages, the taxpayer takes into account 40 percent of $80,000,
or $32,000. The taxpayer calculates the deduction by taking the
lesser of 20 percent of $40,000 ($8,000) or 50 percent of
$32,000 ($16,000), which in this case is $8,000. In this
example, the W-2 wage limitation is not binding.
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\145\ This example illustrates the operation of the exclusion of a
specified service trade or business when the W-2 wage, or W-2 wage and
capital, limitation does not bind. For more comprehensive examples
showing the interaction among various rules of the provision, see
below.
\146\ 1 - ($187,500 - $157,500)/$50,000 = 1 - $30,000/$50,000 = 1 -
0.6 = 40 percent.
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As another example,\147\ a taxpayer (who is subject to the
W-2 wage, or W-2 wage and capital, limitation) has a sole
proprietorship that manufactures widgets. The business buys a
widget-making machine for $100,000 and places it in service in
2020. The business has no employees in 2020. The limitation in
2020 is the greater of (a) 50 percent of W-2 wages, or $0, or
(b) the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of
the unadjusted basis of the machine immediately after its
acquisition ($2,500). The taxpayer's section 199A deduction for
2020 for the widget sole proprietorship may not exceed $2,500.
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\147\ This example illustrates the operation of the W-2 wage, or W-
2 wage and capital, limitation. For more comprehensive examples showing
the interaction among various rules of the provision, see below.
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Regulatory authority with respect to W-2 wage, or W-2 wage
and capital, limitation
Property that is no longer available for use in the
qualified trade or business, for example because it was sold,
is not taken into account in determining the W-2 wage and
capital limitation. The Secretary is required to provide rules
for applying the limitation in cases of a short taxable year
and when the taxpayer acquires, or disposes of, the major
portion of a trade or business or the major portion of a
separate unit of a trade or business during the year. The
Secretary is required to provide guidance applying rules
similar to the rules of section 179(d)(2) to address
acquisitions of property from a related party, as well as in a
sale-leaseback or other transaction as needed to carry out the
purposes of the provision. Similarly, the Secretary is required
to provide guidance prescribing rules for determining the
unadjusted basis immediately after acquisition of qualified
property acquired in like-kind exchanges or involuntary
conversions as needed to carry out the purposes of the
provision and to provide anti-abuse rules, including under the
limitation based on W-2 wages and capital.
Partnerships and S corporations
In the case of a partnership or S corporation, the section
199A deduction is determined at the partner or shareholder
level. Each partner in a partnership takes into account the
partner's allocable share of each qualified item of income,
gain, deduction, and loss, and is treated as having W-2 wages
and unadjusted basis of qualified property for the taxable year
equal to the partner's allocable share of W-2 wages and
unadjusted basis of qualified property of the partnership. The
partner's allocable share of W-2 wages and unadjusted basis of
qualified property are required to be determined in the same
manner as the partner's allocable share of wage expenses and
depreciation, respectively.\148\ Similarly, each shareholder of
an S corporation takes into account the shareholder's pro rata
share of each qualified item of income, gain, deduction, and
loss of the S corporation, and is treated as having W-2 wages
and unadjusted basis of qualified property for the taxable year
equal to the shareholder's pro rata share of W-2 wages and
unadjusted basis of qualified property of the S corporation.
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\148\ The partner's allocable share of unadjusted basis of
qualified property is determined in the same manner as the partner's
allocable share of depreciation, regardless of whether certain items of
qualified property are fully depreciated as of the close of the taxable
year. The Treasury Department will provide guidance regarding the
determination of a partner's allocable share of unadjusted basis of
qualified property in taxable years in which the partnership does not
have a depreciation deduction.
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Qualified REIT dividends, qualified cooperative
dividends,\149\ and qualified publicly traded
partnership income
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\149\ The discussion of qualified cooperative dividends in this
section reflects the provision as originally enacted. Modifications
enacted March 23, 2018, are described in the Appendix.
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A deduction is allowed for 20 percent of the taxpayer's
aggregate amount of qualified REIT dividends, qualified
cooperative dividends, and qualified publicly traded
partnership income for the taxable year.\150\ If the taxpayer's
aggregate amount of qualified REIT dividends, qualified
cooperative dividends, and qualified publicly traded
partnership income is a loss for the taxable year, the combined
qualified business income amount for that taxable year is
reduced by 20 percent of the aggregate amount of such items.
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\150\ See sec. 199A(a) and (b).
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Qualified REIT dividends do not include any portion of a
dividend received from a REIT that is a capital gain dividend
\151\ or qualified dividend income.\152\ It is intended that
holding period rules (similar to section 1(h)(11)(B)(iii))
apply to stock giving rise to qualified REIT dividends under
section 199A, to prevent an individual from buying REIT stock
immediately before the stock goes ex-dividend and selling it
immediately after it goes ex-dividend and claiming the
qualified business income deduction on the dividend.\153\
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\151\ Defined in sec. 857(b)(3).
\152\ Defined in sec. 1(h)(11). See sec. 199A(e)(3).
\153\ A technical correction may be needed to carry out this
intent.
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A qualified cooperative dividend \154\ means any patronage
dividend,\155\ per-unit retain allocation,\156\ qualified
written notice of allocation,\157\ or any other similar amount,
provided such amount is includible in gross income and is
received from either (1) a tax-exempt organization described in
section 501(c)(12) \158\ or a taxable or tax-exempt cooperative
that is described in section 1381(a), or (2) a taxable
cooperative governed by tax rules applicable to cooperatives
before the enactment of subchapter T of the Code in 1962.\159\
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\154\ As originally enacted. Modifications enacted March 23, 2018,
are described in the Appendix.
\155\ Defined in sec. 1388(a).
\156\ Defined in sec. 1388(f).
\157\ Defined in sec. 1388(c).
\158\ Organizations described in section 501(c)(12) are benevolent
life insurance associations of a purely local character, mutual ditch
or irrigation companies, mutual or cooperative telephone companies, or
like organizations, but only if 85 percent or more of the income
consists of amounts collected from members for the sole purpose of
meeting losses and expenses. Sec. 501(c)(12)(A).
\159\ Sec. 199A(e)(4).
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Qualified publicly traded partnership income means (with
respect to any qualified trade or business of the taxpayer) the
sum of (a) the net amount of the taxpayer's allocable share of
each qualified item of income, gain, deduction, and loss of the
partnership from a publicly traded partnership not treated as a
corporation,\160\ and (b) gain recognized by the taxpayer on
disposition of its interest in such partnership that is treated
as ordinary income (for example, by reason of section
751).\161\
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\160\ Such items must be effectively connected with a U.S. trade or
business, be included or allowed in determining taxable income for the
taxable year, and not constitute excepted enumerated investment-type
income. Such items do not include the taxpayer's reasonable
compensation, guaranteed payments for services, or (to the extent
provided in regulations) section 707(a) payments for services.
\161\ Sec. 199A(e)(5).
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Many individuals invest in REIT stock or interests in
publicly traded partnerships indirectly through a regulated
investment company (a ``RIC'' or mutual fund). The RIC may
receive amounts that would be treated as qualified REIT
dividends or qualified publicly traded partnership income \162\
eligible for the section 199A deduction in the hands of an
individual RIC shareholder had that individual directly held
the REIT stock or the interest in the publicly traded
partnership. It is intended that in the case of an individual
shareholder of a RIC that itself owns stock in a REIT or
interests in a publicly traded partnership, the individual is
treated as receiving qualified REIT dividends or qualified
publicly traded partnership income to the extent any dividends
received by the individual from the RIC are attributable to
qualified REIT dividends or qualified publicly traded
partnership income received by the RIC.
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\162\ Sec. 199A(b)(1)(B).
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Determination of the taxpayer's deduction
The taxpayer's deduction for qualified business income for
the taxable year is equal to the sum of (1) the lesser of (a)
the combined qualified business income amount for the taxable
year, or (b) an amount equal to 20 percent of taxable income
\163\ (reduced by any net capital gain \164\ and qualified
cooperative dividends), plus (2) the lesser of (a) 20 percent
of qualified cooperative dividends, or (b) taxable income
(reduced by net capital gain). This sum may not exceed the
taxpayer's taxable income for the taxable year (reduced by net
capital gain).\165\ The combined qualified business income
amount for the taxable year is the sum of the deductible
amounts determined for each qualified trade or business carried
on by the taxpayer \166\ and 20 percent of the taxpayer's
qualified REIT dividends and qualified publicly traded
partnership income.\167\
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\163\ Section 63(a) defines taxable income as ``gross income minus
the deductions allowed by'' chapter 1 of the Code. For these purposes,
taxable income is also computed without regard to the deduction
allowable under section 199A. See sec. 199A(e)(1).
\164\ Defined in sec. 1(h).
\165\ Sec. 199A(a).
\166\ This amount cannot be less than zero. A technical correction
may be necessary to reflect this intent.
\167\ Sec. 199A(b)(1).
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Specified agricultural or horticultural cooperatives with qualified
business income \168\
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\168\ The discussion in this section reflects the provision as
originally enacted. Modifications enacted March 23, 2018, are described
in the Appendix.
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For taxable years beginning after December 31, 2017, and
before January 1, 2026, a deduction is allowed to any specified
agricultural or horticultural cooperative equal to the lesser
of (a) 20 percent of the excess (if any) of the cooperative's
gross income over the qualified cooperative dividends paid
during the taxable year for the taxable year, or (b) the
greater of 50 percent of the W-2 wages paid by the cooperative
with respect to its trade or business or the sum of 25 percent
of the W-2 wages of the cooperative with respect to its trade
or business plus 2.5 percent of the unadjusted basis
immediately after acquisition of qualified property of the
cooperative. The cooperative's section 199A(g) deduction may
not exceed its taxable income for the taxable year.\169\
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\169\ For this purpose, taxable income is computed without regard
to the cooperative's deduction under section 199A(g).
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A specified agricultural or horticultural cooperative is an
organization to which part I of subchapter T applies that is
engaged in (a) the manufacturing, production, growth, or
extraction in whole or significant part of any agricultural or
horticultural product, (b) the marketing of agricultural or
horticultural products that its patrons have so manufactured,
produced, grown, or extracted, or (c) the provision of
supplies, equipment, or services to farmers or organizations
described in the foregoing.
Additional rules and regulatory authority
The taxpayer's deduction for qualified business income is
not allowed in computing adjusted gross income; instead, the
deduction is allowed in computing taxable income.\170\ The
deduction is available to both individuals who itemize their
deductions and individuals who do not itemize their
deductions.\171\
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\170\ Sec. 62(a).
\171\ Sec. 63(b) and (d).
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For purposes of the provision, taxable income is determined
without regard to the deduction allowable under the provision.
Qualified business income is determined without regard to
any adjustments prescribed under the rules of the alternative
minimum tax.
Trusts and estates are eligible for the 20-percent
deduction under the provision. Rules similar to the rules under
former section 199 (as in effect on December 1, 2017) apply for
apportioning between fiduciaries and beneficiaries any W-2
wages and unadjusted basis of qualified property under the
limitation based on W-2 wages and capital. An electing small
business trust (``ESBT'') \172\ is a trust eligible for the 20-
percent deduction under the provision.
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\172\ Secs. 1361(e) and 641(c).
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The deduction under the provision is allowed only for
Federal income tax purposes. Thus, the deduction is not allowed
in determining net earnings from self-employment or self-
employment tax, for example.
For purposes of determining a substantial underpayment of
income tax under the accuracy related penalty,\173\ a
substantial underpayment exists if the amount of the
understatement exceeds the greater of five percent (not 10
percent) of the tax required to be shown on the return or
$5,000.
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\173\ Sec. 6662(d)(1)(A).
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Authority is provided to promulgate regulations needed to
carry out the purposes of the provision, including regulations
requiring, or restricting, the allocation of items of income,
gain, loss, or deduction, or of W-2 wages, and unadjusted basis
of qualified property, under the provision. In addition,
regulatory authority is provided to address reporting
requirements appropriate under the provision, and the
application of the provision in the case of tiered entities.
The provision does not apply to taxable years beginning
after December 31, 2025.
Additional examples
The following additional examples further illustrate the
application of the provision.
Example 1
H and W file a joint return for 2018 on which they report
taxable income of $340,000 (determined without regard to this
provision). This amount exceeds the threshold amount for joint
filers by $25,000. H is a partner in a trade or business that
is not a specified service trade or business (``qualified
business A''). W has a sole proprietorship that is a specified
service trade or business (``qualified business B''). H and W
also received $10,000 in qualified REIT dividends during the
tax year.
H's allocable share of qualified business income from
qualified business A is $200,000, such that 20 percent of the
qualified business income with respect to the business is
$40,000.\174\ H's allocable share of W-2 wages paid by
qualified business A is $50,000, such that 50 percent of the W-
2 wages with respect to the business is $25,000.\175\ Business
A has placed in service depreciable property that is qualified
property, and H's share of the unadjusted basis of the property
immediately after acquisition is $60,000. H's limitation under
the wage and capital limitation is the sum of 25 percent of the
W-2 wages ($12,500 \176\) plus 2.5 percent of the unadjusted
basis, of qualified property ($1,500 \177\), or $14,000. Thus,
H's limitation under the W-2 wage, or W-2 wage and capital,
limitation is the greater of $25,000 or $14,000 (i.e.,
$25,000), subject to the applicable phase-in. As H and W's
taxable income is above the threshold amount for a joint
return, the application of the W-2 wage limit for qualified
business A is phased in. Accordingly, the $40,000 amount (i.e.,
20 percent of H's qualified business income) is reduced by 25
percent \178\ of the difference between $40,000 (i.e., H's
deductible amount without limitation) and $25,000 (i.e., H's
deductible amount with limitation), or $3,750.\179\ H's
deductible amount for qualified business A is $36,250.\180\
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\174\ $200,000 * 20 percent = $40,000.
\175\ $50,000 * 50 percent = $25,000.
\176\ $50,000 * 25 percent = $12,500.
\177\ $60,000 * 2.5 percent = $1,500.
\178\ ($340,000 - $315,000)/$100,000 = 25 percent.
\179\ ($40,000 - $25,000) * 25 percent = $3,750.
\180\ $40,000 - $3,750 = $36,250.
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W's qualified business income and W-2 wages from qualified
business B, which is a specified service trade or business, are
$200,000 and $140,000, respectively. H and W's taxable income
is above the threshold amount for a joint return. Thus, the
exclusion of qualified business income and W-2 wages from the
specified service trade or business are phased in. Assume that
qualified business B has no qualified property, so the W-2 wage
and capital limitation is less than the W-2 wage limitation and
therefore not binding. W has an applicable percentage of 75
percent.\181\ In determining includible qualified business
income, W takes into account 75 percent of $200,000, or
$150,000. In determining includible W-2 wages, W takes into
account 75 percent of $140,000, or $105,000. W calculates the
deductible amount for qualified business B by taking the lesser
of 20 percent of $150,000 ($30,000) or 50 percent of includible
W-2 wages of $105,000 ($52,500).\182\ W's deductible amount for
qualified business B is $30,000.
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\181\ 1-($340,000-$315,000)/$100,000 = 1-$25,000/$100,000 = 1-.25 =
75 percent.
\182\ Although H and W's taxable income is above the threshold
amount for a joint return, the W-2 wage limit is not binding as the 20
percent of includible qualified business income of qualified business B
($30,000) is less than 50 percent of includible W-2 wages of qualified
business B ($52,500).
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H and W's combined qualified business income amount of
$68,250 consists of the deductible amount for qualified
business A of $36,250, the deductible amount for qualified
business B of $30,000, and the deductible amount equal to 20
percent of the $10,000 in qualified REIT dividends ($2,000). H
and W's deduction is limited to 20 percent of their taxable
income for the year ($340,000), or $68,000. The taxable income
limit binds, and accordingly, H and W's total section 199A
deduction for the taxable year is $68,000.
Example 2
Assume the same facts as Example 1, except that W's W-2
wages from qualified business B are $60,000. Consistent with
Example 1, W has an applicable percentage of 75 percent.
Consistent with Example 1, in determining includible qualified
business income, W takes into account 75 percent of $200,000,
or $150,000, so 20 percent of the qualified business income
with respect to qualified business B is $30,000. In determining
includible W-2 wages, W takes into account 75 percent of
$60,000, or $45,000. Fifty percent of the W-2 wages with
respect to the business is $22,500. Because H and W's taxable
income is above the threshold amount for a joint return, the
application of the W-2 wage limit for qualified business B is
phased in. Accordingly, the $30,000 amount (i.e., 20 percent of
W's qualified business income) is reduced by 25 percent \183\
of the difference between $30,000 (i.e., W's deductible amount
without limitation) and $22,500 (i.e., W's deductible amount
with limitation), or $1,875.\184\ W's deductible amount for
qualified business B is $28,125.\185\
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\183\ ($340,000 - $315,000)/$100,000 = 25 percent.
\184\ ($30,000 - $22,500) * 25 percent = $1,875.
\185\ $30,000 - $1,875 = $28,125.
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H and W's combined qualified business income amount of
$66,375 consists of the deductible amount for qualified
business A of $36,250, the deductible amount for qualified
business B of $28,125, and the deductible amount equal to 20
percent of the $10,000 in qualified REIT dividends ($2,000). H
and W's deduction is limited to 20 percent of their taxable
income for the year ($340,000), or $68,000. The taxable income
limit does not bind, and accordingly H and W's total section
199A deduction for the taxable year is $66,375.
Example 3
Assume the same facts as Example 1, except that H's
qualified business A has placed in service depreciable property
that is qualified property and H's share of the unadjusted
basis of the property immediately after acquisition is
$1,300,000. Consistent with Example 1, 20 percent of the
qualified business income with respect to qualified business A
is $40,000. Consistent with Example 1, H's allocable share of
W-2 wages paid by qualified business A is $50,000, such that 50
percent of the W-2 wages with respect to qualified business A
is $25,000. H's limitation under the wage and capital
limitation is the sum of 25 percent of the W-2 wages ($12,500)
plus 2.5 percent of the unadjusted basis of qualified property
($32,500 \186\), or $45,000. Thus, H's limitation under the W-2
wage, or W-2 wage and capital, limitation is the greater of
$25,000 or $45,000 (i.e., $45,000), subject to the applicable
phase-in. As H's W-2 wage and capital limitation of $45,000 is
in excess of 20 percent of H's qualified business income of
$40,000, the W-2 wage and capital limitation is not binding and
no phase-in of the limitation is required. H's deductible
amount for qualified business A is $40,000.
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\186\ $1,300,000 * 2.5 percent = $32,500.
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H and W's combined qualified business income amount of
$70,000 consists of the deductible amount for qualified
business A of $40,000, the deductible amount for qualified
business B of $30,000, and the deductible amount equal to 20
percent of the $10,000 in qualified REIT dividends ($2,000). H
and W's deduction is limited to 20 percent of their taxable
income for the year ($340,000), or $68,000. The taxable income
limit does bind, and accordingly H and W's total section 199A
deduction for the taxable year is $68,000.
Example 4
H and W file a joint return on which they report taxable
income of $100,000 (determined without regard to this
provision). H has a sole proprietorship qualified trade or
business that is not a specified service trade or business
(``qualified business A''). W is a partner in a qualified trade
or business that is not a specified service trade or business
(``qualified business B''). H and W have a carryover qualified
business loss under section 199A(c)(2) of $5,000.
H's qualified business income from qualified business A is
$60,000; 20 percent is $12,000. H and W's taxable income is
below the threshold amount applicable to a joint return, so the
W-2 wage, or W-2 wage and capital, limitation does not apply to
qualified business A. H's deductible amount for qualified
business A is $12,000. W's allocable share of qualified
business income from qualified business B is a loss of $40,000,
such that 20 percent of the qualified business loss with
respect to the business is $8,000. Additionally, the carryover
qualified business loss $5,000 is treated as a loss from a
qualified trade or business in the current year, 20 percent of
which is $1,000.
H and W's combined qualified business income amount of
$3,000 consists of the deductible amount for qualified business
A of $12,000, the reduction to the deduction for qualified
business B of $8,000, and the reduction to the deduction of
$1,000 attributable to the carryover qualified business loss. H
and W's deduction is limited to 20 percent of their taxable
income for the year ($100,000), or $20,000. H and W's deduction
for the taxable year is $3,000.
Example 5
Taxpayer files a return as a single taxpayer on which he
reports taxable income of less than $157,500. Taxpayer has a
sole proprietorship qualified trade or business that is not a
specified service trade or business (``qualified business A'').
Taxpayer is a partner in a qualified trade or business that is
not a specified service trade or business (``qualified business
B'').
In year one, Taxpayer has qualified business income of
$10,000 from qualified business A, a qualified business loss of
$30,000 from qualified business B, and $5,000 of qualified REIT
dividends. Taxpayer is permitted a deduction of $1,000 (i.e.,
20 percent of the $5,000 of REIT dividends) in year one and
carries forward a qualified business loss of $20,000.
In year two, Taxpayer has qualified business income of
$15,000 from qualified business A, qualified business income of
$25,000 from qualified business B, and $5,000 of qualified REIT
dividends. Neither business is subject to the W-2 wage, or W-2
wage and capital, limitation. To determine the deduction for
year two, Taxpayer combines 20 percent of the $40,000 qualified
business income of businesses A and B in year 2 ($8,000) with
20 percent of the $20,000 qualified business loss carryover
from year one (-$4,000) and 20 percent of the qualified REIT
dividends ($1,000 \187\). Taxpayer's deductible amount for Year
2 is $4,000 \188\ plus $1,000, or $5,000.
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\187\ Qualified REIT dividends of $5,000 * 20 percent = $1,000.
\188\ ($40,000 * 20 percent) - ($20,000 * 20 percent) = $8,000 -
$4,000 = $4,000.
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Example 6
H and W file a joint return on which they report taxable
income of $500,000 (determined without regard to this
provision). H has a sole proprietorship qualified trade or
business that is not a specified service trade or business
(``qualified business A''). W is a partner in a qualified trade
or business that is not a specified service trade or business
(``qualified business B'').
H's qualified business income from qualified business A is
$800,000, such that 20 percent of the qualified business income
with respect to the business is $160,000.\189\ H's allocable
share of wages paid by qualified business A is $200,000, such
that 50 percent of the W-2 wages with respect to the business
is $100,000.\190\ Qualified business A does not have qualified
property. H's limitation under the W-2 wage, or W-2 wage and
capital, limitation is the sum of 25 of percent of the W-2
wages ($50,000 \191\) plus 2.5 percent of the unadjusted basis
of qualified property (zero), or $50,000. Thus, H's limitation
under the W-2 wage, or W-2 wage and capital, limitation is the
greater of $100,000 or $50,000 (i.e., $100,000). As H and W's
taxable income is in excess of $415,000, the W-2 wage and W-2
wage and capital limitation is fully phased-in. H's deductible
amount for qualified business A is $100,000.
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\189\ $800,000 * 20 percent = $160,000.
\190\ $200,000 * 50 percent = $100,000.
\191\ $200,000 * 25 percent = $50,000.
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W's qualified business loss from qualified business B is
$100,000, such that 20 percent of the qualified business loss
with respect to the business is a reduction to the deduction of
$20,000.\192\ W's allocable share of wages paid by qualified
business B is $100,000, such that 50 percent of the W-2 wages
with respect to the business is $50,000.\193\ Qualified
business B does not have placed in service depreciable property
that is qualified property. W's limitation under the W-2 wage
and capital limitation is the sum of 25 of percent of the W-2
wages ($25,000 \194\) plus 2.5 percent of the unadjusted basis
of qualified property (zero), or $25,000. Thus, H's limitation
under the W-2 wage, or W-2 wage and capital, limitation is the
greater of a reduction of $50,000 or $25,000 (i.e., $50,000).
As H and W's taxable income is in excess of $415,000, the W-2
wage and W-2 wage and capital limitation is fully phased-in.
W's deductible amount for qualified business B is a reduction
to the deduction of $20,000.\195\
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\192\ ($100,000) * 20 percent = ($20,000).
\193\ $100,000 * 50 percent = $50,000.
\194\ $100,000 * 25 percent = $25,000.
\195\ In situations where a qualified trade or business has a
qualified business loss, and the taxpayer does not have an overall
qualified business loss carryover arising in the taxable year, the
amount determined under section 199A(b)(2) is equal to 20 percent of
the qualified business loss. The application of the W-2 wage, or W-2
wage and capital, limitation is not binding on the qualified trade or
business as the limitation (a positive amount) is greater than 20
percent of the qualified business loss (a negative amount). The
application of the W-2 wage, or W-2 wage and capital, limitation to
each separate qualified trade or business under section 199A(b)(2)(B)
occurs prior to combining the deductible amount from each respective
qualified trade or business (i.e., the deductible amount determined
under section 199A(b)(2)) under section 199A(b)(1)(A).
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H and W's combined qualified business income amount of
$80,000 consists of the deductible amount for qualified
business A of $100,000 and the reduction to the deduction for
qualified business B of $20,000. H and W's deduction is limited
to 20 percent of their taxable income for the year ($500,000),
or $100,000. Accordingly, H and W's deduction for the taxable
year is $80,000.
Example 7
Assume the same facts as Example 6, except that H and W
have a qualified business loss carryover from the prior year of
$25,000. There is no qualified business loss carryover for the
current year as H and W's net amount of qualified business
income from all qualified trades or businesses during the
taxable year is $675,000.
Consistent with Example 6, H's deductible amount for
qualified business A is $100,000 and W's deductible amount for
qualified business B is a reduction to the deduction of
$20,000.
H and W's combined qualified business income amount of
$75,000 consists of the deductible amount for qualified
business A of $100,000, the reduction to the deduction for
qualified business B of $20,000, and the reduction to the
deduction for the qualified business loss carryover of
$5,000.\196\ H and W's deduction is limited to 20 percent of
their taxable income for the year ($500,000), or $100,000.
Accordingly, H and W's deduction for the taxable year is
$75,000.
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\196\ ($25,000) * 20 percent = ($5,000). Similar to a qualified
trade or business with a qualified business loss, in situations where
the taxpayer has a qualified business loss carryover, but does not have
an overall qualified business loss carryover arising in the taxable
year, the amount determined under section 199A(b)(2) for the qualified
business loss carryover is equal to 20 percent of the loss carryover.
The application of the W-2 wage, or W-2 wage and capital, limitation is
not binding on the qualified business loss carryover as the limitation
(a positive amount) is greater than 20 percent of the qualified
business loss carryover (a negative amount).
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Example 8
Assume the same facts as Example 6, except that H and W
have a qualified business loss carryover from the prior year of
$450,000. There is no qualified business loss carryover for the
current year as H and W's net amount of qualified business
income from all qualified trades or businesses during the
taxable year is $250,000.
Consistent with Example 6, H's deductible amount for
qualified business A is $100,000 and W's deductible amount for
qualified business B is a reduction to the deduction of
$20,000.
H and W's combined qualified business income amount of zero
consists of the deductible amount for qualified business A of
$100,000, the reduction to the deduction for qualified business
B of $20,000, and the reduction to the deduction, but not below
zero,\197\ for the qualified business loss carryover of
$90,000.\198\ Accordingly, H and W's deduction for the taxable
year is zero.
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\197\ A technical correction may be necessary to reflect this
intent.
\198\ ($450,000) * 20 percent = ($90,000). Similar to a qualified
trade or business with a qualified business loss, in situations where
the taxpayer has a qualified business loss carryover, but does not have
an overall qualified business loss carryover arising in the taxable
year, the amount determined under section 199A(b)(2) for the qualified
business loss carryover is equal to 20 percent of the loss carryover.
The application of the W-2 wage, or W-2 wage and capital, limitation is
not binding on the qualified business loss carryover as the limitation
(a positive amount) is greater than 20 percent of the qualified
business loss carryover (a negative amount).
The Treasury Department has issued proposed regulations and
published guidance addressing this provision.\199\
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\199\ REG-107892-18, 83 Fed. Reg. 40884, August 16, 2018; and
Notice 2018-64, 2018-35 I.R.B. 347, August 27, 2018.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
As the repeal of former section 199 is also effective for
taxable years beginning after December 31, 2017,\200\ any item
taken into account in determining the qualified production
activities income of the taxpayer under former section 199
cannot be taken into account in determining the combined
qualified business income amount of the taxpayer under section
199A. For example, assume that an individual holds an interest
in a fiscal-year partnership or S corporation, the taxable year
of which began before January 1, 2018, and ends within or with
the individual's first taxable year beginning after December
31, 2017 (e.g., the individual's 2018 calendar taxable year).
The individual's share of any item from the partnership or S
corporation that constitutes qualified business income,
qualified REIT dividends, qualified cooperative dividends,\201\
and qualified publicly traded partnership income and that is
taken into account in determining taxable income for the
individual's 2018 taxable year is eligible for the section 199A
deduction. However, the individual's share of any item from the
partnership or S corporation that would otherwise be taken into
account in determining qualified production activities income
for the individual's 2018 taxable year is not eligible for the
former section 199 deduction, as former section 199 is repealed
for taxable years beginning after December 31, 2017.
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\200\ For a discussion of the effective date of the repeal of
former section 199, see the description of section 13305 of the Act
(Repeal of Deduction for Income Attributable to Domestic Production
Activities).
\201\ As originally enacted. Modifications enacted March 23, 2018,
are described in the Appendix.
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B. Limitation on Losses for Taxpayers Other Than Corporations (sec.
11012 of the Act and sec. 461(l) of the Code)
Prior Law
Loss limitation rules applicable to individuals
Passive loss rules
The passive loss rules limit deductions and credits from
passive trade or business activities.\202\ The passive loss
rules apply to individuals, estates and trusts, and closely
held corporations. A passive activity for this purpose is a
trade or business activity in which the taxpayer owns an
interest, but in which the taxpayer does not materially
participate. A taxpayer is treated as materially participating
in an activity only if the taxpayer is involved in the
operation of the activity on a basis that is regular,
continuous, and substantial.\203\ Deductions attributable to
passive activities, to the extent they exceed income from
passive activities, generally may not be deducted against other
income. Deductions and credits that are suspended under these
rules are carried forward and treated as deductions and credits
from passive activities in the next year. The suspended losses
from a passive activity are allowed in full when a taxpayer
makes a taxable disposition of his entire interest in the
passive activity to an unrelated person.
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\202\ Sec. 469.
\203\ Regulations provide more detailed standards for material
participation. See Treas. Reg. sec. 1.469-5 and -5T.
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Excess farm loss rules
A limitation on excess farm losses applies to taxpayers
other than C corporations.\204\ If a taxpayer other than a C
corporation receives an applicable subsidy \205\ for the
taxable year, the amount of the excess farm loss is not allowed
for the taxable year, and is carried forward and treated as a
deduction attributable to farming businesses in the next
taxable year. An excess farm loss for a taxable year means the
excess of aggregate deductions that are attributable to farming
businesses over the sum of aggregate gross income or gain
attributable to farming businesses plus the threshold amount.
The threshold amount is the greater of (1) $300,000 ($150,000
for married individuals filing separately), or (2) for the
five-consecutive-year period preceding the taxable year, the
excess of the aggregate gross income or gain attributable to
the taxpayer's farming businesses over the aggregate deductions
attributable to the taxpayer's farming businesses.
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\204\ Sec. 461(j).
\205\ For this purpose, an applicable subsidy means (A) any direct
or counter-cyclical payment under title I of the Food, Conservation,
and Energy Act of 2008, or any payment elected to be received in lieu
of such payment, or (B) any Commodity Credit Corporation loan. Sec.
461(j)(3).
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Explanation of Provision
For taxable years beginning after December 31, 2017, and
before January 1, 2026, an excess business loss of a taxpayer
other than a corporation is not allowed for the taxable year.
The disallowed excess business loss is treated as a net
operating loss (``NOL'') for the taxable year for purposes of
determining any NOL carryover to subsequent taxable years.\206\
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\206\ See sec. 172. For a discussion of the changes made by the Act
to section 172, see the description of section 13302 of the Act
(Modification of Net Operating Loss Deduction). A technical correction
may be necessary to reflect the intent that excess business losses that
are not allowed are treated as a net operating loss arising in the
taxable year. Thus, such excess business losses are carried over to a
subsequent taxable year under the applicable NOL rules. For example,
assume that for 2018, H and W file a joint return on which they report
a $1,150,000 loss from their farming business on Schedule F (Form
1040). H and W do not have any other income or loss for 2018. After
application of the $500,000 threshold amount for joint filers (sec.
461(l)(3)(A)(ii)(II)), the remaining $650,000 business loss is an
excess business loss and is not allowed for H and W's taxable year 2018
by reason of section 461(l)(1)(B). Under the provision, H and W have a
$500,000 NOL for 2018 that is eligible for a two-year carryback under
section 172(b)(1)(B), and a $650,000 NOL (increased by any portion of
the $500,000 NOL for 2018 remaining after application of the two-year
carryback) eligible for carryover to 2019. Because the $500,000 NOL for
2018 arises in a taxable year beginning after December 31, 2017, it is
subject to the 80-percent limitation under section 172(a)(2).
Accordingly, in this example, the amount of the taxpayer's $500,000 NOL
carried back to 2016 and 2017 is limited to 80 percent of the taxable
income (determined without regard to the NOL deduction) for the 2016
and 2017 taxable years, respectively.
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An excess business loss for the taxable year is the excess
of aggregate deductions of the taxpayer attributable to trades
or businesses of the taxpayer (determined without regard to the
limitation of the provision),\207\ over the sum of aggregate
gross income or gain attributable to trades or businesses of
the taxpayer plus a threshold amount. The threshold amount for
a taxable year beginning in 2018 is $250,000 (or twice the
otherwise applicable threshold amount in the case of a joint
return, i.e., $500,000). The threshold amount is indexed for
inflation in taxable years beginning after 2018.
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\207\ It is intended that aggregate deductions (for purposes of
section 461(l)) not include the amount of any NOL carryback or
carryover under section 172 that is attributable to such trades or
businesses from a different taxable year. For example, continuing the
example in the preceding footnote, none of the $650,000 excess business
loss in taxable year 2018 is subject to section 461(l) in a subsequent
taxable year. Thus, any deduction with respect to any portion of the
$650,000 that is carried over to a subsequent taxable year under the
rules of section 172 is governed by the rules of section 172 (not
section 461(l)). Similarly, any deduction with respect to any portion
of the $500,000 remaining after carrybacks to 2016 and 2017 that is
carried over to a subsequent year is governed by the rules of section
172 (not section 461(l)).
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The aggregate deductions taken into account to determine
the excess business loss of the taxpayer for the taxable year
that are attributable to trades or businesses of the taxpayer
are determined without regard to the deduction under section
172 or 199A.\208\ For example, assume that a taxpayer has an
NOL carryover from a prior taxable year to the current taxable
year. Such NOL carryover is not part of the taxpayer's
aggregate deductions attributable to the trade or business for
the current taxable year under section 461(l).
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\208\ A technical correction may be necessary to carry out this
intent.
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An excess business loss (the deduction for which is limited
by section 461(l)) does not take into account gross income or
gains or deductions attributable to the trade or business of
performance of services as an employee.\209\ For example,
assume married taxpayers filing jointly for the taxable year
have a loss from a trade or business conducted by one spouse as
a sole proprietorship as well as wage income of the other
spouse from employment. The wage income is not taken into
account in determining the amount of the deduction limited
under section 461(l).
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\209\ A technical correction may be necessary to carry out this
intent. For this purpose, the trade or business of performance of
services by the taxpayer as an employee has the same meaning as it does
under section 62(a)(1).
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In the case of a partnership or S corporation, the
provision applies at the partner or shareholder level. Each
partner's distributive share and each S corporation
shareholder's pro rata share of items of income, gain,
deduction, or loss of a partnership or S corporation are taken
into account in applying the limitation under the provision for
the taxable year of the partner or S corporation shareholder.
Regulatory authority is provided to require any additional
reporting as the Secretary determines is appropriate to carry
out the purposes of the provision (including with respect to
any other passthrough entity to the extent necessary to carry
out the purposes of the provision).
The provision applies after the application of the passive
loss rules.\210\
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\210\ Sec. 469.
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For taxable years beginning after December 31, 2017, and
before January 1, 2026, the prior-law limitation relating to
excess farm losses does not apply.\211\
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\211\ The excess farm loss rules will apply again for taxable years
beginning after December 31, 2025.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
PART III--TAX BENEFITS FOR FAMILIES AND INDIVIDUALS
A. Increase in Standard Deduction (sec. 11021 of the Act and sec. 63 of
the Code)
Prior Law
An individual who does not elect to itemize deductions
reduces his or her adjusted gross income (``AGI'') by the
amount of the applicable standard deduction in arriving at his
or her taxable income. The standard deduction is the sum of the
basic standard deduction and, if applicable, the additional
standard deduction. The basic standard deduction varies
depending upon a taxpayer's filing status. For 2017, the amount
of the basic standard deduction is $6,350 for a single
individual and a married individual filing a separate
return,\212\ $9,350 for a head of household, and $12,700 for a
joint return and a surviving spouse. An additional standard
deduction is allowed to an individual who is elderly (has
attained age 65 before the close of the taxable year) or
blind.\213\
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\212\ In the case of a married individual filing a separate return
where either spouse itemizes deductions, the standard deduction is
zero.
\213\ For 2017, the additional amount is $1,250 for a married
taxpayer (for each spouse meeting the applicable criteria in the case
of a joint return) and surviving spouses. The additional amount for
single individuals and heads of households is $1,550. An individual who
qualifies as both blind and elderly is entitled to two additional
standard deductions, for a total additional amount (for 2017) of $2,500
or $3,100, as applicable.
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In the case of a dependent for whom a deduction for a
personal exemption is allowable to another taxpayer, the
standard deduction may not exceed the greater of (i) $1,050 (in
2017) or (ii) the sum of $350 (in 2017) plus the dependent's
earned income. The standard deduction for an estate or trust is
zero.
The amount of the standard deduction is indexed annually
for inflation.
Explanation of Provision
The provision temporarily increases the basic standard
deduction for individuals. Under the provision, the amount of
the basic standard deduction is temporarily increased to
$24,000 for a joint return and a surviving spouse, $18,000 for
a head of household, and $12,000 for other individuals. The
amount of the standard deduction is indexed for inflation using
the C-CPI-U for taxable years beginning after December 31,
2018.
The additional standard deduction for the elderly and the
blind and the basic standard deduction for dependents are not
changed by the Act (other than the change to the inflation
adjustment).
The increase of the amount of the basic standard deduction
does not apply to taxable years beginning after December 31,
2025.\214\
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\214\ The standard deduction continues to be indexed with the C-
CPI-U after this sunset.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
B. Increase in and Modification of Child Tax Credit (sec. 11022 of the
Act and sec. 24 of the Code)
Prior Law
An individual is allowed a tax credit of $1,000 for each
qualifying child. The aggregate amount of otherwise allowable
child credits is phased out for an individual with income over
a threshold amount. Specifically, the otherwise allowable child
tax credit amount is reduced by $50 for each $1,000 (or
fraction thereof) of modified adjusted gross income (``AGI'')
over $75,000 for single individuals or heads of households,
$110,000 for married individuals filing joint returns, and
$55,000 for married individuals filing separate returns. For
purposes of this limitation, modified AGI includes certain
otherwise excludable income earned by U.S. citizens or
residents living abroad or in certain U.S. possessions.
The credit is allowable against both the regular tax and
the alternative minimum tax (``AMT'').
In some circumstances, all or a portion of the otherwise
allowable credit is treated as a refundable credit (the
``additional child tax credit''). The amount treated as a
refundable credit reduces the amount of the nonrefundable
credit. A refundable credit creates an overpayment of income
tax to the extent the credit (together with other refundable
credits) exceeds the taxpayer's income tax liability (reduced
by nonrefundable credits).
The credit is treated as refundable in an amount equal to
15 percent of earned income in excess of $3,000 (the ``earned
income'' formula). Earned income is defined as the sum of
wages, salaries, tips, and other taxable employee compensation
plus net self-employment earnings. Only items taken into
account in computing taxable income are treated as earned
income.\215\ However, at the taxpayer's election, combat pay
may be treated as earned income for these purposes.
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\215\ Some ministers' parsonage allowances are considered self-
employment income, and thus are considered earned income for purposes
of computing the EIC, but the allowances are excluded from gross income
for income tax purposes, and thus are not considered earned income for
purposes of the additional child tax credit since the income is not
included in taxable income.
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A taxpayer with three or more qualifying children may
determine the additional child tax credit using the
``alternative formula,'' if this results in a larger additional
child credit than determined under the earned income formula.
Under the alternative formula, the additional child tax credit
equals the amount by which the taxpayer's social security taxes
exceed the taxpayer's earned income credit (``EIC'').
The name and taxpayer identification number (``TIN'') \216\
of the qualifying child must appear on the return and the TIN
must be issued on or before the due date for filing the return.
The TIN of the taxpayer must also be issued on or before the
due date for filing the return.
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\216\ A Social Security number or an Individual Taxpayer
Identification Number (``ITIN'').
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Qualifying child
Generally, for purposes of the child tax credit, a
qualifying child is any individual under the age of 17 \217\
who is the taxpayer's son, daughter, stepson, stepdaughter,
brother, sister, stepbrother, stepsister, or a descendant of
any such individual. The child must share the same principal
place of abode as the taxpayer for more than one-half of the
taxable year, may not have provided over one-half of their own
support for the taxable year, and may not file a joint return
with a spouse.\218\ In order to qualify for the child tax
credit, the child must be a U.S. citizen, national, or
resident.
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\217\ Sec. 24(c)(1).
\218\ Sec. 152(c).
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Other dependents
An individual may be claimed as a taxpayer's dependent, for
purposes of the deduction for personal exemptions, if the
individual is a qualifying child \219\ or a qualifying relative
of the taxpayer and meets certain other requirements.\220\ An
individual is a taxpayer's qualifying relative if such
individual (1) bears the appropriate relationship to the
taxpayer; (2) has a gross income that does not exceed the
personal exemption amount; (3) receives one-half of his or her
support from the taxpayer; and (4) is not a qualifying child of
the taxpayer. Generally, an individual bears the appropriate
relationship to the taxpayer if the individual is the
taxpayer's lineal descendent or ancestor, brother, sister,
aunt, uncle, niece, or nephew. Some relations by marriage also
qualify, including stepmothers, stepfathers, stepbrothers,
stepsisters, sons-in-law, daughters-in-law, fathers-in-law,
mothers-in-law, brothers-in-law, and sisters-in-law. In
addition, an individual bears the appropriate relationship if
the individual has the same principal place of abode as the
taxpayer and is a member of the taxpayer's household. In order
to claim the personal exemption deduction with respect to any
individual, the taxpayer must include the individual's TIN on
the tax return.
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\219\ In the context of the dependency rules under section 152, the
age requirements differ from the rules for the child tax credit. Under
these rules, an individual meets the age requirement either a) if they
are under age 19 or b) they are a student who is under age 24. Thus,
for example, a student who is age 20 and meets the otherwise applicable
requirements would not be eligible for the child tax credit, but would
still be considered a qualifying child for purposes of the dependency
rules. See sec. 152(c)(3).
\220\ Sec. 152(d).
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Children who are U.S. citizens or nationals living abroad
or non-U.S. citizens or nationals living in Canada or Mexico
may qualify as dependents. In addition, a legally adopted child
who does not satisfy the residency or citizenship requirement
may nevertheless qualify as a dependent if (1) the child's
principal place of abode is the taxpayer's home and (2) the
taxpayer is a citizen or national of the United States.
Explanation of Provision
The provision temporarily increases the child tax credit to
$2,000 per qualifying child, and provides a $500 \221\
nonrefundable credit for each dependent other than a qualifying
child.\222\ The provision generally retains the prior-law
definition of a dependent.\223\
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\221\ Neither the $2,000 nor the $500 credit amounts are indexed
for inflation.
\222\ Qualifying child for these purposes retains the same
definition as under the prior law child tax credit. An individual who,
under prior law, would have been a qualifying child for purposes of the
dependency exemption under section 151, but not a qualifying child for
purposes of the child tax credit (e.g., a child who is age 17 or 18, or
a student under the age of 24) is eligible to be a qualifying dependent
for purposes of the $500 nonrefundable credit.
\223\ A technical correction may be necessary to achieve this
result. Additionally, under the provision the $500 nonrefundable credit
may be claimed only with respect to any dependent who is a citizen,
national or resident of the United States. Thus, non-U.S. citizens
living in Canada and Mexico may not qualify for the $500 nonrefundable
credit.
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The AGI threshold amount at which the credit begins to
phase out is $400,000 in the case of a joint return and
$200,000 for all other taxpayers. These phase-out thresholds
are not indexed for inflation.
To receive the credit (both the refundable and
nonrefundable portions) for a qualifying child, a taxpayer must
include the Social Security number of the child on the tax
return claiming the credit.\224\ For these purposes, the Social
Security number must be issued before the due date for the
filing of the return for the taxable year. The Social Security
number also must be issued to a citizen of the United States or
pursuant to a provision of the Social Security Act relating to
the lawful admission for employment in the United States.\225\
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\224\ A qualifying child with respect to whom the child tax credit
is not allowed because the child does not have a proper Social Security
number as the child's taxpayer identification number may nonetheless
qualify as a dependent for purposes of the non-refundable $500 credit.
\225\ Sec. 205(c)(2)(B)(i)(I) (or that portion of subclause (III)
that relates to subclause (I)) of the Social Security Act.
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The Social Security number requirement does not apply with
respect to a qualifying dependent for whom a $500 nonrefundable
credit is claimed. In order to claim the $500 nonrefundable
credit with respect to any individual, however, the taxpayer
must include such individual's TIN on the tax return.\226\
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\226\ A technical correction may be necessary to reflect this
intent.
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The provision lowers the earned income threshold for the
refundable child tax credit from $3,000 to $2,500. The maximum
amount of the refundable child credit may not exceed $1,400 per
qualifying child. This $1,400 amount is indexed for inflation,
although the amount may not exceed $2,000.
The modifications described above do not apply to taxable
years beginning after December 31, 2025.
The Treasury Department has issued published guidance
addressing this provision.\227\
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\227\ Notice 2018-70, 2018-38 I.R.B. 441, September 17, 2018.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
C. Modifications to the Deduction for Charitable Contributions (secs.
11023, 13704, and 13705 of the Act and sec. 170 of the Code)
Prior Law
In general
The Internal Revenue Code allows taxpayers to reduce their
income tax liability by taking deductions for contributions to
certain organizations, including charities, Federal, State,
local, and Indian tribal governments, and certain other
organizations.
To be deductible, a charitable contribution generally must
meet several threshold requirements. First, the recipient of
the transfer must be eligible to receive charitable
contributions (i.e., an organization or entity described in
section 170(c)). Second, the transfer must be made with
gratuitous intent and without the expectation of a benefit of
substantial economic value in return. Third, the transfer must
be complete and generally must be a transfer of a donor's
entire interest in the contributed property (i.e., not a
contingent or partial interest contribution). To qualify for a
current year charitable deduction, payment of the contribution
must be made within the taxable year.\228\ Fourth, the transfer
must be of money or property--contributions of services are not
deductible.\229\ Finally, the transfer must be substantiated
and in the proper form.
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\228\ Sec. 170(a)(1).
\229\ For example, the value of time spent volunteering for a
charitable organization is not deductible. Incidental expenses such as
mileage, supplies, or other expenses incurred while volunteering for a
charitable organization, however, may be deductible.
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In general, a charitable deduction is not allowed for
income, estate, or gift tax purposes if the donor transfers an
interest in property to a charity while retaining an interest
in that property or transferring an interest in that property
to a noncharity for less than full and adequate
consideration.\230\ This rule of nondeductibility, often
referred to as the partial interest rule, generally prohibits a
charitable deduction for contributions of income interests,
remainder interests, or rights to use property.
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\230\ Secs. 170(f)(3)(A) (income tax), 2055(e)(2) (estate tax), and
2522(c)(2) (gift tax).
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As discussed below, special rules limit the deductibility
of a taxpayer's charitable contributions in a given year to a
percentage of income, and those rules, in part, turn on whether
the organization receiving the contributions is a public
charity or a private foundation. Other special rules determine
the deductible value of contributed property for each type of
property.
Percentage limits on charitable contributions
Individual taxpayers
Charitable contributions by individual taxpayers are
limited to a specified percentage of the individual's
contribution base. The contribution base is the taxpayer's
adjusted gross income (``AGI'') for a taxable year,
disregarding any net operating loss carryback to the year under
section 172.\231\
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\231\ Sec. 170(b)(1)(G).
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The deduction for charitable contributions by an individual
taxpayer of cash and property that is not appreciated to a
charitable organization described in section 170(b)(1)(A)
(public charities, private foundations other than nonoperating
private foundations, and certain governmental units) may not
exceed 50 percent of the taxpayer's contribution base.
Contributions of this type of property to nonoperating private
foundations generally may be deducted up to the lesser of 30
percent of the taxpayer's contribution base or the excess of
(i) 50 percent of the contribution base over (ii) the amount of
contributions subject to the 50 percent limitation.
Contributions of appreciated capital gain property to
public charities and other organizations described in section
170(b)(1)(A) generally are deductible up to 30 percent of the
taxpayer's contribution base (after taking into account
contributions other than contributions of capital gain
property).\232\ An individual may elect, however, to bring all
these contributions of appreciated capital gain property for a
taxable year within the 50-percent limitation category by
reducing the amount of the contribution deduction by the amount
of the appreciation in the capital gain property. Contributions
of appreciated capital gain property to nonoperating private
foundations are deductible up to the lesser of 20 percent of
the taxpayer's contribution base or the excess of (i) 30
percent of the contribution base over (ii) the amount of
contributions subject to the 30 percent limitation.
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\232\ Special percentage limits and carryforward rules apply to
qualified conservation contributions. Secs. 170(b)(1)(E) and
170(b)(2)(B).
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Finally, contributions that are for the use of (not to) the
donee charity get less favorable percentage limits.
Contributions of capital gain property for the use of public
charities and other organizations described in section
170(b)(1)(A) also are limited to 20 percent of the taxpayer's
contribution base. Property contributed for the use of an
organization generally has been interpreted to mean property
contributed in trust for the organization.\233\ Charitable
contributions of income interests (where deductible) also
generally are treated as contributions for the use of the donee
organization.
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\233\ Rockefeller v. Commissioner, 676 F.2d 35, 39 (2d Cir. 1982).
TABLE 3.--CHARITABLE CONTRIBUTION PERCENTAGE LIMITS FOR INDIVIDUAL TAXPAYERS \234\
----------------------------------------------------------------------------------------------------------------
Capital Gain
Ordinary Income Capital Gain Property for the
Property and Cash Property to the use of the
Recipient \235\ Recipient
----------------------------------------------------------------------------------------------------------------
Public Charities, Private Operating Foundations, and 50% \236\ 30% 20%
Private Distributing Foundations......................
Nonoperating Private Foundations....................... 30% 20% 20%
----------------------------------------------------------------------------------------------------------------
Corporate taxpayers
A corporation generally may deduct charitable contributions
up to 10 percent of the corporation's taxable income for the
taxable year.\237\ For this purpose, taxable income is
determined without regard to: (1) the charitable contributions
deduction; (2) any net operating loss carryback to the taxable
year; (3) deductions for dividends received; and (4) any
capital loss carryback to the taxable year.\238\
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\234\ Percentages shown are the percentage of an individual's
contribution base.
\235\ Capital gain property contributed to public charities,
private operating foundations, or private distributing foundations will
be subject to the 50-percent limitation if the donor elects to reduce
the fair market value of the property by the amount that would have
been long-term capital gain if the property had been sold.
\236\ Certain qualified conservation contributions to public
charities (generally, conservation easements), qualify for more
generous contribution limits. In general, the 30-percent limit
applicable to contributions of capital gain property is increased to
100 percent if the individual making the qualified conservation
contribution is a qualified farmer or rancher or to 50 percent if the
individual is not a qualified farmer or rancher.
\237\ Sec. 170(b)(2)(A).
\238\ Sec. 170(b)(2)(D).
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Carryforwards of excess contributions
Charitable contributions that exceed the applicable
percentage limit generally may be carried forward for up to
five years.\239\ In general, contributions carried over from a
prior year are taken into account after contributions for the
current year that are subject to the same percentage limit.
Excess contributions made for the use of (rather than to) an
organization generally may not be carried forward.
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\239\ Sec. 170(d).
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Valuation of charitable contributions
In general
For purposes of the income tax charitable deduction, the
value of property contributed to charity may be limited to the
fair market value of the property, the donor's tax basis in the
property, or in some cases a different amount.
Charitable contributions of cash are deductible in the
amount contributed, subject to the percentage limits discussed
above. In addition, a taxpayer generally may deduct the full
fair market value of long-term capital gain property
contributed to charity.\240\ Contributions of tangible personal
property also generally are deductible at fair market value if
the use by the recipient charitable organization is related to
its tax-exempt purpose.
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\240\ Capital gain property means any capital asset or property
used in the taxpayer's trade or business, the sale of which at its fair
market value, at the time of contribution, would have resulted in gain
that would have been long-term capital gain. Sec. 170(e)(1)(A).
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In certain other cases, however, section 170(e) limits the
deductible value of the contribution of appreciated property to
the donor's tax basis in the property. This limitation of the
property's deductible value to basis generally applies, for
example, for: (1) contributions of inventory or other ordinary
income or short-term capital gain property; \241\ (2)
contributions of tangible personal property if the use by the
recipient charitable organization is unrelated to the
organization's tax-exempt purpose; \242\ and (3) contributions
to or for the use of a private foundation (other than certain
private operating foundations).\243\
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\241\ Sec. 170(e). Special rules, discussed below, apply for
certain contributions of inventory and other property.
\242\ Sec. 170(e)(1)(B)(i)(I).
\243\ Sec. 170(e)(1)(B)(ii). For contributions of qualified
appreciated stock, the above-described rule that limits the value of
property contributed to or for the use of a private nonoperating
foundation to the taxpayer's basis in the property does not apply;
therefore, subject to certain limits, contributions of qualified
appreciated stock to a nonoperating private foundation may be deducted
at fair market value. Sec. 170(e)(5). Certain contributions of patents
or other intellectual property also generally are limited to the
donor's basis in the property. Sec. 170(e)(1)(B)(iii). However, a
special rule permits additional charitable deductions beyond the
donor's tax basis in certain situations.
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Although most charitable contributions of property are
valued at fair market value or the donor's tax basis in the
property, certain statutorily described contributions of
appreciated inventory and other property qualify for an
``enhanced deduction'' valuation that exceeds the donor's tax
basis in the property, but which is less than the fair market
value of the property.\244\
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\244\ Sec. 170(e)(3).
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Contributions of property with a fair market value that is
less than the donor's tax basis generally are deductible at the
fair market value of the property.
College athletic seating rights
In general, where a taxpayer receives or expects to receive
a substantial return benefit for a payment to charity, the
payment is not deductible as a charitable contribution.
However, special rules apply to certain payments to
institutions of higher education in exchange for which the
payor receives the right to purchase tickets for seating at an
athletic event. Specifically, the payor may treat 80 percent of
a payment as a charitable contribution where: (1) the amount is
paid to or for the benefit of an institution of higher
education (as defined in section 3304(f)) described in section
(b)(1)(A)(ii) (generally, a school with a regular faculty and
curriculum and meeting certain other requirements), and (2)
such amount would be allowable as a charitable deduction but
for the fact that the taxpayer receives (directly or
indirectly) as a result of the payment the right to purchase
tickets for seating at an athletic event in an athletic stadium
of such institution.\245\
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\245\ Sec. 170(l).
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Substantiation and other formal requirements
In general
A donor who claims a deduction for a charitable
contribution must maintain reliable written records regarding
the contribution, regardless of the value or amount of such
contribution.\246\ In the case of a charitable contribution of
money, regardless of the amount, applicable recordkeeping
requirements are satisfied only if the donor maintains as a
record of the contribution a bank record or a written
communication from the donee showing the name of the donee
organization, the date of the contribution, and the amount of
the contribution. In such cases, the recordkeeping requirements
may not be satisfied by maintaining other written records.
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\246\ Sec. 170(f)(17).
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No charitable contribution deduction is allowed for a
separate contribution of $250 or more unless the donor obtains
a contemporaneous written acknowledgement of the contribution
from the charity indicating whether the charity provided any
good or service (and an estimate of the value of any such good
or service) to the taxpayer in consideration for the
contribution.\247\
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\247\ Such acknowledgement must include the amount of cash and a
description (but not value) of any property other than cash
contributed, whether the donee provided any goods or services in
consideration for the contribution, and a good faith estimate of the
value of any such goods or services. Sec. 170(f)(8).
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In addition, any charity receiving a contribution exceeding
$75 made partly as a gift and partly as consideration for goods
or services furnished by the charity (a ``quid pro quo''
contribution) is required to inform the contributor in writing
of an estimate of the value of the goods or services furnished
by the charity and that only the portion exceeding the value of
the goods or services is deductible as a charitable
contribution.\248\
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\248\ Sec. 6115.
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If the total charitable deduction claimed for noncash
property is more than $500, the taxpayer must attach a
completed Form 8283 (Noncash Charitable Contributions) to the
taxpayer's return or the deduction is not allowed.\249\ In
general, taxpayers are required to obtain a qualified appraisal
for donated property with a value of more than $5,000, and to
attach an appraisal summary to the tax return.
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\249\ Sec. 170(f)(11).
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Exception for certain contributions reported by the donee
organization
Subsection 170(f)(8)(D) provides an exception to the
contemporaneous written acknowledgment requirement described
above. Under the exception, a contemporaneous written
acknowledgment is not required if the donee organization files
a return, on such form and in accordance with such regulations
as the Secretary may prescribe, that includes the same content.
``[T]he section 170(f)(8)(D) exception is not available unless
and until the Treasury Department and the IRS issue final
regulations prescribing the method by which donee reporting may
be accomplished.'' \250\ No such final regulations have been
issued.\251\
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\250\ See IRS, Notice of Proposed Rulemaking, Substantiation
Requirement for Certain Contributions, REG-138344-13 (October 13,
2015), I.R.B. 2015-41 (preamble).
\251\ In October 2015, the IRS issued proposed regulations that, if
finalized, would have implemented the section 170(f)(8)(D) exception to
the contemporaneous written acknowledgment requirement. The proposed
regulations provided that a return filed by a donee organization under
section 170(f)(8)(D) must include, in addition to the information
generally required on a contemporaneous written acknowledgment: (1) the
name and address of the donee organization; (2) the name and address of
the donor; and (3) the taxpayer identification number of the donor. In
addition, the return must be filed with the IRS (with a copy provided
to the donor) on or before February 28 of the year following the
calendar year in which the contribution was made. Under the proposed
regulations, donee reporting would have been optional and would have
been available solely at the discretion of the donee organization. The
proposed regulations were withdrawn in January 2016. See Prop. Treas.
Reg. sec 1.170A-13(f)(18).
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Explanation of Provision
The provision makes the following modifications to the
charitable deduction rules. The first modification (relating to
percentage limits) is temporary. The other modifications are
permanent.
Temporary increase in percentage limit for contributions of cash to
public charities
In general
The provision adds new subparagraph 170(b)(1)(G), which
increases the income-based percentage limit from 50 percent to
60 percent for certain charitable contributions by an
individual taxpayer of cash to organizations described in
section 170(b)(1)(A) (generally, public charities and certain
private foundations that are not nonoperating private
foundations).\252\ To the extent such contributions exceed the
60-percent limit for any taxable year, the excess is carried
forward and treated as a charitable contribution that is
subject to the 60-percent limit in each of the five succeeding
taxable years in order of time.
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\252\ New sec. 170(b)(1)(G).
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The provision applies to the amount of charitable
contributions taken into account for taxable years beginning
after December 31, 2017, and before January 1, 2026.
Coordination with certain other percentage limits
applicable to individuals
It is intended that any contribution of cash by an
individual to an organization described in section 170(b)(1)(A)
(generally, public charities and certain private foundations
that are not nonoperating private foundations) shall be allowed
to the extent that the aggregate of such contributions for the
taxable year does not exceed 60 percent of the taxpayer's
contribution base, reduced by the aggregate amount of the
contributions allowed under section 170(b)(1)(A) for the year.
In other words, the 60-percent limit for cash contributions is
intended to be applied after (and reduced by) the amount of
noncash contributions to organizations described in section
170(b)(1)(A).\253\
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\253\ A technical correction may be needed to reflect this intent.
In the absence of a technical correction, there is concern that some
might interpret the provision as requiring that the 50-percent limit
for noncash contributions under section 170(b)(1)(A) be applied after
(and reduced by) the amount of cash contributions allowed under the 60-
percent limit of section 170(b)(1)(G).
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For example, assume an individual with a contribution base
of $100,000 for taxable year 2018 makes two contributions to
public charities: unappreciated property with a fair market
value of $50,000 and $10,000 in cash. The individual makes no
other charitable contributions in 2018 and has no charitable
contribution carryforwards from a prior year. The cash
contribution limit under new section 170(b)(1)(G) is determined
after accounting for noncash contributions. Thus, the $50,000
contribution of unappreciated property is accounted for first,
using up the individual's entire 50-percent contribution limit
under section 170(b)(1)(A) (50 percent of the individual's
$100,000 contribution base), and leaving $10,000 in allowable
cash contributions under the 60-percent limit ($60,000 (60
percent of $100,000) reduced by the $50,000 in noncash
contributions allowed under section 170(b)(1)(A)).
Denial of charitable deduction for college athletic event seating
rights
The provision amends section 170(l) to provide that no
charitable deduction shall be allowed for any amount described
in paragraph 170(l)(2), generally, a payment to an institution
of higher education in exchange for which the payor receives
the right to purchase tickets for seating at an athletic event.
Repeal of substantiation exception for certain contributions reported
by the donee organization
The provision repeals the section 170(f)(8)(D) exception to
the contemporaneous written acknowledgment requirement.
Effective Date
The provisions that increase the charitable contribution
percentage limit and deny a deduction for stadium seating
payments are effective for contributions made in taxable years
beginning after December 31, 2017. The provision that repeals
the substantiation exception for certain contributions reported
by the donee organization is effective for contributions made
in taxable years beginning after December 31, 2016.
D. Increased Contributions to ABLE Accounts (sec. 11024 of the Act and
secs. 25B and 529A of the Code)
Prior Law
Qualified ABLE programs
The Code provides for a tax-favored savings program
intended to benefit disabled individuals, known as qualified
ABLE programs.\254\ A qualified ABLE program is a program
established and maintained by a State or agency or
instrumentality thereof. A qualified ABLE program must meet the
following conditions: (1) under the provisions of the program,
contributions may be made to an account (an ``ABLE account''),
established for the purpose of meeting the qualified disability
expenses of the designated beneficiary of the account; (2) the
program must limit a designated beneficiary to one ABLE
account; and (3) the program must meet certain other
requirements discussed below. A qualified ABLE program is
generally exempt from income tax, but is otherwise subject to
the taxes imposed on the unrelated business income of tax-
exempt organizations.
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\254\ Sec. 529A.
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A designated beneficiary of an ABLE account is the owner of
the ABLE account. A designated beneficiary must be an eligible
individual (defined below) who established the ABLE account and
who is designated at the commencement of participation in the
qualified ABLE program as the beneficiary of amounts paid (or
to be paid) into and from the program.
Contributions to an ABLE account must be made in cash and
are not deductible for Federal income tax purposes. Except in
the case of a rollover contribution from another ABLE account,
an ABLE account must provide that it may not receive aggregate
contributions during a taxable year in excess of the amount
under section 2503(b) of the Code (the annual gift tax
exclusion). For 2017, this is $14,000.\255\ Additionally, a
qualified ABLE program must provide adequate safeguards to
ensure that ABLE account contributions do not exceed the limit
imposed on accounts under the qualified tuition program of the
State maintaining the qualified ABLE program. Amounts in the
account accumulate on a tax-deferred basis (i.e., income on
accounts under the program is not subject to current income
tax).
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\255\ The amount under sec. 2503(b) is indexed for inflation. In
the case that contributions to an ABLE account exceed the annual limit,
an excise tax in the amount of six percent of the excess contribution
to such account is imposed on the designated beneficiary. Such tax does
not apply in the event that the trustee of such account makes a
corrective distribution of such excess amounts by the due date
(including extensions) of the individual's tax return for the year in
which the excess contribution was made.
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Saver's credit
Certain taxpayers may claim a nonrefundable tax credit for
eligible taxpayers for qualified retirement savings
contributions.\256\ The tax credit is such savings
contributions as do not exceed $2,000 multiplied by the credit
rate. The credit rate depends on the adjusted gross income
(``AGI'') of the taxpayer. For this purpose, AGI is determined
without regard to certain excludable foreign-source earned
income and certain U.S. possession income.
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\256\ Sec. 25B.
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For taxable years beginning in 2017, married taxpayers
filing joint returns with AGI of $62,000 or less, taxpayers
filing head of household returns with AGI of $46,500 or less,
and all other taxpayers filing returns with AGI of $31,000 or
less are eligible for the credit. As the taxpayer's AGI
increases, the credit rate available to the taxpayer is
reduced, until, at certain AGI levels, the credit is
unavailable. The credit rates based on AGI for taxable years
beginning in 2017 are provided in the table below. The AGI
levels used for the determination of the available credit rate
are indexed for inflation.
TABLE 4.--CREDIT RATES FOR SAVER'S CREDIT
----------------------------------------------------------------------------------------------------------------
Joint Filers Heads of Households All Other Filers Credit Rate
----------------------------------------------------------------------------------------------------------------
$0-$37,000........................... $0-$27,750............. $0-$18,500............. 50 percent
$37,001-$40,000...................... $27,751-$30,000........ $18,501-$20,000........ 20 percent
$40,001-$62,000...................... $30,001-$46,500........ $20,001-$31,000........ 10 percent
Over $62,000......................... Over $46,500........... Over $31,000........... 0 percent
----------------------------------------------------------------------------------------------------------------
The saver's credit is in addition to any deduction or
exclusion that would otherwise apply with respect to the
contribution. The credit offsets alternative minimum tax
liability as well as regular tax liability. The credit is
available to individuals who are 18 years old or older, other
than individuals who are full-time students or claimed as a
dependent on another taxpayer's return.
Qualified retirement savings contributions consist of (1)
elective deferrals to a section 401(k) plan, a section 403(b)
plan, a governmental section 457 plan, a SIMPLE plan, or a
SARSEP; (2) contributions to a traditional or Roth IRA; and (3)
voluntary after-tax employee contributions to a qualified
retirement plan or section 403(b) plan. Under the rules
governing these arrangements, an individual's contribution to
the arrangement generally cannot exceed the lesser of an annual
dollar amount (for example, in 2017, $5,500 in the case of an
IRA of an individual under age 50) or the individual's
compensation that is includible in income. In the case of IRA
contributions of a married couple, the combined includible
compensation of both spouses may be taken into account.
The amount of any contribution eligible for the credit is
reduced by distributions received by the taxpayer (or by the
taxpayer's spouse if the taxpayer files a joint return with the
spouse) from any retirement plan to which eligible
contributions can be made during the taxable year for which the
credit is claimed, during the two taxable years prior to the
year for which the credit is claimed, and during the period
after the end of the taxable year for which the credit is
claimed and prior to the due date (including extensions) for
filing the taxpayer's return for the year. Distributions that
are rolled over to another retirement plan do not affect the
credit.
Explanation of Provision
The provision temporarily increases the contribution
limitation to ABLE accounts under certain circumstances. While
the annual limitation on contributions (the per-donee annual
gift tax exclusion ($15,000 for 2018)) and the overall
limitation remain the same, the limitation is increased with
respect to contributions made by the designated beneficiary of
the ABLE account. Under the provision, an ABLE account's
designated beneficiary may contribute an additional amount each
year, without regard to the annual limitation, up to the lesser
of (a) the Federal poverty line for a one-person household; or
(b) the individual's compensation for the taxable year.
Additionally, the provision allows a designated beneficiary
of an ABLE account to claim the saver's credit for
contributions made to his or her ABLE account.
The modifications described above do not apply to taxable
years beginning after December 31, 2025.
Effective Date
The provision is effective for taxable years beginning
after the date of enactment (December 22, 2017).
E. Rollovers to ABLE Programs from 529 Programs (sec. 11025 of the Act
and secs. 529 and 529A of the Code)
Prior Law
Qualified ABLE programs
The Code provides for a tax-favored savings program
intended to benefit disabled individuals, known as qualified
ABLE programs.\257\ A qualified ABLE program is a program
established and maintained by a State or agency or
instrumentality thereof. A qualified ABLE program must meet the
following conditions: (1) under the provisions of the program,
contributions may be made to an account (an ``ABLE account''),
established for the purpose of meeting the qualified disability
expenses of the designated beneficiary of the account; (2) the
program must limit a designated beneficiary to one ABLE
account; and (3) the program must meet certain other
requirements discussed below. A qualified ABLE program is
generally exempt from income tax, but is otherwise subject to
the taxes imposed on the unrelated business income of tax-
exempt organizations.
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\257\ Sec. 529A.
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A designated beneficiary of an ABLE account is the owner of
the ABLE account. A designated beneficiary must be an eligible
individual (defined below) who established the ABLE account and
who is designated at the commencement of participation in the
qualified ABLE program as the beneficiary of amounts paid (or
to be paid) into and from the program.
Contributions to an ABLE account must be made in cash and
are not deductible for Federal income tax purposes. Except in
the case of a rollover contribution from another ABLE account,
an ABLE account must provide that it may not receive aggregate
contributions during a taxable year in excess of the amount
under section 2503(b) of the Code (the annual gift tax
exclusion). For 2017, this is $14,000.\258\ Additionally, a
qualified ABLE program must provide adequate safeguards to
ensure that ABLE account contributions do not exceed the limit
imposed on accounts under the qualified tuition program of the
State maintaining the qualified ABLE program. Amounts in the
account accumulate on a tax-deferred basis (i.e., income on
accounts under the program is not subject to current income
tax).
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\258\ The 2503(b) amount is indexed for inflation. In the case that
contributions to an ABLE account exceed the annual limit, an excise tax
in the amount of six percent of the excess contribution to such account
is imposed on the designated beneficiary. Such tax does not apply in
the event that the trustee of such account makes a corrective
distribution of such excess amounts by the due date (including
extensions) of the individual's tax return for the year in which the
excess contribution was made.
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Explanation of Provision
The provision temporarily allows for amounts from qualified
tuition programs (also known as ``529 accounts''') to be rolled
over to an ABLE account without penalty, provided that the ABLE
account is owned by the designated beneficiary of that 529
account, or a member of such designated beneficiary's
family.\259\ Such rolled-over amounts count towards the annual
limitation on amounts that can be contributed to an ABLE
account within a taxable year.\260\ Any amount rolled over that
is in excess of this limitation shall be includible in the
gross income of the distributee in a manner provided by section
72.\261\
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\259\ For these purposes, a member of the family means, with
respect to any designated beneficiary, the designated beneficiary's:
(1) spouse; (2) child or descendant of a child; (3) brother, sister,
stepbrother or stepsister; (4) father, mother or ancestor of either;
(5) stepfather or stepmother; (6) niece or nephew; (7) aunt or uncle;
(8) in-law; (9) the spouse of any individual described in (2)-(8); and
(10) any first cousin.
\260\ Sec. 529A(b)(2)(B)(i).
\261\ Sec. 529(c)(3)(A).
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The provision does not apply to distributions made after
December 31, 2025.
Effective Date
The provision applies to distributions after the date of
enactment (December 22, 2017).
F. Treatment of Certain Individuals Performing Services in the Sinai
Peninsula of Egypt (sec. 11026 of the Act and secs. 2, 112, 692, 2201,
3401, 4253, 6013, and 7508 of the Code)
Prior Law
Members of the Armed Forces serving in a combat zone are
afforded a number of tax benefits. These include:
1. An exclusion from gross income of certain military pay
received for any month during which the member served in a
combat zone or was hospitalized as a result of serving in a
combat zone; \262\
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\262\ Sec. 112; see also, sec. 3401(a)(1), exempting such income
from wage withholding.
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2. An exemption from taxes on death while serving in a
combat zone or dying as a result of wounds, disease, or injury
incurred while so serving; \263\
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\263\ Sec. 692.
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3. Special estate tax rules where death occurs in a combat
zone; \264\
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\264\ Sec. 2201.
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4. Special benefits to surviving spouses in the event of a
service member's death or missing status; \265\
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\265\ Secs. 2(a)(3) and 6013(f)(1).
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5. An extension of time limits governing the filing of
returns and other rules regarding timely compliance with
Federal income tax rules; \266\ and
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\266\ Sec. 7508.
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6. An exclusion from telephone excise taxes.\267\
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\267\ Sec. 4253(d).
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The land area (not including airspace) of Egypt has been
designated as an imminent danger pay area since January 29,
1997,\268\ but is not a designated combat zone.
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\268\ Dept. of Defense reg. sec. 7000.14-R, Vol. 7A, Chapter 10,
Figure 10-1, November 2016.
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Explanation of Provision
The provision temporarily identifies the Sinai Peninsula of
Egypt as a ``qualified hazardous duty area'' that is to be
treated in the same manner as a combat zone for purposes of
determining eligibility for the benefits available to members
of the Armed Forces. This qualified hazardous duty area
designation applies only during periods in which a member of
the Armed Forces is entitled to special pay under 37 U.S.C.
sec. 310 for duty subject to hostile fire or imminent danger
for services performed in the Sinai Peninsula of Egypt.
The identification of the Sinai Peninsula of Egypt as a
qualified hazardous duty area begins June 9, 2015, and includes
the portion of the first taxable year ending after that date,
as well as all subsequent taxable years beginning before
January 1, 2026.\269\
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\269\ The IRS has provided guidance on how to claim these benefits
retroactively in Publication 3, Armed Forces' Tax Guide, p. 13, 2017,
and in the instructions for Form 1040X, rev. January 2018, p. 5.
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Effective Date
The provision is generally effective beginning June 9,
2015. The portion of the provision that excludes qualified
hazardous duty area pay from wage withholding applies to
remuneration paid on or after the date of enactment (December
22, 2017).
G. Temporary Reduction in Medical Expense Deduction Floor (sec. 11027
of the Act and sec. 213 of the Code)
Prior Law
Individuals may claim an itemized deduction for
unreimbursed medical expenses, but only to the extent that the
expenses exceed 10 percent of adjusted gross income.\270\ For
taxable years beginning before January 1, 2017, the 10-percent
threshold was reduced to 7.5 percent in the case of a taxpayer
who attained age 65 before the close of the taxable year. In
the case of a married taxpayer, the 7.5-percent threshold
applies if either the taxpayer or the taxpayer's spouse
attained age 65 before the close of the taxable year.
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\270\ Sec. 213. The threshold was amended by the Patient Protection
and Affordable Care Act (Pub. L. No. 111-118). For taxable years
beginning before January 1, 2013, the threshold was 7.5 percent for
regular tax purposes and 10 percent for AMT purposes.
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For all individuals the threshold is 10 percent for
purposes of the alternative minimum tax (``AMT'').
Explanation of Provision
Under the provision, for taxable years beginning after
December 31, 2016, and ending before January 1, 2019, the
threshold for deducting medical expenses is 7.5 percent of
adjusted gross income for all individuals. For these years,
this threshold applies for purposes of the AMT as well as the
regular tax.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2016.
H. Relief for 2016 Disaster Areas (sec. 11028 of the Act and secs.
72(t), 165, 401-403, 408, 457, and 3405 of the Code)
Prior Law
Distributions from tax-favored retirement plans
A distribution from a qualified retirement plan, a tax-
sheltered annuity plan (a ``section 403(b) plan''), an eligible
deferred compensation plan of a State or local government
employer (a ``governmental section 457(b) plan''), or an
individual retirement arrangement (an ``IRA'') generally is
included in income for the year distributed.\271\ These plans
are referred to collectively as ``eligible retirement plans.''
In addition, unless an exception applies, a distribution from a
qualified retirement plan, a section 403(b) plan, or an IRA
received before age 59\1/2\ is subject to a 10-percent
additional tax (referred to as the ``early withdrawal tax'') on
the amount includible in income.\272\
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\271\ Secs. 401(a), 403(a), 403(b), 457(b) and 408. Under section
3405, distributions from these plans are generally subject to income
tax withholding unless the recipient elects otherwise. In addition,
certain distributions from a qualified retirement plan, a section
403(b) plan, or a governmental section 457(b) plan are subject to
mandatory income tax withholding at a 20-percent rate unless the
distribution is rolled over.
\272\ Sec. 72(t). The 10-percent early withdrawal tax does not
apply to distributions from a governmental section 457(b) plan.
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In general, a distribution from an eligible retirement plan
may be rolled over to another eligible retirement plan within
60 days, in which case the amount rolled over generally is not
includible in income. The IRS has the authority to waive the
60-day requirement if failure to waive the requirement would be
against equity or good conscience, including cases of casualty,
disaster, or other events beyond the reasonable control of the
individual.
The terms of a qualified retirement plan, section 403(b)
plan, or governmental section 457(b) plan generally determine
when distributions are permitted. However, in some cases,
restrictions may apply to distribution before an employee's
termination of employment, referred to as ``in-service''
distributions. Despite such restrictions, an in-service
distribution may be permitted in the case of financial hardship
or an unforeseeable emergency.
Tax-favored retirement plans are generally required to be
operated in accordance with the terms of the plan document, and
amendments to reflect changes to the plan generally must be
adopted within a limited period.
Itemized deduction for casualty losses
A taxpayer may generally claim a deduction for any loss
sustained during the taxable year and not compensated by
insurance or otherwise.\273\ For individual taxpayers,
deductible losses must be incurred in a trade or business or
other profit-seeking activity or consist of property losses
arising from fire, storm, shipwreck, or other casualty, or from
theft. Personal casualty or theft losses are deductible only if
they exceed $100 per casualty or theft. In addition, aggregate
net casualty and theft losses are deductible only to the extent
they exceed 10 percent of an individual taxpayer's adjusted
gross income.
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\273\ Sec. 165.
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Explanation of Provision
In general
The provision provides tax relief, as described below,
relating to any area with respect to which a major disaster was
declared by the President under section 401 of the Robert T.
Stafford Disaster Relief and Emergency Assistance Act during
calendar year 2016 (a ``2016 disaster area'').
Distributions from eligible retirement plans
Under the provision, an exception to the 10-percent early
withdrawal tax applies in the case of a qualified 2016 disaster
distribution from a qualified retirement plan, a section 403(b)
plan, or an IRA. In addition, as discussed further, income
attributable to a qualified 2016 disaster distribution may be
included in income ratably over three years, and the amount of
a qualified 2016 disaster distribution may be recontributed to
an eligible retirement plan within three years.
A qualified 2016 disaster distribution is a distribution
from an eligible retirement plan made on or after January 1,
2016, and before January 1, 2018, to an individual whose
principal place of abode at any time during calendar year 2016
was located in a 2016 disaster area and who has sustained an
economic loss by reason of the events giving rise to the
Presidential disaster declaration.
The total amount of distributions to an individual from all
eligible retirement plans that may be treated as qualified 2016
disaster distributions is $100,000. Thus, any distributions in
excess of $100,000 during the applicable period are not
qualified 2016 disaster distributions.
Any amount required to be included in income as a result of
a qualified 2016 disaster is included in income ratably over
the three-year period beginning with the year of distribution
unless the individual elects not to have ratable inclusion
apply.
Any portion of a qualified 2016 disaster distribution may,
at any time during the three-year period beginning the day
after the date on which the distribution was received, be
recontributed to an eligible retirement plan to which a
rollover can be made. Any amount recontributed within the
three-year period is treated as a rollover and thus is not
includible in income. For example, if an individual receives a
qualified 2016 disaster distribution in 2016, that amount is
included in income, generally ratably over the year of the
distribution and the following two years, but is not subject to
the 10-percent early withdrawal tax. If, in 2018, the amount of
the qualified 2016 disaster distribution is recontributed to an
eligible retirement plan, the individual may file an amended
return to claim a refund of the tax attributable to the amount
previously included in income. In addition, if, under the
ratable inclusion provision, a portion of the distribution has
not yet been included in income at the time of the
contribution, the remaining amount is not includible in income.
A qualified 2016 disaster distribution is a permissible
distribution from a qualified retirement plan, section 403(b)
plan, or governmental section 457(b) plan, regardless of
whether a distribution otherwise would be permissible.\274\ A
plan is not treated as violating any Code requirement merely
because it treats a distribution as a qualified 2016 disaster
distribution, provided that the aggregate amount of such
distributions from plans maintained by the employer and members
of the employer's controlled group or affiliated service group
does not exceed $100,000. Thus, a plan is not treated as
violating any Code requirement merely because an individual
might receive total distributions in excess of $100,000, taking
into account distributions from plans of other employers or
IRAs.
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\274\ A qualified 2016 disaster distribution is subject to income
tax withholding unless the recipient elects otherwise. Mandatory 20-
percent withholding does not apply.
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A plan amendment made pursuant to the provision (or a
regulation issued thereunder) may be retroactively effective
if, in addition to the requirements described below, the
amendment is made on or before the last day of the first plan
year beginning after December 31, 2018 (or in the case of a
governmental plan, December 31, 2020), or a later date
prescribed by the Secretary. In addition, the plan will be
treated as operated in accordance with plan terms during the
period beginning with the date the provision or regulation
takes effect (or the date specified by the plan if the
amendment is not required by the provision or regulation) and
ending on the last permissible date for the amendment (or, if
earlier, the date the amendment is adopted). For an amendment
to be retroactively effective, it must apply retroactively for
that period, and the plan must be operated in accordance with
the amendment during that period.
Modification of rules related to casualty losses
Under the provision, in the case of a personal casualty
loss which arose on or after January 1, 2016, in a 2016
disaster area and was attributable to the events giving rise to
the Presidential disaster declaration, such losses are
deductible without regard to whether aggregate net losses
exceed 10 percent of a taxpayer's adjusted gross income. Under
the provision, to be deductible, the losses must exceed $500
per casualty. Additionally, such losses may be claimed in
addition to the standard deduction.
Effective Date
The provision is effective on the date of enactment
(December 22, 2017). The casualty loss relief under the
provision applies to losses arising in taxable years beginning
after December 31, 2015, and before January 1, 2018.
PART IV--EDUCATION
A. Treatment of Student Loans Discharged on Account of Death or
Disability (sec. 11031 of the Act and sec. 108 of the Code)
Prior Law
Gross income generally includes the discharge of
indebtedness of the taxpayer. Under an exception to this
general rule, gross income does not include any amount from the
forgiveness (in whole or in part) of certain student loans,
provided that the forgiveness is contingent on the student's
working for a certain period of time in certain professions for
any of a broad class of employers.\275\
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\275\ Sec. 108(f).
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Student loans eligible for this special rule must be made
to an individual to assist the individual in attending an
educational institution that normally maintains a regular
faculty and curriculum and normally has a regularly enrolled
body of students in attendance at the place where its education
activities are regularly carried on. Loan proceeds may be used
not only for tuition and required fees, but also to cover room
and board expenses. The loan must be made by (1) the United
States (or an instrumentality or agency thereof), (2) a State
(or any political subdivision thereof), (3) certain tax-exempt
public benefit corporations that control a State, county, or
municipal hospital and whose employees have been deemed to be
public employees under State law, or (4) an educational
organization that originally received the funds from which the
loan was made from the United States, a State, or a tax-exempt
public benefit corporation.
In addition, an individual's gross income does not include
amounts from the forgiveness of loans made by educational
organizations (and certain tax-exempt organizations in the case
of refinancing loans) out of private, nongovernmental funds if
the proceeds of such loans are used to pay costs of attendance
at an educational institution or to refinance any outstanding
student loans (not just loans made by educational
organizations) and the student is not employed by the lender
organization. In the case of such loans made or refinanced by
educational organizations (or refinancing loans made by certain
tax-exempt organizations), cancellation of the student loan
must be contingent on the student working in an occupation or
area with unmet needs and such work must be performed for, or
under the direction of, a tax-exempt charitable organization or
a governmental entity.
Finally, an individual's gross income does not include any
loan repayment amount received under the National Health
Service Corps loan repayment program, certain State loan
repayment programs, or any amount received by an individual
under any State loan repayment or loan forgiveness program that
is intended to provide for the increased availability of health
care services in underserved or health professional shortage
areas (as determined by the State).
Explanation of Provision
The provision temporarily modifies the exclusion of student
loan discharges from gross income by expanding the exclusion to
include certain discharges on account of death or disability.
Loans eligible for the exclusion under the provision are (1)
loans made by the United States \276\ (or an instrumentality or
agency thereof), (2) loans made by a State (or any political
subdivision thereof), (3) loans made by certain tax-exempt
public benefit corporations that control a State, county, or
municipal hospital and whose employees have been deemed to be
public employees under State law, (4) loans made by an
educational organization that originally received the funds
from which the loan was made from the United States, a State,
or a tax-exempt public benefit corporation, or (5) private
education loans (for this purpose, private education loan is
defined in section 140(7) of the Consumer Credit Protection
Act).\277\
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\276\ A technical correction may be needed to reflect the intent to
include Parent PLUS loans.
\277\ 15 U.S.C. sec. 1650(7).
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Under the provision, the discharge of a loan as described
above is excluded from gross income if the discharge was
pursuant to the death or total and permanent disability of the
student.\278\ The provision does not apply to loans discharged
after December 31, 2025.
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\278\ Although the provision makes specific reference to those
provisions of the Higher Education Act of 1965 that discharge William
D. Ford Federal Direct Loan Program loans, Federal Family Education
Loan Program loans, and Federal Perkins Loan Program loans in the case
of death and total and permanent disability, the provision also
contains a catch-all exclusion in the case of a student loan discharged
on account of the death or total and permanent disability of the
student, in addition to those specific statutory references.
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Effective Date
The provision applies to discharges of loans after December
31, 2017.
B. 529 Account Funding for Elementary and Secondary Education (sec.
11032 of the Act and sec. 529 of the Code)
Prior Law
In general
A qualified tuition program is a program established and
maintained by a State or agency or instrumentality thereof, or
by one or more eligible educational institutions, which
satisfies certain requirements and under which a person may
purchase tuition credits or certificates on behalf of a
designated beneficiary that entitle the beneficiary to the
waiver or payment of qualified higher education expenses of the
beneficiary (a ``prepaid tuition program''). Section 529
provides specified income tax and transfer tax rules for the
treatment of accounts and contracts established under qualified
tuition programs.\279\ In the case of a program established and
maintained by a State or agency or instrumentality thereof, a
qualified tuition program also includes a program under which a
person may make contributions to an account that is established
for the purpose of satisfying the qualified higher education
expenses of the designated beneficiary of the account, provided
it satisfies certain specified requirements (a ``savings
account program''). Under both types of qualified tuition
programs, a contributor establishes an account for the benefit
of a particular designated beneficiary to provide for that
beneficiary's higher education expenses.
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\279\ For purposes of this description, the term ``account'' is
used interchangeably to refer to a prepaid tuition benefit contract or
a tuition savings account established pursuant to a qualified tuition
program.
---------------------------------------------------------------------------
In general, prepaid tuition contracts and tuition savings
accounts established under a qualified tuition program involve
prepayments or contributions made by one or more individuals
for the benefit of a designated beneficiary. Decisions with
respect to the contract or account are typically made by an
individual who is not the designated beneficiary. Qualified
tuition accounts or contracts generally require the designation
of a person (generally referred to as an ``account owner'')
\280\ whom the program administrator (oftentimes a third-party
administrator retained by the State or by the educational
institution that established the program) may look to for
decisions, recordkeeping, and reporting with respect to the
account established for a designated beneficiary. The person or
persons who make the contributions to the account need not be
the same person who is regarded as the account owner for
purposes of administering the account. Under many qualified
tuition programs, the account owner generally has control over
the account or contract, including the ability to change
designated beneficiaries and to withdraw funds at any time and
for any purpose. Thus, in practice, qualified tuition accounts
or contracts generally involve a contributor, a designated
beneficiary, an account owner (who oftentimes is not the
contributor or the designated beneficiary), and an
administrator of the account or contract.
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\280\ Section 529 refers to contributors and designated
beneficiaries, but does not define or otherwise refer to the term
``account owner,'' which is a commonly used term among qualified
tuition programs.
---------------------------------------------------------------------------
Qualified higher education expenses
Distributions for the purpose of meeting the designated
beneficiary's higher education expenses are generally not
subject to tax. For purposes of receiving a distribution from a
qualified tuition program that qualifies for this favorable tax
treatment, qualified higher education expenses means tuition,
fees, books, supplies, and equipment required for the
enrollment or attendance of a designated beneficiary at an
eligible educational institution, and expenses for special
needs services in the case of a special needs beneficiary that
are incurred in connection with such enrollment or attendance.
Qualified higher education expenses generally also include room
and board for students who are enrolled at least half-time.
Qualified higher education expenses include the purchase of any
computer technology or equipment, or Internet access or related
services, if such technology or services were to be used
primarily by the beneficiary during any of the years a
beneficiary is enrolled at an eligible institution.
Contributions to qualified tuition programs
Contributions to a qualified tuition program must be made
in cash. Section 529 does not impose a specific dollar limit on
the amount of contributions, account balances, or prepaid
tuition benefits relating to a qualified tuition account;
however, the program is required to have adequate safeguards to
prevent contributions in excess of amounts necessary to provide
for the beneficiary's qualified higher education expenses.
Contributions generally are treated as a completed gift
eligible for the gift tax annual exclusion. Contributions are
not tax deductible for Federal income tax purposes, although
they may be deductible for State income tax purposes. Amounts
in the account accumulate on a tax-free basis (i.e., income on
accounts in the plan is not subject to current income tax).
A qualified tuition program may not permit any contributor
to, or designated beneficiary under, the program to direct
(directly or indirectly) the investment of any contributions
(or earnings thereon) more than two times in any calendar year,
and must provide separate accounting for each designated
beneficiary. A qualified tuition program may not allow any
interest in an account or contract (or any portion thereof) to
be used as security for a loan.
Explanation of Provision
The provision modifies section 529 plans to allow such
plans to distribute not more than $10,000 in expenses for
tuition incurred during the taxable year in connection with the
enrollment or attendance of the designated beneficiary at a
public, private, or religious elementary or secondary
school.\281\ This limitation applies on a per-student basis,
rather than a per-account basis. Thus, under the provision,
although an individual may be the designated beneficiary of
multiple accounts, that individual may receive a maximum of
$10,000 in distributions free of tax, regardless of whether the
funds are distributed from multiple accounts. Any excess
distributions received by the individual would be treated as a
distribution subject to tax under the general rules of section
529.
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\281\ This special treatment of elementary and secondary school
tuition expenses is pursuant to section 529(c)(7), which provides that
these expenses are treated as qualified higher education expenses for
purposes of this subsection (i.e., sec. 529(c)). Thus, elementary and
secondary school tuition is not treated as a qualified higher education
expense for purposes of section 529 other than with respect to the tax
treatment of distributions. For instance, for purposes of section
529(b)(6), which requires that a 529 plan must provide adequate
safeguards to prevent contributions on behalf of a designated
beneficiary in excess of those necessary to provide for the qualified
higher education expenses of such beneficiary, the maximum contribution
amounts for purposes of such a prohibition should remain unchanged. See
Prop. Treas. Reg. sec. 1.529-2(i)(2) (providing for a safe harbor under
this requirement if the 529 plan limits the total account balance to
actuarial estimates of the amount needed to pay tuition, required fees
and room and board expenses of the designated beneficiary for five
years of undergraduate enrollment at the highest cost institution
allowed by the program).
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Effective Date
The provision applies to distributions made after December
31, 2017.
PART V--DEDUCTIONS AND EXCLUSIONS
A. Suspension of Deduction for Personal Exemptions (sec. 11041 of the
Act and sec. 151 of the Code)
Prior Law
In determining taxable income, an individual reduces
adjusted gross income by any personal exemption deductions and
either the applicable standard deduction or his or her itemized
deductions. Personal exemptions generally are allowed for the
taxpayer (both taxpayers in the case of a joint return) and any
dependents of the taxpayer.\282\ For 2017, the amount
deductible for each personal exemption is $4,050. This amount
is indexed annually for inflation. The personal exemption
amount is phased out in the case of an individual with AGI in
excess of $313,800 for married taxpayers filing jointly,
$287,650 for heads of household, $156,900 for married taxpayers
filing separately, and $261,500 for all other filers. In
addition, no deduction for a personal exemption is allowed to a
dependent if a personal exemption deduction for the dependent
is allowable to another taxpayer or if an individual's TIN is
not included on the return claiming the exemption.
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\282\ In addition, a married taxpayer filing a separate return may
claim a personal exemption deduction for a spouse if the spouse has no
gross income and is not a dependent of another taxpayer.
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Withholding rules
The amount of tax required to be withheld by employers from
a taxpayer's wages is based in part on the number of
withholding exemptions a taxpayer claims on his Form W-4. An
employee is entitled to the following exemptions: (1) an
exemption for himself, unless he is allowed to be claimed as a
dependent of another person; (2) an exemption to which the
employee's spouse would be entitled, if that spouse does not
file a Form W-4 for that taxable year claiming an exemption
described in (1); (3) an exemption for each individual who is a
dependent (but only if the employee's spouse has not also
claimed such a withholding exemption on a Form W-4); (4)
additional withholding allowances (taking into account
estimated itemized deductions, estimated tax credits, and
additional deductions as provided by the Secretary of the
Treasury); and (5) a standard deduction allowance.
Filing requirements
An unmarried individual is required to file a tax return
for a taxable year if the individual has gross income for the
year which equals or exceeds the sum of the exemption amount
plus the standard deduction applicable to such individual
(i.e., single, head of household, or surviving spouse). An
individual entitled to file a joint return is required to do so
unless that individual's gross income, when combined with the
individual's spouse's gross income for the taxable year, is
less than the sum of twice the exemption amount plus the basic
standard deduction applicable to a joint return, provided that
the individual and his spouse, at the close of the taxable
year, had the same household as their home, the individual's
spouse did not make a separate return, and no other taxpayer is
entitled to an exemption for the individual's spouse.
Trusts and estates
In lieu of the deduction for personal exemptions, an estate
is allowed a deduction of $600. A trust is allowed a deduction
of $100; $300 if required to distribute all its income
currently; and an amount equal to the personal exemption of an
individual in the case of a qualified disability trust.
Explanation of Provision
Under the provision, for taxable years 2018 through 2025,
the amount of a personal exemption is zero.\283\
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\283\ The provision also clarifies that, for purposes of taxable
years in which the personal exemption is reduced to zero, this should
not alter the operation of those provisions of the Code that refer to a
taxpayer allowed a deduction (or an individual with respect to whom a
taxpayer is allowed a deduction) under section 151. Thus, for instance,
sec. 24(a) allows a credit against tax with respect to each qualifying
child of the taxpayer for which the taxpayer is allowed a deduction
under section 151. A qualifying child, as defined under section 152(c),
remains eligible to be treated as such for purposes of the credit,
notwithstanding that the deduction under section 151 has been reduced
to zero.
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The Act modifies the provision relating to persons required
to file an income tax return to take account of the reduction
of the exemption amount to zero. Under the provision, as under
prior law, every individual who has gross income for the
taxable year is required to file an income tax return. However,
an unmarried individual is exempt from the filing requirement
if the individual's gross income for the taxable year is less
than or equal to the individual's applicable standard
deduction. A married individual is exempt from the filing
requirement if the individual's gross income, when combined
with the individual's spouse's gross income, for the taxable
year, is more than the standard deduction applicable to the
joint return of the individuals, provided that: (i) such
individual and his spouse, at the close of the taxable year,
had the same household as their home; (ii) the individual's
spouse does not make a separate return; and (iii) neither the
individual nor his spouse is a dependent of another taxpayer
who has income (other than earned income) in excess of $500
(indexed for inflation).
Under the provision, the Secretary of the Treasury is to
develop rules to determine the amount of tax required to be
withheld by employers from a taxpayer's wages.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
Under the provision, the Secretary may administer the
withholding rules under section 3402 for taxable years
beginning before January 1, 2019, without regard to the
provision. Thus, at the Secretary's discretion, wage
withholding rules may remain the same as under prior law for
2018.
B. Limitation on Deduction for State and Local, etc. Taxes (sec. 11042
of the Act and sec. 164 of the Code)
Prior Law
Individuals are permitted a deduction for certain taxes
paid or accrued, whether or not incurred in a taxpayer's trade
or business or activity for the production of income. These
taxes are: (i) State and local, and foreign, real property
taxes; \284\ (ii) State and local personal property taxes;
\285\ and (iii) State and local, and foreign, income, war
profits, and excess profits taxes.\286\ At the election of the
taxpayer, an itemized deduction may be taken for State and
local general sales taxes in lieu of the itemized deduction for
State and local income taxes.\287\ An individual may elect to
claim a credit rather than a deduction for foreign income, war
profits, and excess profits taxes.\288\
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\284\ Sec. 164(a)(1).
\285\ Sec. 164(a)(2).
\286\ Sec. 164(a)(3).
\287\ Sec. 164(b)(5).
\288\ Sec. 901.
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Property taxes may be allowed as a deduction in computing
adjusted gross income if incurred in connection with property
used in a trade or business; otherwise they are an itemized
deduction. In the case of State and local income taxes, the
deduction is an itemized deduction notwithstanding that the tax
may be imposed on profits from a trade or business.\289\
---------------------------------------------------------------------------
\289\ See H. Rep. No. 1365 to accompany Individual Income Tax Bill
of 1944 (78th Cong., 2d. Sess.), reprinted at 19 C.B. 839 (1944); S.
Rep. No. 884 to accompany Individual Income Tax Bill of 1944 (78th
Cong, 2d Sess.), reprinted at 19 C.B. 878 (1944).
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Individuals also are permitted a deduction for Federal and
State generation skipping transfer tax (``GST tax'') imposed on
certain income distributions that are included in the gross
income of the distributee.\290\ In addition, individuals are
permitted a deduction for one-half of self-employment
taxes.\291\
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\290\ Sec. 164(a)(4).
\291\ Sec. 164(f).
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In determining an individual's alternative minimum taxable
income, no itemized deduction for property, income, or sales
tax is allowed.\292\
---------------------------------------------------------------------------
\292\ Sec. 56(b)(1)(A)(ii).
---------------------------------------------------------------------------
Explanation of Provision
Under the provision, in the case of an individual,\293\ the
itemized deduction for the aggregate of (i) State and local
property taxes not paid or accrued in carrying on a trade or
business, or an activity described in section 212, and (ii)
State and local income, war profits, and excess profits taxes
(or sales taxes in lieu of income, etc. taxes) paid or accrued
in the taxable year, is limited to $10,000 ($5,000 for a
married taxpayer filing a separate return). It is intended that
the limitation apply to the deduction for amounts paid or
accrued to a cooperative housing corporation by a tenant-
stockholder under section 216(a)(1) (relating to real estate
taxes) in the same manner as the limitation applies to real
estate taxes under section 164.\294\ Under the provision,
foreign real property taxes may not be deducted.
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\293\ The $10,000 limitation applies to all tax returns of
individuals other than married taxpayers filing separate returns, for
whom the limitation is $5,000. The use of the phrase ``in the case of
an individual'' in the statute distinguishes those taxpayers to whom
the limit applies from corporate taxpayers (for whom the limit is not
applicable). The use of the term ``individual'' does not allow each
spouse filing a joint return to deduct up to $10,000. Rather, the limit
applies to the tax-filing unit. This is consistent with longstanding
usage elsewhere in the Code. See, e.g., section 21 (limitations on
child care credit understood to apply to the tax filing unit in the
aggregate, notwithstanding the credit applying ``in the case of an
individual''), section 36 (maximum allowable credit understood to apply
to the tax filing unit in the aggregate, notwithstanding that the
credit is provided ``in the case of an individual who is a first-time
homebuyer''), section 67 (two-percent floor on miscellaneous itemized
deductions understood to apply to the tax filing unit in the aggregate,
notwithstanding that the floor is applied ``in the case of an
individual''), section 165 (per-loss limitations understood to apply to
the tax filing unit, notwithstanding that the limitations apply in the
case of ``any loss of an individual''), and section 1411 (measurement
of net investment income understood to apply to the tax-filing unit,
notwithstanding that the adjusted gross income threshold upon which the
tax is measured is stated ``in the case of an individual'').
Many other Code sections use the term ``in the case of an
individual'' to specify that a particular credit or deduction is not
available to corporate taxpayers, and provide further evidence that
limitations on those credits or deductions are meant to apply on a per-
tax filing units by describing limitations in terms of the
``taxpayer.'' See, e.g., secs. 23, 25A, 25C, 25D, 32, 35, 151,
170(b)(1)(A), 221, and 222. The Conference Report to the Act explicitly
states ``Under the provision a taxpayer may claim an itemized deduction
of up to $10,000 ($5,000 for married taxpayers filing a separate
return) for the aggregate of . . .'' (emphasis added).
The $5,000 limitation applicable to married taxpayers filing a
separate return is consistent with a $10,000 limitation applying to
married taxpayers filing jointly, with such limitation applying to the
tax-filing unit. There is no Code provision wherein a specific
limitation provided for married taxpayers who file separately is
anything other than half of the limitation imposed on married taxpayers
filing jointly (other than those instances in which married taxpayers
filing separately are forbidden from claiming the benefit altogether).
\294\ A technical correction may be needed to achieve this result.
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Thus, under the provision, in the case of an
individual,\295\ as a general matter, State, local, and foreign
property taxes and State and local sales taxes are not subject
to the above-described limitation only when paid or accrued in
carrying on a trade or business, or an activity described in
section 212 (relating to expenses for the production of
income).\296\ Thus, the provision does not limit those
deductions for State, local, and foreign property taxes, and
sales taxes which are taken into account in computing items of
income on Schedule C, Schedule E, or Schedule F of the
individual's income tax return. For instance, in the case of
property taxes, an individual may deduct these taxes if imposed
on business assets (such as residential rental property).
---------------------------------------------------------------------------
\295\ See section 641(b) regarding the computation of taxable
income of an estate or trust in the same manner as an individual.
\296\ The provision does not modify the deductibility of GST tax
imposed on certain income distributions. Additionally, taxes imposed at
the entity level, such as a business tax imposed on pass-through
entities, that are reflected in a partner's or S corporation
shareholder's distributive or pro-rata share of income or loss on a
Schedule K-1 (or similar form), will continue to reduce such partner's
or shareholder's distributive or pro-rata share of income as under
prior law.
---------------------------------------------------------------------------
The limitation applies to taxable years beginning after
December 31, 2017, and beginning before January 1, 2026.
In the case of an amount paid in a taxable year beginning
before January 1, 2018, with respect to a State or local income
tax imposed for a taxable year beginning after December 31,
2017, the payment shall be treated as paid on the last day of
the taxable year for which such tax is so imposed for purposes
of applying the provision limiting the dollar amount of the
deduction. Thus, under the provision, an individual may not
claim an itemized deduction in 2017 on a prepayment of income
tax for a future taxable year in order to avoid the dollar
limitation applicable for taxable years beginning after 2017.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2016.
C. Limitation on Deduction for Qualified Residence Interest (sec. 11043
of the Act and sec. 163(h) of the Code)
Prior Law
As a general matter, personal interest is not
deductible.\297\ Qualified residence interest is not treated as
personal interest and is allowed as an itemized deduction,
subject to limitations.\298\ Qualified residence interest means
interest paid or accrued during the taxable year on either
acquisition indebtedness or home equity indebtedness. A
qualified residence means the taxpayer's principal residence
and one other residence of the taxpayer selected to be a
qualified residence. A qualified residence can be a house,
condominium, cooperative, mobile home, house trailer, or boat.
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\297\ Sec. 163(h)(1).
\298\ Sec. 163(h)(2)(D) and (h)(3).
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Acquisition indebtedness
Acquisition indebtedness is indebtedness that is incurred
in acquiring, constructing, or substantially improving a
qualified residence of the taxpayer and that secures the
residence. The maximum amount treated as acquisition
indebtedness is $1 million ($500,000 in the case of a married
person filing a separate return).
Acquisition indebtedness also includes indebtedness from
the refinancing of other acquisition indebtedness but only to
the extent of the amount (and term) of the refinanced
indebtedness. Thus, for example, if the taxpayer incurs
$200,000 of acquisition indebtedness to acquire a principal
residence and pays down the debt to $150,000, the taxpayer's
acquisition indebtedness with respect to the residence cannot
thereafter be increased above $150,000 (except by indebtedness
incurred to substantially improve the residence).
Interest on acquisition indebtedness is deductible in
computing alternative minimum taxable income. However, in the
case of a second residence, the acquisition indebtedness may
only be incurred with respect to a house, apartment,
condominium, or a mobile home that is not used on a transient
basis.
Home equity indebtedness
Home equity indebtedness is indebtedness (other than
acquisition indebtedness) secured by a qualified residence.
The amount of home equity indebtedness may not exceed
$100,000 ($50,000 in the case of a married individual filing a
separate return) and may not exceed the fair market value of
the residence reduced by the acquisition indebtedness.
Interest on home equity indebtedness is not deductible in
computing alternative minimum taxable income.
Interest on qualifying home equity indebtedness is
deductible, regardless of how the proceeds of the indebtedness
are used. For example, personal expenditures may include health
costs and education expenses for the taxpayer's family members
or any other personal expenses such as vacations, furniture, or
automobiles. A taxpayer and a mortgage company can contract for
the home equity indebtedness loan proceeds to be transferred to
the taxpayer in a lump sum payment (e.g., a traditional
mortgage), a series of payments (e.g., a reverse mortgage), or
the lender may extend the borrower a line of credit up to a
fixed limit over the term of the loan (e.g., a home equity line
of credit).
Thus, the aggregate limitation on the total amount of a
taxpayer's acquisition indebtedness and home equity
indebtedness with respect to a taxpayer's principal residence
and a second residence that may give rise to deductible
interest is $1,100,000 ($550,000, for married persons filing a
separate return).
Explanation of Provision
Under the provision, in the case of taxable years beginning
after December 31, 2017, and beginning before January 1, 2026,
the maximum amount treated as acquisition indebtedness is
$750,000 ($375,000 in the case of a married person filing a
separate return). However, in the case of acquisition
indebtedness incurred before December 15, 2017,\299\ the
limitation remains at $1,000,000 ($500,000 in the case of
married taxpayers filing separately).\300\ For taxable years
beginning after December 31, 2025, a taxpayer may treat up to
$1,000,000 ($500,000 in the case of married taxpayers filing
separately) of indebtedness as acquisition indebtedness,
regardless of when the indebtedness was incurred.
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\299\ Under the provision, a taxpayer who has entered into a
binding written contract before December 15, 2017, to close on the
purchase of a principal residence before January 1, 2018, and who
purchases such residence before April 1, 2018, shall be considered to
have incurred acquisition indebtedness prior to December 15, 2017.
\300\ Special rules apply in the case of indebtedness from
refinancing existing acquisition indebtedness. Specifically, the
$1,000,000 ($500,000 in the case of married taxpayers filing
separately) limitation continues to apply to any indebtedness incurred
on or after December 15, 2017, to refinance qualified residence
indebtedness incurred before that date to the extent the amount of the
indebtedness resulting from the refinancing does not exceed the amount
of the refinanced indebtedness, and the refinancing does not extend the
term of indebtedness. Thus, the maximum dollar amount that may be
treated as principal residence acquisition indebtedness will not
decrease by reason of a refinancing.
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Additionally, the provision suspends the deduction for
interest on home equity indebtedness. Thus, for taxable years
beginning after December 31, 2017, a taxpayer may not claim a
deduction for interest on home equity indebtedness. The
suspension ends for taxable years beginning after December 31,
2025.
To illustrate the operation of the provision, assume a
taxpayer incurred $700,000 acquisition indebtedness prior to
December 15, 2017. On May 1, 2018, the taxpayer incurs a home
equity loan of $100,000, none of the proceeds of which are used
to finance a substantial improvement to the taxpayer's
residence. Interest on the acquisition indebtedness remains
deductible in 2018 and thereafter. No interest on the home
equity loan is deductible. However, if the proceeds of the home
equity loan are used to make substantial improvements on the
taxpayer's residence, then the loan is considered acquisition
indebtedness for purposes of the home mortgage interest
deduction. Accordingly, the taxpayer may deduct interest on
$50,000 of the $100,000 home equity loan ($50,000 equals
$750,000 reduced by the pre-December 15 2017, acquisition
indebtedness of $700,000). To the extent the principal of the
old loan is reduced below $700,000, additional interest on the
principal of the home equity loan becomes deductible.
Assume however, the taxpayer incurred $800,000 acquisition
indebtedness prior to December 15, 2017. Interest on the
$800,000 indebtedness remains deductible in 2018 and
thereafter. No interest on the home equity interest loan
incurred in 2018 is deductible notwithstanding that the loan
proceeds may have been used for substantial improvements to the
taxpayer's home. This is because the $750,000 limitation on
acquisition indebtedness incurred after December 15, 2017, is
reduced (but not below zero) by the $800,000 acquisition
indebtedness incurred before December 15, 2017. If the
taxpayer's old acquisition indebtedness is reduced to less than
$750,000, interest on the portion of the taxpayer's home equity
indebtedness may be deductible (to the extent that $750,000
exceeds the indebtedness of the old loan), assuming the
indebtedness qualifies as acquisition indebtedness (i.e., the
loan proceeds were used for substantial improvements on the
home).
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
D. Modification of Deduction for Personal Casualty Losses (sec. 11044
of the Act and sec. 165 of the Code)
Prior Law
A taxpayer may generally claim an itemized deduction for
any loss sustained during the taxable year, not compensated by
insurance or otherwise. For individual taxpayers, deductible
losses must be incurred in a trade or business or other profit-
seeking activity or consist of property losses arising from
fire, storm, shipwreck, or other casualty, or from theft.\301\
Personal casualty or theft losses are deductible only if they
exceed $100 per casualty or theft. In addition, aggregate net
casualty and theft losses are deductible only to the extent
they exceed 10 percent of an individual taxpayer's adjusted
gross income.
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\301\ Sec. 165(c).
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Explanation of Provision
The provision temporarily modifies the itemized deduction
for personal casualty and theft losses. Under the provision, an
individual may claim an itemized deduction for a personal
casualty loss (subject to the limitations described above) only
if such loss was attributable to a disaster declared by the
President under section 401 of the Robert T. Stafford Disaster
Relief and Emergency Assistance Act. An exception applies to
the extent a loss of an individual does not exceed the
individual's personal casualty gains.
The above limitation does not apply with respect to losses
incurred after December 31, 2025.
Effective Date
The provision is effective for losses incurred in taxable
years beginning after December 31, 2017.
E. Suspension of Miscellaneous Itemized Deductions (sec. 11045 of the
Act and secs. 62, 67 and 212 of the Code)
Prior Law
Individuals may deduct certain expenses in computing
taxable income that do not reduce adjusted gross income
(``AGI''). These deductions are referred to as ``itemized
deductions''. Some of these expenses (``miscellaneous itemized
deductions'') are deductible only if, in the aggregate, they
exceed two percent of the taxpayer's AGI.\302\ The deductions
listed below are miscellaneous itemized deductions subject to
the two-percent floor.
---------------------------------------------------------------------------
\302\ Sec. 67(a).
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Expenses for the production or collection of income
Individuals may deduct all ordinary and necessary expenses
paid or incurred for the production or collection of income.
These expenses are defined as ordinary and necessary expenses
paid or incurred in a taxable year: (1) for the production or
collection of income; \303\ (2) for the management,
conservation, or maintenance of property held for the
production of income; \304\ or (3) in connection with the
determination, collection, or refund of any tax.\305\
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\303\ Sec. 212(1).
\304\ Sec. 212(2).
\305\ Sec. 212(3).
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IRS guidance provides examples of items that may be
deducted under this provision. This non-exhaustive list
includes: \306\
---------------------------------------------------------------------------
\306\ See IRS Publication 529, Miscellaneous Deductions (2016), p.
9.
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Appraisal fees for a casualty loss or
charitable contribution;
Casualty and theft losses from property used
in performing services as an employee;
Clerical help and office rent in caring for
investments;
Depreciation on home computers used for
investments;
Excess deductions (including administrative
expenses) allowed a beneficiary on termination of an
estate or trust;
Fees to collect interest and dividends;
Hobby expenses, but generally not more than
hobby income;
Indirect miscellaneous deductions from pass-
through entities;
Investment fees and expenses;
Loss on deposits in an insolvent or bankrupt
financial institution;
Loss on traditional IRAs or Roth IRAs, when
all amounts have been distributed;
Repayments of income;
Safe deposit box rental fees, except for
storing jewelry and other personal effects;
Service charges on dividend reinvestment
plans;
Tax preparation fees; and
Trustee's fees for an IRA, if separately
billed and paid.
Unreimbursed expenses attributable to the trade or business of being an
employee
In general, unreimbursed business expenses incurred by an
employee are deductible, but only as an itemized deduction and
only to the extent the expenses exceed two percent of adjusted
gross income.\307\
---------------------------------------------------------------------------
\307\ Secs. 62(a)(1) and 67.
---------------------------------------------------------------------------
IRS guidance provides examples of items that may be
deducted under this provision. This non-exhaustive list
includes: \308\
---------------------------------------------------------------------------
\308\ See IRS Publication 529, Miscellaneous Deductions (2016), p.
3.
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Business bad debt of an employee;
Business liability insurance premiums;
Damages paid to a former employer for breach
of an employment contract;
Depreciation on a computer a taxpayer's
employer requires him to use in his work;
Dues to a chamber of commerce if membership
helps the taxpayer perform his job;
Dues to professional societies;
Educator expenses; \309\
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\309\ Under a special provision, these expenses are deductible
``above the line'' up to $250.
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Home office or part of a taxpayer's home
used regularly and exclusively in the taxpayer's work;
Job search expenses in the taxpayer's
present occupation;
Laboratory breakage fees;
Legal fees related to the taxpayer's job;
Licenses and regulatory fees;
Malpractice insurance premiums;
Medical examinations required by an
employer;
Occupational taxes;
Passport fees for a business trip;
Repayment of an income aid payment received
under an employer's plan;
Research expenses of a college professor;
Rural mail carriers' vehicle expenses;
Subscriptions to professional journals and
trade magazines related to the taxpayer's work;
Tools and supplies used in the taxpayer's
work;
Purchase of travel, transportation, meals,
entertainment, gifts, and local lodging related to the
taxpayer's work;
Union dues and expenses;
Work clothes and uniforms if required and
not suitable for everyday use; and
Work-related education.
Other miscellaneous itemized deductions
Other miscellaneous itemized deductions include:
Repayments of income received under a claim
of right (only subject to the two-percent floor if less
than $3,000);
Repayments of Social Security benefits; and
The share of deductible investment expenses
from pass-through entities.
Explanation of Provision
The provision temporarily eliminates all miscellaneous
itemized deductions that were subject to the two-percent floor
under prior law.\310\ Thus, under the provision, taxpayers may
not claim an itemized deduction for any of the above-listed
items. The provision does not apply for taxable years beginning
after December 31, 2025.
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\310\ Notwithstanding the temporary repeal of miscellaneous
itemized deductions, working condition fringes continue to be excluded
under section 132(d). Because section 132(d) provides that a working
condition fringe is excluded from an employee's gross income to the
extent that had the employee paid for the benefit, such payment would
be allowable as a deduction to the employee under section 162 or 167,
the provision does not affect the exclusion. A deduction for these
items would still be allowable under section 162, notwithstanding that
the deduction may have been subsequently disallowed under section 67. A
similar result is achieved under prior law, wherein a working condition
fringe was excludable in its entirety, notwithstanding that a deduction
under section 162 was limited by the prior-law section 67 two-percent
haircut on miscellaneous itemized deductions.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
F. Suspension of Overall Limitation on Itemized Deductions (sec. 11046
of the Act and sec. 68 of the Code)
Prior Law
The total amount of most otherwise allowable itemized
deductions (other than the deductions for medical expenses,
investment interest and casualty, theft or gambling losses) is
limited for certain upper-income individuals.\311\ All other
limitations applicable to such deductions (such as the separate
floors) are first applied and, then, the otherwise allowable
total amount of itemized deductions is reduced by three percent
of the amount by which the taxpayer's adjusted gross income
exceeds a threshold amount.
---------------------------------------------------------------------------
\311\ Sec. 68.
---------------------------------------------------------------------------
For 2017, the threshold amounts are $261,500 for single
taxpayers, $287,650 for heads of household, $313,800 for
married couples filing jointly, and $156,900 for married
taxpayers filing separately. These threshold amounts are
indexed for inflation. The otherwise allowable itemized
deductions may not be reduced by more than 80 percent by reason
of the overall limit on itemized deductions.
Explanation of Provision
The provision temporarily eliminates the overall limitation
on itemized deductions. The provision does not apply to taxable
years beginning after December 31, 2025.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
G. Suspension of Exclusion for Qualified Bicycle Commuting
Reimbursement (sec. 11047 of the Act and sec. 132(f) of the Code)
Prior Law
Qualified bicycle commuting reimbursements of up to $20 per
qualifying bicycle commuting month in a calendar year are
excludable from an employee's gross income.\312\ A qualifying
bicycle commuting month is any month during which the employee
regularly uses the bicycle for a substantial portion of the
travel between the employee's residence and place of employment
and during which the employee does not receive any qualified
transportation fringe benefit for transportation in a commuter
highway vehicle (in connection with travel between the
employee's residence and place of employment), a transit pass,
or qualified parking.\313\
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\312\ Secs. 132(a)(5), 132(f)(1)(D), and 132((f)(5)(F)(ii).
\313\ Sec. 132(f)(5)(F)(iii).
---------------------------------------------------------------------------
A qualified bicycle commuting reimbursement for a calendar
year is an employer reimbursement during the 15-month period
beginning with the first day of the calendar year for
reasonable expenses incurred by the employee during such
calendar year for the purchase of a bicycle and bicycle
improvements, repair, and storage, if the bicycle is regularly
used for travel between the employee's residence and place of
employment.\314\
---------------------------------------------------------------------------
\314\ Sec. 132(f)(5)(F)(i).
---------------------------------------------------------------------------
Qualified bicycle commuting reimbursements that are
excludable from gross income for income tax purposes are also
excluded from wages for employment tax purposes.
Explanation of Provision
The provision temporarily repeals the exclusion from gross
income and wages for qualified bicycle commuting
reimbursements.\315\ The exclusion does not apply to taxable
years beginning after December 31, 2017, and before January 1,
2026.
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\315\ A technical correction may be necessary to reflect that the
suspension relates to the exclusion (under subsection (a)(5) of section
132) rather than the definition of a qualified bicycle commuting
reimbursement as a qualified transportation fringe, so that such
taxable benefits are excepted from the deduction disallowance of
section 274(a). See description of section 13304 of the Act (Limitation
on Deduction by Employers of Expenses for Fringe Benefits) and related
footnote, infra.
The Treasury Department has issued published guidance
addressing this provision.\316\
---------------------------------------------------------------------------
\316\ IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits
(revised Feb. 22, 2018), p. 21.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
H. Suspension of Exclusion for Qualified Moving Expense Reimbursement
(sec. 11048 of the Act and sec. 132(g) of the Code)
Prior Law
Qualified moving expense reimbursements are excluded from
an employee's gross income,\317\ and are defined as any amount
received (directly or indirectly) by an individual from an
employer as a payment for (or reimbursement of) expenses which
would be deductible as moving expenses under section 217 \318\
if directly paid or incurred by the individual. However, any
such amount actually deducted by the individual is not eligible
for this exclusion. Qualified moving expense reimbursements
that are excludible from gross income for income tax purposes
are also excluded from wages for employment tax purposes.
---------------------------------------------------------------------------
\317\ Secs. 132(a)(6) and 132(g).
\318\ Individuals are allowed an itemized deduction for moving
expenses paid or incurred during the taxable year in connection with
the commencement of work by the taxpayer as an employee or as a self-
employed individual at a new principal place of work. Such expenses are
deductible only if the move meets certain conditions related to
distance from the taxpayer's previous residence and the taxpayer's
status as a full-time employee in the new location.
---------------------------------------------------------------------------
Explanation of Provision
For taxable years beginning after December 31, 2017, and
before January 1, 2026, the provision repeals the exclusion
from gross income and wages for qualified moving expense
reimbursements except in the case of a member of the Armed
Forces of the United States on active duty who moves pursuant
to a military order and incident to a permanent change of
station.
If an employee incurs moving expenses in a taxable year
beginning before January 1, 2018, an employer payment for (or
reimbursement of) such expenses that would otherwise be
excludable under prior law is excludable from gross income for
income tax purposes and from wages for employment tax purposes,
notwithstanding that the payment (or reimbursement) may occur
in a taxable year beginning on or after January 1, 2018.
However, if an employee incurs expenses in a taxable year
beginning after December 31, 2017, and before January 1, 2026,
any reimbursement for such expenses is not excludable (other
than to a member of the Armed Forces to whom the exclusion
continues to apply).
The Treasury Department has issued published guidance
addressing this provision.\319\
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\319\ Notice 2018-75, 2018-41 I.R.B. 556.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
I. Suspension of Deduction for Moving Expenses (sec. 11049 of the Act,
and sec. 217 of the Code)
Prior Law
Individuals are permitted an above-the-line deduction for
moving expenses paid or incurred during the taxable year in
connection with the commencement of work by the taxpayer as an
employee or as a self-employed individual at a new principal
place of work.\320\ Such expenses are deductible only if the
move meets certain conditions related to distance from the
taxpayer's previous residence and the taxpayer's status as a
full-time employee in the new location.
---------------------------------------------------------------------------
\320\ Sec. 217(a).
---------------------------------------------------------------------------
Special rules apply in the case of a member of the Armed
Forces of the United States. In the case of any such individual
who is on active duty, who moves pursuant to a military order
and incident to a permanent change of station, the limitations
related to distance from the taxpayer's previous residence and
status as a full-time employee in the new location do not
apply.\321\ Additionally, any moving and storage expenses that
are furnished in kind to such an individual, spouse, or
dependents, or if such expenses are reimbursed or an allowance
for such expenses is provided, such amounts are excluded from
gross income.\322\ Rules also apply to exclude amounts
furnished to the spouse and dependents of such an individual in
the event that such individuals move to a location other than
to where the member of the Armed Forces is moving.
---------------------------------------------------------------------------
\321\ Sec. 217(g).
\322\ Sec. 217(g)(2).
---------------------------------------------------------------------------
Income exclusions apply to various benefits provided to
members of the Armed Forces.\323\
---------------------------------------------------------------------------
\323\ Sec. 134.
---------------------------------------------------------------------------
Explanation of Provision
Generally, the provision temporarily eliminates the
deduction for moving expenses for taxable years 2018 through
2025. However, during that period, the provision retains the
deduction for moving expenses and the rules providing for
exclusions of amounts attributable to in-kind moving and
storage expenses (and reimbursements or allowances for these
expenses) for members of the Armed Forces (or their spouses or
dependents) on active duty who move pursuant to a military
order and incident to a permanent change of station.
The provision does not apply to taxable years beginning
after December 31, 2025.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
J. Limitation on Wagering Losses (sec. 11050 of the Act and sec. 165(d)
of the Code)
Prior Law
Losses sustained during the taxable year on wagering
transactions are allowed as a deduction only to the extent of
the gains during the taxable year from such transactions.\324\
---------------------------------------------------------------------------
\324\ Sec. 165(d).
---------------------------------------------------------------------------
Explanation of Provision
The provision clarifies the scope of ``losses from wagering
transactions'' as that term is used in section 165(d). Under
the provision, this term includes any deduction otherwise
allowable under chapter 1 of the Code incurred in carrying on
any wagering transaction.
The provision is intended to clarify that the limitation on
losses from wagering transactions applies not only to the
actual costs of wagers incurred by an individual, but to other
expenses incurred by the individual in connection with the
conduct of that individual's gambling activity.\325\ The
provision clarifies, for instance, that an individual's
otherwise deductible expenses in traveling to or from a casino
are subject to the limitation under section 165(d).
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\325\ The provision thus reverses the result reached by the Tax
Court in Ronald A. Mayo v. Commissioner, 136 T.C. 81 (2011). In that
case, the Court held that a taxpayer's expenses incurred in the conduct
of the trade or business of gambling, other than the cost of wagers,
were not limited by sec. 165(d), and were thus deductible under sec.
162(a).
---------------------------------------------------------------------------
The provision does not apply to taxable years beginning
after December 31, 2025.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
K. Repeal of Deduction for Alimony Payments (sec. 11051 of the Act and
secs. 61, 71, 215, and 682 of the Code)
Prior Law
Alimony and separate maintenance payments are deductible by
the payor spouse and includible in income by the recipient
spouse.\326\ Child support payments are not treated as
alimony.\327\ Also, certain income of an estate or trust in the
case of a divorce, etc. are includible in the income of the
recipient spouse.\328\
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\326\ Secs. 215(a), 61(a)(8) and 71(a).
\327\ Sec. 71(c).
\328\ Sec. 682.
---------------------------------------------------------------------------
Explanation of Provision
Under the provision, alimony and separate maintenance
payments are not deductible by the payor spouse. The provision
also repeals the Code provisions that specify that alimony and
separate maintenance payments are included in income. Thus, the
intent of the provision is to adopt the approach reflected in
the United States Supreme Court's holding in Gould v.
Gould,\329\ in which the Court held that such payments are not
income to the recipient (in the absence of a specific statutory
rule providing for the inclusion of such payments in income).
Income used for alimony payments is taxed at the rates
applicable to the payor spouse rather than the recipient
spouse. The treatment of child support is not changed. The
provision treating income of an estate or trust as income of
the recipient spouse in the case of a divorce, etc. is
repealed.
---------------------------------------------------------------------------
\329\ 245 U.S. 151 (1917).
---------------------------------------------------------------------------
Effective Date
The provision is effective for any divorce or separation
instrument executed after December 31, 2018, or for any divorce
or separation instrument executed on or before December 31,
2018, and modified after that date, if the modification
expressly provides that the amendments made by this provision
apply to such modification.
PART VI--INCREASE IN ESTATE AND GIFT TAX EXEMPTION
A. Increase in Estate and Gift Tax Exemption (sec. 11061 of the Act and
secs. 2001 and 2010 of the Code)
Prior Law
In general
A gift tax is imposed on certain lifetime transfers, and an
estate tax is imposed on certain transfers at death. A
generation-skipping transfer tax generally is imposed on
transfers, either directly or in trust or similar arrangement,
to a ``skip person'' (i.e., a beneficiary in a generation more
than one generation younger than that of the transferor).
Transfers subject to the generation-skipping transfer tax
include direct skips, taxable terminations, and taxable
distributions.
Income tax rules determine the recipient's tax basis in
property acquired from a decedent or by gift. Gifts and
bequests generally are excluded from the recipient's gross
income.\330\
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\330\ Sec. 102.
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Common features of the estate, gift and generation-skipping transfer
taxes
Unified credit (exemption) and tax rates
Unified credit.--A unified credit is available with respect
to taxable transfers by gift and at death.\331\ The unified
credit offsets tax, computed using the applicable estate and
gift tax rates, on a specified amount of transfers, referred to
as the applicable exclusion amount, or exemption amount. The
exemption amount was set at $5 million for 2011 and is indexed
for inflation for later years. For 2017, the inflation-indexed
exemption amount is $5.49 million.\332\ Exemption used during
life to offset taxable gifts reduces the amount of exemption
that remains at death to offset the value of a decedent's
estate. An election is available under which exemption that is
not used by a decedent may be used by the decedent's surviving
spouse (exemption portability).
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\331\ Sec. 2010.
\332\ For 2017, the $5.49 million exemption amount results in a
unified credit of $2,141,800, after applying the applicable rates set
forth in section 2001(c).
---------------------------------------------------------------------------
Common tax rate table.--A common tax-rate table with a top
marginal tax rate of 40 percent is used to compute gift tax and
estate tax. The 40-percent rate applies to transfers in excess
of $1 million (to the extent not exempt). Because the 2017
exemption amount shields the first $5.49 million in gifts and
bequests from tax, transfers in excess of the exemption amount
generally are subject to tax at the highest marginal rate (40
percent).
Generation-skipping transfer tax exemption and rate.--The
generation-skipping transfer tax is a separate tax that can
apply in addition to either the gift tax or the estate tax. The
tax rate and exemption amount for generation-skipping transfer
tax purposes, however, are set by reference to the estate tax
rules. Generation-skipping transfer tax is imposed using a flat
rate equal to the highest estate tax rate (40 percent). Tax is
imposed on cumulative generation-skipping transfers in excess
of the generation-skipping transfer tax exemption amount in
effect for the year of the transfer. The generation-skipping
transfer tax exemption for a given year is equal to the estate
tax exemption amount in effect for that year ($5.49 million for
2017).
Transfers between spouses.--A 100-percent marital deduction
generally is permitted for the value of property transferred
between spouses.\333\ In addition, transfers of ``qualified
terminable interest property'' also are eligible for the
marital deduction. Qualified terminable interest property is
property (1) that passes from the decedent, (2) in which the
surviving spouse has a ``qualifying income interest for life,''
and (3) to which an election under these rules applies. A
qualifying income interest for life exists if (1) the surviving
spouse is entitled to all the income from the property (payable
annually or at more frequent intervals) or has the right to use
the property during the spouse's life, and (2) no person has
the power to appoint any part of the property to any person
other than the surviving spouse.
---------------------------------------------------------------------------
\333\ Secs. 2056 and 2523.
---------------------------------------------------------------------------
A marital deduction generally is denied for property
passing to a surviving spouse who is not a citizen of the
United States. A marital deduction is permitted, however, for
property passing to a qualified domestic trust of which the
noncitizen surviving spouse is a beneficiary. A qualified
domestic trust is a trust that has as its trustee at least one
U.S. citizen or U.S. corporation. No corpus may be distributed
from a qualified domestic trust unless the U.S. trustee has the
right to withhold any estate tax imposed on the distribution.
Tax is imposed on (1) any distribution from a qualified
domestic trust before the date of the death of the noncitizen
surviving spouse and (2) the value of the property remaining in
a qualified domestic trust on the date of death of the
noncitizen surviving spouse. The tax is computed as an
additional estate tax on the estate of the first spouse to die.
Transfers to charity.--Contributions to section 501(c)(3)
charitable organizations and certain other organizations may be
deducted from the value of a gift or from the value of the
assets in an estate for Federal gift or estate tax
purposes.\334\ The effect of the deduction generally is to
remove the full fair market value of assets transferred to
charity from the gift or estate tax base; unlike the income tax
charitable deduction, there are no percentage limits on the
deductible amount. For estate tax purposes, the charitable
deduction is limited to the value of the transferred property
that is required to be included in the gross estate.\335\ A
charitable contribution of a partial interest in property, such
as a remainder or future interest, generally is not deductible
for gift or estate tax purposes.\336\
---------------------------------------------------------------------------
\334\ Secs. 2055 and 2522.
\335\ Sec. 2055(d).
\336\ Secs. 2055(e)(2) and 2522(c)(2).
---------------------------------------------------------------------------
The estate tax
Overview
The Code imposes a tax on the transfer of the taxable
estate of a decedent who is a citizen or resident of the United
States.\337\ The taxable estate is determined by deducting from
the value of the decedent's gross estate any deductions
provided for in the Code. After applying tax rates to determine
a tentative amount of estate tax, certain credits are
subtracted to determine estate tax liability.\338\
---------------------------------------------------------------------------
\337\ Sec. 2001(a).
\338\ The taxable estate is combined with the value of adjusted
taxable gifts made during the decedent's life (generally, post-1976
gifts), before applying tax rates to determine a tentative total amount
of tax. The portion of the tentative tax attributable to lifetime gifts
is then subtracted from the total tentative tax to determine the gross
estate tax, i.e., the amount of estate tax before considering available
credits. Credits are then subtracted to determine the estate tax
liability.
This method of computation was designed to ensure that a taxpayer
only gets one run up through the rate brackets for all lifetime gifts
and transfers at death, at a time when the thresholds for applying the
higher marginal rates exceeded the exemption amount. However, the
higher ($5.49 million) 2017 exemption amount effectively renders the
lower rate brackets irrelevant, because the top marginal rate bracket
applies to all transfers in excess of $1 million. In other words, all
transfers that are not exempt by reason of the $5.49 million exemption
amount are taxed at the highest marginal rate of 40 percent.
---------------------------------------------------------------------------
Because the estate tax shares a common unified credit
(exemption) and tax rate table with the gift tax, the exemption
amounts and tax rates are described together above, along with
certain other common features of these taxes.
Gross estate
A decedent's gross estate includes, to the extent provided
for in other sections of the Code, the date-of-death value of
all of a decedent's property, real or personal, tangible or
intangible, wherever situated.\339\ In general, the value of
property for this purpose is the fair market value of the
property as of the date of the decedent's death, although an
executor may elect to value certain property as of the date
that is six months after the decedent's death (the alternate
valuation date).\340\
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\339\ Sec. 2031(a).
\340\ Sec. 2032.
---------------------------------------------------------------------------
The gross estate includes not only property directly owned
by the decedent, but also other property in which the decedent
had a beneficial interest at the time of his or her death.\341\
The gross estate also includes certain transfers made by the
decedent prior to his or her death, including (1) certain gifts
made within three years prior to the decedent's death;\342\ (2)
certain transfers of property in which the decedent retained a
life estate;\343\ (3) certain transfers taking effect at
death;\344\ and (4) revocable transfers.\345\ In addition, the
gross estate includes property with respect to which the
decedent had, at the time of death, a general power of
appointment (generally, the right to determine who will have
beneficial ownership).\346\ The value of a life insurance
policy on the decedent's life is included in the gross estate
if the proceeds are payable to the decedent's estate or the
decedent had incidents of ownership with respect to the policy
at the time of his or her death.\347\
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\341\ Sec. 2033.
\342\ Sec. 2035.
\343\ Sec. 2036.
\344\ Sec. 2037.
\345\ Sec. 2038.
\346\ Sec. 2041.
\347\ Sec. 2042.
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Deductions from the gross estate
A decedent's taxable estate is determined by subtracting
from the value of the gross estate any deductions provided for
in the Code.
Marital and charitable transfers.--As described above,
transfers to a surviving spouse or to charity generally are
deductible for estate tax purposes. The effect of the marital
and charitable deductions generally is to remove assets
transferred to a surviving spouse or to charity from the estate
tax base.
State death taxes.--An estate tax deduction is permitted
for death taxes (e.g., any estate, inheritance, legacy, or
succession taxes) actually paid to any State or the District of
Columbia, in respect of property included in the gross estate
of the decedent.\348\ Such State taxes must have been paid and
claimed before the expiration of the applicable limitations
period, which is generally four years after the filing of the
estate tax return.\349\
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\348\ Sec. 2058.
\349\ Sec. 2058(b) provides that taxes must have been paid and
deductions claimed before the later of (1) four years after the filing
of the estate tax return; or (2) (a) 60 days after a decision of the
U.S. Tax Court determining the estate tax liability becomes final, (b)
the expiration of the period of extension to pay estate taxes over time
under section 6166, or (c) the expiration of the period of limitations
in which to file a claim for refund or 60 days after a decision of a
court in which such refund suit has become final.
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Other deductions.--A deduction is available for funeral
expenses, estate administration expenses, and claims against
the estate, including certain taxes.\350\ A deduction also is
available for uninsured casualty and theft losses incurred
during the settlement of the estate.\351\
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\350\ Sec. 2053.
\351\ Sec. 2054.
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Credits against tax
After accounting for allowable deductions, a gross amount
of estate tax is computed. Estate tax liability is then
determined by subtracting allowable credits from the gross
estate tax.
Unified credit.--The most significant credit allowed for
estate tax purposes is the unified credit, which is discussed
in greater detail above.\352\ For 2017, the value of the
unified credit is $2,141,800, which has the effect of exempting
$5.49 million in transfers from tax. The unified credit
available at death is reduced by the amount of unified credit
used to offset gift tax on gifts made during the decedent's
life.
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\352\ Sec. 2010.
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Other credits.--Estate tax credits also are allowed for (1)
gift tax paid on certain pre-1977 gifts (before the estate and
gift tax computations were integrated); \353\ (2) estate tax
paid on certain prior transfers (to limit the estate tax burden
when estate tax is imposed on transfers of the same property in
two estates by reason of deaths in rapid succession); \354\ and
(3) certain foreign death taxes paid (generally, where the
property is situated in a foreign country but included in the
decedent's U.S. gross estate).\355\
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\353\ Sec. 2012.
\354\ Sec. 2013.
\355\ Sec. 2014. In certain cases, an election may be made to
deduct foreign death taxes. See section 2053(d).
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Provisions affecting small and family-owned businesses and
farms
Special-use valuation.--An executor can elect to value for
estate tax purposes certain ``qualified real property'' used in
farming or another qualifying closely-held trade or business at
its current-use value, rather than its fair market value.\356\
The maximum reduction in value for such real property is
$750,000 (adjusted for inflation occurring after 1997; the
inflation-adjusted amount for 2017 is $1,120,000). In general,
real property qualifies for special-use valuation only if (1)
at least 50 percent of the adjusted value of the decedent's
gross estate (including both real and personal property)
consists of a farm or closely-held business property in the
decedent's estate and (2) at least 25 percent of the adjusted
value of the gross estate consists of farm or closely held
business real property. In addition, the property must be used
in a qualified use (e.g., farming) by the decedent or a member
of the decedent's family for five of the eight years before the
decedent's death.
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\356\ Sec. 2032A.
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If, after a special-use valuation election is made, the
heir who acquired the real property ceases to use it in its
qualified use within 10 years of the decedent's death, an
additional estate tax is imposed to recapture the entire
estate-tax benefit of the special-use valuation.
Installment payment of estate tax for closely held
businesses.--Under prior law, the estate tax generally is due
within nine months of a decedent's death. However, an executor
generally may elect to pay estate tax attributable to an
interest in a closely held business in two or more installments
(but no more than 10).\357\ An estate is eligible for payment
of estate tax in installments if the value of the decedent's
interest in a closely held business exceeds 35 percent of the
decedent's adjusted gross estate (i.e., the gross estate less
certain deductions). If the election is made, the estate may
defer payment of principal and pay only interest for the first
five years, followed by up to 10 annual installments of
principal and interest.
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\357\ Sec. 6166.
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This provision effectively extends the time for paying
estate tax by 14 years from the original due date of the estate
tax. A special two-percent interest rate applies to the amount
of deferred estate tax attributable to the first $1 million
(adjusted annually for inflation occurring after 1998; the
inflation-adjusted amount for 2017 is $1,490,000) in taxable
value of a closely held business. The interest rate applicable
to the amount of estate tax attributable to the taxable value
of the closely held business in excess of $1 million (adjusted
for inflation) is equal to 45 percent of the rate applicable to
underpayments of tax under section 6621 of the Code (i.e., 45
percent of the sum of the Federal short-term rate and three
percentage points).\358\ Interest paid on deferred estate taxes
is not deductible for estate or income tax purposes.
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\358\ The interest rate on this portion adjusts with the Federal
short-term rate.
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The gift tax
Overview
The Code imposes a tax for each calendar year on the
transfer of property by gift during such year by any
individual, whether a resident or nonresident of the United
States.\359\ The amount of taxable gifts for a calendar year is
determined by subtracting from the total amount of gifts made
during the year: (1) the gift tax annual exclusion (described
below); and (2) allowable deductions.
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\359\ Sec. 2501(a). However, if the donor is neither a citizen nor
a resident of the United States, the transfer is taxable only if the
property is situated in the United States. Sec. 2511.
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Gift tax for the current taxable year is determined by: (1)
computing a tentative tax on the combined amount of all taxable
gifts for the current and all prior calendar years using the
common gift tax and estate tax rate table; (2) computing a
tentative tax only on all prior-year gifts; (3) subtracting the
tentative tax on prior-year gifts from the tentative tax
computed for all years to arrive at the portion of the total
tentative tax attributable to current-year gifts; and, finally,
(4) subtracting the amount of unified credit not consumed by
prior-year gifts.
Because the gift tax shares a common unified credit
(exemption) and tax rate table with the estate tax, the
exemption amounts and tax rates are described together above,
along with certain other common features of these taxes.
Transfers by gift
The gift tax applies to a transfer by gift regardless of
whether (1) the transfer is made outright or in trust; (2) the
gift is direct or indirect; or (3) the property is real or
personal, tangible or intangible.\360\ For gift tax purposes,
the value of a gift of property is the fair market value of the
property at the time of the gift.\361\ Where property is
transferred for less than full consideration, the amount by
which the value of the property exceeds the value of the
consideration is considered a gift and is included in computing
the total amount of a taxpayer's gifts for a calendar
year.\362\
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\360\ Sec. 2511(a).
\361\ Sec. 2512(a).
\362\ Sec. 2512(b).
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For a gift to occur, a donor generally must relinquish
dominion and control over donated property. For example, if a
taxpayer transfers assets to a trust established for the
benefit of his or her children, but retains the right to revoke
the trust, the taxpayer may not have made a completed gift,
because the taxpayer has retained dominion and control over the
transferred assets. A completed gift made in trust, on the
other hand, often is treated as a gift to the trust
beneficiaries.
By reason of statute, certain transfers are not treated as
transfers by gift for gift tax purposes. These include, for
example, certain transfers for educational and medical
purposes,\363\ transfers to section 527 political
organizations,\364\ and transfers to tax-exempt organizations
described in sections 501(c)(4), (5), or (6).\365\
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\363\ Sec. 2503(e).
\364\ Sec. 2501(a)(4).
\365\ Sec. 2501(a)(6).
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Taxable gifts
As stated above, the amount of a taxpayer's taxable gifts
for the year is determined by subtracting from the total amount
of the taxpayer's gifts for the year the gift tax annual
exclusion and any available deductions.
Gift tax annual exclusion.--Under prior law, donors of
lifetime gifts are provided an annual exclusion of $14,000 per
donee in 2017 (indexed for inflation from the 1997 annual
exclusion amount of $10,000) for gifts of present interests in
property during the taxable year.\366\ If the non-donor spouse
consents to split the gift with the donor spouse, then the
annual exclusion is $28,000 per donee in 2017. In general,
unlimited transfers between spouses are permitted without
imposition of a gift tax. Special rules apply to the
contributions to a qualified tuition program (``529 Plan'')
including an election to treat a contribution that exceeds the
annual exclusion as a contribution made ratably over a five-
year period beginning with the year of the contribution.\367\
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\366\ Sec. 2503(b).
\367\ Sec. 529(c)(2).
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Marital and charitable deductions.--As described above,
transfers to a surviving spouse or to charity generally are
deductible for gift tax purposes. The effect of the marital and
charitable deductions generally is to remove assets transferred
to a surviving spouse or to charity from the gift tax base.
The generation-skipping transfer tax
A generation-skipping transfer tax generally is imposed (in
addition to the gift tax or the estate tax) on transfers,
either directly or in trust or similar arrangement, to a ``skip
person'' (i.e., a beneficiary in a generation more than one
generation below that of the transferor). Transfers subject to
the generation-skipping transfer tax include direct skips,
taxable terminations, and taxable distributions.
Exemption and tax rate
An exemption generally equal to the estate tax exemption
amount ($5.49 million for 2017) is provided for each person
making generation-skipping transfers. The exemption may be
allocated by a transferor (or his or her executor) to
transferred property, and in some cases is automatically
allocated. The allocation of generation-skipping transfer tax
exemption effectively reduces the tax rate on a generation-
skipping transfer.
The tax rate on generation-skipping transfers is a flat
rate of tax equal to the maximum estate and gift tax rate (40
percent) multiplied by the ``inclusion ratio.'' The inclusion
ratio with respect to any property transferred indicates the
amount of ``generation-skipping transfer tax exemption''
allocated to a trust (or to property transferred in a direct
skip) relative to the total value of property transferred.\368\
If, for example, a taxpayer transfers $5 million in property to
a trust and allocates $5 million of exemption to the transfer,
the inclusion ratio is zero, and the applicable tax rate on any
subsequent generation-skipping transfers from the trust is zero
percent (40 percent multiplied by the inclusion ratio of zero).
If, however, the taxpayer allocated only $2.5 million of
exemption to the transfer, the inclusion ratio is 0.5, and the
applicable tax rate on any subsequent generation-skipping
transfers from the trust is 20 percent (40 percent multiplied
by the inclusion ratio of 0.5). If the taxpayer allocates no
exemption to the transfer, the inclusion ratio is one, and the
applicable tax rate on any subsequent generation-skipping
transfers from the trust is 40 percent (40 percent multiplied
by the inclusion ratio of one).
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\368\ The inclusion ratio is one minus the applicable fraction. The
applicable fraction is the amount of exemption allocated to a trust (or
to a direct skip) divided by the value of assets transferred.
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Generation-skipping transfers
Generation-skipping transfer tax generally is imposed at
the time of a generation-skipping transfer, i.e., a direct
skip, a taxable termination, or a taxable distribution.
A direct skip is any transfer subject to estate or gift tax
of an interest in property to a skip person. A skip person may
be a natural person or certain trusts. All persons assigned to
the second or more remote generation below the transferor are
skip persons (e.g., grandchildren and great-grandchildren).
Trusts are skip persons if (1) all interests in the trust are
held by skip persons, or (2) no person holds an interest in the
trust and at no time after the transfer may a distribution
(including distributions and terminations) be made to a non-
skip person.
A taxable termination is a termination (by death, lapse of
time, release of power, or otherwise) of an interest in
property held in trust unless, immediately after such
termination, a non-skip person has an interest in the property,
or unless at no time after the termination may a distribution
(including a distribution upon termination) be made from the
trust to a skip person.
A taxable distribution is a distribution from a trust to a
skip person (other than a taxable termination or direct skip).
If a transferor allocates generation-skipping transfer tax
exemption to a trust prior to the taxable distribution,
generation-skipping transfer tax may be avoided.
Income tax basis in property received
In general
Gain or loss, if any, on the disposition of property is
measured by the taxpayer's amount realized on the disposition,
less the taxpayer's basis in such property. Basis generally
represents a taxpayer's investment in property with certain
adjustments required after acquisition. For example, basis is
increased by the cost of capital improvements made to the
property and decreased by depreciation deductions taken with
respect to the property.
A gift or bequest of appreciated (or loss) property is not
an income tax realization event for the transferor. The Code
provides special rules for determining a recipient's basis in
assets received by lifetime gift or from a decedent.
Basis in property received by lifetime gift
Under prior law, property received from a donor of a
lifetime gift generally takes a carryover basis.\369\
``Carryover basis'' means that the basis in the hands of the
donee is the same as it was in the hands of the donor. The
basis of property transferred by lifetime gift also is
increased, but not above fair market value, by any gift tax
paid by the donor. The basis of a lifetime gift, however,
generally cannot exceed the property's fair market value on the
date of the gift. If a donor's basis in property is greater
than the fair market value of the property on the date of the
gift, then, for purposes of determining loss on a subsequent
sale of the property, the donee's basis is the property's fair
market value on the date of the gift.
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\369\ See sec. 1015.
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Basis in property acquired from a decedent
Property acquired from a decedent's estate generally takes
a stepped-up basis.\370\ ``Stepped-up basis'' means that the
basis of property acquired from a decedent's estate generally
is the fair market value on the date of the decedent's death
(or, if the alternate valuation date is elected, the earlier of
six months after the decedent's death or the date the property
is sold or distributed by the estate). Providing a fair market
value basis eliminates the recognition of income on any
appreciation of the property that occurred prior to the
decedent's death and eliminates the tax benefit from any
unrealized loss.
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\370\ See sec. 1014.
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In community property states, a surviving spouse's one-half
share of community property held by the decedent and the
surviving spouse (under the community property laws of any
State, U.S. possession, or foreign country) generally is
treated as having passed from the decedent and, thus, is
eligible for stepped-up basis. Thus, both the decedent's one-
half share and the surviving spouse's one-half share are
stepped up to fair market value. This rule applies if at least
one-half of the whole of the community interest is includible
in the decedent's gross estate.
Stepped-up basis treatment generally is denied to certain
interests in foreign entities. Stock in a passive foreign
investment company (including those for which a mark-to-market
election has been made) generally takes a carryover basis,
except that stock of a passive foreign investment company for
which a decedent shareholder had made a qualified electing fund
election is allowed a stepped-up basis. Stock owned by a
decedent in a domestic international sales corporation (or
former domestic international sales corporation) takes a
stepped-up basis reduced by the amount (if any) which would
have been included in gross income under section 995(c) as a
dividend if the decedent had lived and sold the stock at its
fair market value on the estate tax valuation date (i.e.,
generally the date of the decedent's death unless an alternate
valuation date is elected).
Explanation of Provision
The provision doubles the estate and gift tax exemption for
estates of decedents dying and gifts made after December 31,
2017, and before January 1, 2026. This is accomplished by
increasing the basic exclusion amount provided in section
2010(c)(3) of the Code from $5 million to $10 million. The $10
million amount is indexed for inflation occurring after 2011.
For 2018, the basic exclusion amount is $11,180,000 for
determining the amount of the unified credit against estate
tax.\371\ Because the generation-skipping transfer tax
exemption under section 2631(c) is set by cross-reference to
the basic exclusion amount in effect for estate tax purposes,
this increase to the basic exclusion amount also increases the
amount of generation-skipping transfer tax exemption available
to be allocated from January 1, 2018, through December 31,
2025.\372\
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\371\ Rev. Proc. 2018-18, 2018-10 I.R.B. 392, p. 397 (March 5,
2018).
\372\ For example, assume that on March 15, 2016, T gave property
with a value of $6,000,000 to a trust for the benefit of T's
descendants (Trust A) and T's entire then-remaining generation-skipping
transfer tax exemption of $5,400,000 was allocated to trust A on a
timely filed 2016 gift tax return. As of the date of the 2016 gift,
Trust A has an inclusion ratio of 0.100 [1 - ($5,400,000/$6,000,000)].
On July 1, 2018, when the property in Trust A has a fair market value
of $7,000,000, T files a gift tax return and allocates $700,000 of
generation-skipping transfer tax exemption to Trust A, reducing Trust
A's inclusion ratio from 0.100 to zero [1 - (($700,000 + (90% x
$7,000,000)) / $7,000,000))], effective on July 1, 2018. Absent
additional contributions to Trust A, the generation-skipping transfer
tax on taxable distributions from, or a taxable termination with
respect to, Trust A on or after July 1, 2018, is determined using an
inclusion ratio of zero.
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As a conforming amendment to section 2001(g) (regarding
computation of estate tax), the provision provides that the
Secretary shall prescribe regulations as may be necessary or
appropriate to carry out the purposes of the section with
respect to differences between the basic exclusion amount in
effect at the time of the decedent's death and at the time of
any gifts made by the decedent. It is intended that such
regulations will address in particular the computation of the
estate tax where (1) a decedent dies in a year in which the
basic exclusion amount is lower than the basic exclusion amount
that was in effect when the decedent made taxable gifts during
his or her life, and (2) such taxable gifts exceeded the basic
exclusion amount in effect at the time of the decedent's death.
Because the increase in the basic exclusion amount does not
apply for estates of decedents dying after December 31, 2025,
it is expected that this guidance will prevent the estate tax
computation under section 2001(g) from recapturing, or
``clawing back,'' all or a portion of the benefit of the
increased basic exclusion amount used to offset gift tax for
certain decedents who make taxable gifts between January 1,
2018, and December 31, 2025, and die after December 31, 2025.
Effective Date
The provision is effective for estates of decedents dying
and gifts made after December 31, 2017.
PART VII--EXTENSION OF TIME LIMIT FOR CONTESTING IRS LEVY
A. Extension of Time Limit for Contesting IRS Levy (sec. 11071 of the
Act and secs. 6343 and 6532 of the Code)
Prior Law
The IRS is authorized to return property that has been
wrongfully levied upon.\373\ In general, monetary proceeds from
the sale of levied property may be returned within nine months
of the date of the levy.
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\373\ Sec. 6343.
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Generally, any person (other than the person against whom
is assessed the tax out of which such levy arose) who claims an
interest in levied property and that such property was
wrongfully levied upon may bring a civil action for wrongful
levy in a district court of the United States.\374\ Generally,
an action for wrongful levy must be brought within nine months
from the date of levy.\375\
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\374\ Sec. 7426.
\375\ Sec. 6532.
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Explanation of Provision
The provision extends from nine months to two years the
period for returning the monetary proceeds from the sale of
property that has been wrongfully levied upon.
The provision also extends from nine months to two years
the period for bringing a civil action for wrongful levy.
Effective Date
The provision is effective with respect to: (1) levies made
after the date of enactment (December 22, 2017); and (2) levies
made on or before the date of enactment provided that the nine-
month period has not expired as of the date of enactment.
PART VIII--INDIVIDUAL MANDATE
A. Elimination of Shared Responsibility Payment for Individuals Failing
to Maintain Minimum Essential Coverage (sec. 11081 of the Act and sec.
5000A of the Code)
Prior Law
Under the Affordable Care Act,\376\ individuals must have
minimum essential coverage, qualify for an exemption, or make a
shared responsibility payment (also referred to as a tax or
penalty) for failure to maintain the coverage (commonly
referred to as the ``individual mandate'').\377\ Minimum
essential coverage includes government-sponsored programs
(including Medicare, Medicaid, and CHIP, among others),
eligible employer-sponsored plans, plans in the individual
market, grandfathered group health plans and grandfathered
health insurance coverage, and other coverage as recognized by
the Secretary of Health and Human Services (``HHS'') in
coordination with the Secretary of the Treasury.\378\ The tax
is imposed for any month that an individual does not have
minimum essential coverage unless the individual qualifies for
an exemption for the month as described below.
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\376\ Patient Protection and Affordable Care Act, Pub. L. No. 111-
148, and Health Care and Education Reconciliation Act of 2010, Pub. L.
No. 111-152.
\377\ Sec. 5000A. If an individual is a dependent, as defined in
section 152, of another taxpayer, the other taxpayer is liable for any
tax for failure to maintain the required coverage with respect to the
individual. Sec. 5000A(b)(3)(A).
\378\ Sec. 5000A(f)(1). Minimum essential coverage does not include
coverage that consists of only certain excepted benefits, such as
limited scope dental and vision benefits or long-term care insurance
offered under a separate policy, certificate, or contract. Sec.
5000A(f)(3).
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The tax for any calendar month is one-twelfth of the tax
calculated as an annual amount. The annual amount is equal to
the greater of a flat dollar amount or an excess income amount.
The flat dollar amount is the lesser of (1) the sum of the
individual annual dollar amounts for the members of the
taxpayer's family and (2) 300 percent of the adult individual
dollar amount. The individual adult annual dollar amount is
$695 for 2017 and 2018.\379\ For an individual who has not
attained age 18, the individual annual dollar amount is one
half of the adult amount. The excess income amount is 2.5
percent of the excess of the taxpayer's household income for
the taxable year over the threshold amount of income for
requiring the taxpayer to file an income tax return.\380\ The
total annual household payment may not exceed the national
average annual premium for bronze level health plans for the
applicable family size offered through Exchanges that
year.\381\
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\379\ For years after 2016, the $695 amount is indexed to CPI-U,
rounded to the next lowest multiple of $50.
\380\ The threshold amount is the amount of gross income specified
in section 6012(a)(1) with respect to the taxpayer for the taxable
year.
\381\ Sec. 5000A(c).
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Exemptions from the requirement to maintain minimum
essential coverage are provided if an individual, with respect
to any month, is: (1) an individual for whom coverage is
unaffordable because the required contribution exceeds 8.16
percent of household income,\382\ (2) an individual with
household income below the income tax return filing threshold,
(3) a member of an Indian tribe, (4) a member of certain
recognized religious sects or a health care sharing ministry,
(5) not a citizen or national of the United States or an alien
not lawfully present in the United States,\383\ (6)
incarcerated, other than incarceration pending the disposition
of charges, (7) an individual with a coverage gap for a
continuous period of less than three months, or (8) determined
by the Secretary of HHS to have suffered a hardship with
respect to the capability to obtain coverage.\384\
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\382\ For 2017. The rate applicable for 2018 is 8.05 percent of
household income.
\383\ In addition, certain individuals present or residing outside
of the United States and bona fide residents of United States
territories are deemed to maintain minimum essential coverage for any
month in which the applicable requirements are met. Sec. 5000A(f)(4).
\384\ Secs. 5000A(d) and (e).
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Explanation of Provision
The provision reduces the amount of the individual shared
responsibility payment, enacted as part of the Affordable Care
Act, to zero.
Effective Date
The provision is effective for months beginning after
December 31, 2018.
SUBTITLE B--ALTERNATIVE MINIMUM TAX
A. Repeal of Tax for Corporations; Credit for Prior Year Minimum Tax
Liability of Corporations; Increased Exemption for Individuals (secs.
12001-12003 of the Act and secs. 53 and 55-59 of the Code)
Prior Law
Corporate alternative minimum tax
In general
An alternative minimum tax (``AMT'') is imposed on a
corporation to the extent the corporation's tentative minimum
tax exceeds its regular tax. This tentative minimum tax is
computed at the rate of 20 percent on the AMTI in excess of a
$40,000 exemption amount that phases out. The exemption amount
is phased out by an amount equal to 25 percent of the amount
that the corporation's AMTI exceeds $150,000.
AMTI is the taxpayer's taxable income increased by certain
preference items and adjusted by determining the tax treatment
of certain items in a manner that negates the deferral of
income resulting from the regular tax treatment of those items.
A corporation with average gross receipts of less than $7.5
million for the prior three taxable years is exempt from the
corporate minimum tax. The $7.5 million threshold is reduced to
$5 million for the corporation's first three-taxable year
period.
Preference items in computing AMTI
The corporate minimum tax preference items are:
1. The excess of the deduction for percentage depletion
over the adjusted basis of the property at the end of the
taxable year. This preference does not apply to percentage
depletion allowed with respect to oil and gas properties.
2. The amount by which excess intangible drilling costs
arising in the taxable year exceed 65 percent of the net income
from oil, gas, and geothermal properties. This preference does
not apply to an independent producer to the extent the
preference would not reduce the producer's AMTI by more than 40
percent.
3. Tax-exempt interest income on private activity bonds
(other than qualified 501(c)(3) bonds, certain housing bonds,
and bonds issued in 2009 and 2010) issued after August 7, 1986.
4. Accelerated depreciation or amortization on certain
property placed in service before January 1, 1987.
Adjustments in computing AMTI
The adjustments that corporations must make in computing
AMTI are:
1. Depreciation on property placed in service after 1986
and before January 1, 1999, must be computed by using the
generally longer class lives prescribed by the alternative
depreciation system of section 168(g) and either (a) the
straight-line method in the case of property subject to the
straight-line method under the regular tax or (b) the 150-
percent declining balance method in the case of other property.
Depreciation on property placed in service after December 31,
1998, is computed by using the regular tax recovery periods and
the AMT methods described in the previous sentence.
Depreciation on property which is allowed ``bonus
depreciation'' for the regular tax is computed without regard
to any AMT adjustments.
2. Mining exploration and development costs must be
capitalized and amortized over a 10-year period.
3. Taxable income from a long-term contract (other than a
home construction contract) must be computed using the
percentage of completion method of accounting.
4. The amortization deduction allowed for pollution control
facilities placed in service before January 1, 1999 (generally
determined using 60-month amortization for a portion of the
cost of the facility under the regular tax), must be calculated
under the alternative depreciation system (generally, using
longer class lives and the straight-line method). The
amortization deduction allowed for pollution control facilities
placed in service after December 31, 1998, is calculated using
the regular tax recovery periods and the straight-line method.
5. The special rules applicable to Merchant Marine
construction funds are not applicable.
6. The special deduction allowable under section 833(b) for
Blue Cross and Blue Shield organizations is not allowed.
7. The adjusted current earnings adjustment applies, as
described below.
Adjusted current earning (``ACE'') adjustment
The adjusted current earnings adjustment is the amount
equal to 75 percent of the amount by which the adjusted current
earnings of a corporation exceed its AMTI (determined without
the ACE adjustment and the alternative tax net operating loss
deduction). In determining ACE the following rules apply:
1. For property placed in service before 1994, depreciation
generally is determined using the straight-line method and the
class life determined under the alternative depreciation
system.
2. Amounts excluded from gross income under the regular tax
but included for purposes of determining earnings and profits
are generally included in determining ACE.
3. The inside build-up of a life insurance contract is
included in ACE (and the related premiums are deductible).
4. Intangible drilling costs of integrated oil companies
must be capitalized and amortized over a 60-month period.
5. The regular tax rules of section 173 (allowing
circulation expenses to be amortized) and section 248 (allowing
organizational expenses to be amortized) do not apply.
6. Inventory must be calculated using the FIFO, rather than
LIFO, method.
7. The installment sales method generally may not be used.
8. No loss may be recognized on the exchange of any pool of
debt obligations for another pool of debt obligations having
substantially the same effective interest rates and maturities.
9. Depletion (other than for oil and gas properties) must
be calculated using the cost, rather than the percentage,
method.
10. In certain cases, the assets of a corporation that has
undergone an ownership change must be stepped down to their
fair market values.
Other rules
The taxpayer's net operating loss carryover generally
cannot reduce the taxpayer's AMT liability by more than 90
percent of AMTI determined without this deduction.
The various nonrefundable business credits allowed under
the regular tax generally are not allowed against the AMT.
Certain exceptions apply.
If a corporation is subject to AMT in any year, the amount
of AMT is allowed as an AMT credit in any subsequent taxable
year to the extent the taxpayer's regular tax liability exceeds
its tentative minimum tax in the subsequent year. Corporations
are allowed to claim a limited amount of AMT credits in lieu of
bonus depreciation.
A corporation may elect to write off certain expenditures
paid or incurred with respect of circulation expenses, research
and experimental expenses, intangible drilling and development
expenditures, development expenditures, and mining exploration
expenditures over a specified period (three years in the case
of circulation expenses, 60 months in the case of intangible
drilling and development expenditures, and 10 years in case of
other expenditures). The election applies for purposes of both
the regular tax and the alternative minimum tax.
Individual alternative minimum tax
In general
An AMT is also imposed on an individual, estate, or trust
in an amount by which the tentative minimum tax exceeds the
regular income tax for the taxable year. For taxable years
beginning in 2017, the tentative minimum tax is the sum of (1)
26 percent of so much of the taxable excess as does not exceed
$187,800 ($93,900 in the case of a married individual filing a
separate return) and (2) 28 percent of the remaining taxable
excess. The breakpoints are indexed for inflation. The taxable
excess is so much of the alternative minimum taxable income
(``AMTI'') as exceeds the exemption amount. The maximum tax
rates on net capital gain and dividends used in computing the
regular tax are used in computing the tentative minimum tax.
AMTI is the taxable income adjusted to take account of
specified tax preferences and adjustments.
The exemption amounts for taxable years beginning in 2017
are: (1) $84,500 in the case of married individuals filing a
joint return and surviving spouses; (2) $54,300 in the case of
other unmarried individuals; (3) $42,250 in the case of married
individuals filing separate returns; and (4) $24,100 in the
case of an estate or trust. For taxable years beginning in
2017, the exemption amounts are phased out by an amount equal
to 25 percent of the amount by which the individual's AMTI
exceeds (1) $160,900 in the case of married individuals filing
a joint return and surviving spouses, (2) $120,700 in the case
of other unmarried individuals, and (3) $80,450 in the case of
married individuals filing separate returns or an estate or a
trust. The amounts are indexed for inflation.
AMTI is the taxpayer's taxable income increased by certain
preference items and adjusted by determining the tax treatment
of certain items in a manner that negates the deferral of
income resulting from the regular tax treatment of those items.
Preference items in computing AMTI
The minimum tax preference items are:
1. The excess of the deduction for percentage depletion
over the adjusted basis of each mineral property (other than
oil and gas properties) at the end of the taxable year.
2. The amount by which excess intangible drilling costs
(i.e., expenses in excess the amount that would have been
allowable if amortized over a 10-year period) exceed 65 percent
of the net income from oil, gas, and geothermal properties.
This preference applies to independent producers only to the
extent it reduces the producer's AMTI (determined without
regard to this preference and the net operating loss deduction)
by more than 40 percent.
3. Tax-exempt interest income on private activity bonds
(other than qualified 501(c)(3) bonds, certain housing bonds,
and bonds issued in 2009 and 2010) issued after August 7, 1986.
4. Accelerated depreciation or amortization on certain
property placed in service before January 1, 1987.
5. Seven percent of the amount excluded from income under
section 1202 (relating to gains on the sale of certain small
business stock).
In addition, losses from any tax shelter farm activity or
passive activities are not taken into account in computing
AMTI.
Adjustments in computing AMTI
The adjustments that individuals must make to compute AMTI
are:
1. Depreciation on property placed in service after 1986
and before January 1, 1999, is computed by using the generally
longer class lives prescribed by the alternative depreciation
system of section 168(g) and either (a) the straight-line
method in the case of property subject to the straight-line
method under the regular tax or (b) the 150-percent declining
balance method in the case of other property. Depreciation on
property placed in service after December 31, 1998, is computed
by using the regular tax recovery periods and the AMT methods
described in the previous sentence. Depreciation on property
acquired after September 10, 2001, which is allowed an
additional allowance under section 168(k) for the regular tax
is computed without regard to any AMT adjustments.
2. Mining exploration and development costs are capitalized
and amortized over a 10-year period.
3. Taxable income from a long-term contract (other than a
home construction contract) is computed using the percentage of
completion method of accounting.
4. The amortization deduction allowed for pollution control
facilities placed in service before January 1, 1999 (generally
determined using 60-month amortization for a portion of the
cost of the facility under the regular tax), is calculated
under the alternative depreciation system (generally, using
longer class lives and the straight-line method). The
amortization deduction allowed for pollution control facilities
placed in service after December 31, 1998, is calculated using
the regular tax recovery periods and the straight-line method.
5. Miscellaneous itemized deductions are not allowed.
6. Itemized deductions for State, local, and foreign real
property taxes; State and local personal property taxes; State,
local, and foreign income, war profits, and excess profits
taxes; and State and local sales taxes are not allowed.
7. Medical expenses are allowed only to the extent they
exceed 10 percent of the taxpayer's adjusted gross income.
8. Deductions for interest on home equity loans are not
allowed.
9. The standard deduction and the deduction for personal
exemptions are not allowed.
10. The amount allowable as a deduction for circulation
expenditures is capitalized and amortized over a three-year
period.
11. The amount allowable as a deduction for research and
experimentation expenditures from passive activities is
capitalized and amortized over a 10-year period.
12. The regular tax rules relating to incentive stock
options do not apply.
Other rules
The taxpayer's net operating loss deduction generally
cannot reduce the taxpayer's AMTI by more than 90 percent of
the AMTI (determined without the net operating loss deduction).
The alternative minimum tax foreign tax credit reduces the
tentative minimum tax.
The various nonrefundable business credits allowed under
the regular tax generally are not allowed against the AMT.
Certain exceptions apply.
If an individual is subject to AMT in any year, the amount
of tax exceeding the taxpayer's regular tax liability is
allowed as a credit (the ``AMT credit'') in any subsequent
taxable year to the extent the taxpayer's regular tax liability
exceeds his or her tentative minimum tax liability in such
subsequent year. The AMT credit is allowed only to the extent
that the taxpayer's AMT liability is the result of adjustments
that are timing in nature. The individual AMT adjustments
relating to itemized deductions and personal exemptions are not
timing in nature, and no minimum tax credit is allowed with
respect to these items.
An individual may elect to write off certain expenditures
paid or incurred with respect of circulation expenses, research
and experimental expenses, intangible drilling and development
expenditures, development expenditures, and mining exploration
expenditures over a specified period (three years in the case
of circulation expenses, 60 months in the case of intangible
drilling and development expenditures, and 10 years in case of
other expenditures). The election applies for purposes of both
the regular tax and the alternative minimum tax.
Explanation of Provision
Corporate alternative minimum tax
The provision repeals the corporate alternative minimum
tax.
In the case of a corporation, the provision allows the AMT
credit to offset the entire regular tax liability for a taxable
year. In addition, the AMT credit is allowable and is
refundable for a taxable year beginning after 2017 and before
2022 in an amount equal to 50 percent (100 percent in the case
of taxable years beginning in 2021) of the excess (if any) of
the minimum tax credit for the taxable year over the amount of
the credit allowed for the year against regular tax liability.
For taxable years beginning after 2021, the amount of the
minimum tax credit in the case of a corporation will be zero.
Individual alternative minimum tax
The provision temporarily increases the exemption amounts
and the exemption amount phase-out thresholds for the
individual AMT. For taxable years beginning after December 31,
2017, and beginning before January 1, 2026, the exemption
amount is increased to $109,400 for married taxpayers filing a
joint return and surviving spouses (half this amount for
married taxpayers filing a separate return), and $70,300 for
all other taxpayers (other than estates and trusts). The phase-
out threshold is increased to $1,000,000 for married taxpayers
filing a joint return and surviving spouses, and $500,000 for
all other taxpayers (other than estates and trusts). These
amounts are indexed for inflation.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
SUBTITLE C--BUSINESS-RELATED PROVISIONS
PART I--CORPORATE PROVISIONS
A. 21-Percent Corporate Tax Rate (sec. 13001 of the Act and sec. 11 of
the Code)
Prior Law
Corporate taxable income is subject to tax under a four-
step graduated rate structure.\385\ The top corporate tax rate
is 35 percent on taxable income in excess of $10 million. The
corporate taxable income brackets and tax rates are as set
forth in the table below.
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\385\ Secs. 11(a) and (b)(1).
------------------------------------------------------------------------
Taxable income Tax rate (percent)
------------------------------------------------------------------------
Not over $50,000................................. 15
Over $50,000 but not over $75,000................ 25
Over $75,000 but not over $10,000,000............ 34
Over $10,000,000................................. 35
------------------------------------------------------------------------
An additional five-percent tax is imposed on a
corporation's taxable income in excess of $100,000. The maximum
additional tax is $11,750. Also, a second additional three-
percent tax is imposed on a corporation's taxable income in
excess of $15 million. The maximum second additional tax is
$100,000.
Certain personal service corporations pay tax on their
entire taxable income at the rate of 35 percent.\386\
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\386\ Sec. 11(b)(2).
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If the maximum corporate tax rate exceeds 35 percent, the
maximum rate on a corporation's net capital gain will be 35
percent.\387\
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\387\ Sec. 1201(a).
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Explanation of Provision
The provision taxes corporate taxable income at 21 percent,
eliminating the graduated corporate rate structure and the
special rate for personal service corporations.
The provision repeals the maximum corporate tax rate on net
capital gain as obsolete.
In addition, for taxpayers subject to the normalization
method of accounting (e.g., regulated public utilities), the
provision clarifies the normalization of excess tax reserves
resulting from the reduction of the corporate income tax rate
(with respect to prior depreciation or recovery allowances
taken on assets placed in service as of the day before the
corporate rate reduction takes effect).
The excess tax reserve is the excess of the reserve for
deferred taxes as of the day before the corporate rate
reduction takes effect over what the reserve for deferred taxes
would be if the corporate rate reduction had been in effect for
all prior periods. If an excess tax reserve is reduced more
rapidly or to a greater extent than such reserve would be
reduced under the average rate assumption method, the taxpayer
will not be treated as using a normalization method with
respect to the corporate rate reduction. If the taxpayer does
not use a normalization method of accounting for the corporate
rate reduction, the taxpayer's tax for the taxable year shall
be increased by the amount by which it reduces its excess tax
reserve more rapidly than permitted under a normalization
method of accounting and the taxpayer will not be treated as
using a normalization method of accounting for purposes of
section 168(f)(2) and (i)(9)(C).\388\
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\388\ Section 168(f)(2) and (i)(9)(C) provide that if a taxpayer is
required to use a normalization method of accounting with respect to
public utility property and does not do so, such taxpayer must compute
its depreciation allowances for Federal income tax purposes using the
depreciation method, useful life determination, averaging convention,
and salvage value limitation used for purposes of setting rates and
reflecting operating results in its regulated books of account.
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The average rate assumption method \389\ reduces the excess
tax reserve over the remaining regulatory lives of the property
that gave rise to the reserve for deferred taxes during the
years in which the deferred tax reserve related to such
property is reversing. Under this method, the excess tax
reserve is reduced as the timing differences (i.e., differences
between tax depreciation and regulatory depreciation with
respect to the property) reverse over the remaining life of the
asset. The reversal of timing differences generally occurs when
the amount of the tax depreciation taken with respect to an
asset is less than the amount of the regulatory depreciation
taken with respect to the asset. To ensure that the deferred
tax reserve, including the excess tax reserve, is reduced to
zero at the end of the regulatory life of the asset that
generated the reserve, the amount of the timing difference
which reverses during a taxable year is multiplied by the ratio
of (1) the aggregate deferred taxes as of the beginning of the
period in question to (2) the aggregate timing differences for
the property as of the beginning of the period in question.
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\389\ See sec. 2.04 of Rev. Proc. 88-12, 1988-1 C.B. 637.
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The following example illustrates the application of the
average rate assumption method. A calendar year regulated
utility placed property costing $100 million in service in
2016. For regulatory (book) purposes, the property is
depreciated over 10 years on a straight line basis with a full
year's allowance in the first year. For tax purposes, the
property is depreciated over five years using the 200 percent
declining balance method and a half-year placed in service
convention.\390\
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\390\ The five-year tax and 10-year book lives are used for
illustration purposes only. In general, public utility property may be
depreciated over various periods ranging from five to 20 years under
MACRS. For regulatory purposes, public utility property may, in certain
cases, have a useful life of 30 years or more.
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The excess tax reserve as of December 31, 2017, the day
before the corporate rate reduction takes effect, is $4.5
million.\391\ The taxpayer will begin taking the excess tax
reserve into account in the 2021 taxable year, which is the
first year in which the tax depreciation taken with respect to
the property is less than the depreciation reflected in the
regulated books of account. The annual adjustment to the
deferred tax reserve for the 2021 through 2025 taxable years is
multiplied by 31.1 percent, which is the ratio of the aggregate
deferred taxes as of the beginning of 2021 ($13.77 million) to
the aggregate timing differences for the property as of the
beginning of 2021 ($44.24 million).
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\391\ The excess tax reserve of $4.5 million is equal to the
cumulative deferred tax reserve as of December 31, 2017 ($11.2 million)
minus the cumulative timing difference as of December 31, 2017 ($32
million) multiplied by 21 percent.
NORMALIZATION CALCULATION FOR CORPORATE RATE REDUCTION
[Millions of dollars]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Year(s)
----------------------------------------------------------------------------------------------------------------------------------------------
2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Total
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Tax expense..................................... 20.00 32.00 19.20 11.52 11.52 5.76 0.00 0.00 0.00 0.00 100.00
Book depreciation............................... 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 100.00
Timing difference............................... 10.00 22.00 9.20 1.52 1.52 -4.24 -10.00 -10.00 -10.00 -10.00 0.00
Tax rate........................................ 35.00% 35.00% 21.00% 21.00% 21.00% 31.13% 31.13% 31.13% 31.13% 31.13%
Annual adjustment to reserve.................... 3.50 7.70 1.93 0.32 0.32 -1.32 -3.11 -3.11 -3.11 -3.11 0.00
Cumulative deferred tax reserve................. 3.50 11.20 13.13 13.45 13.77 12.45 9.34 6.23 3.11 0.00 0.00
Annual adjustment at 21%........................ ........... ........... ........... ........... ........... (0.89) (2.10) (2.10) (2.10) (2.10) (9.29)
Annual adjustment at average rate............... ........... ........... ........... ........... ........... (1.32) (3.11) (3.11) (3.11) (3.11) (13.77)
Excess tax reserve.............................. ........... ........... ........... ........... ........... 0.43 1.01 1.01 1.01 1.01 4.48
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* Details may not add to totals due to rounding.
Instead of the average rate assumption method, a taxpayer
may also use the alternative method as its normalization method
if certain requirements are met. If, as of the first day of the
taxable year that includes December 22, 2017 (i.e., the date of
enactment of the Act), (i) the taxpayer was required by a
regulatory agency to compute depreciation for public utility
property on the basis of an average life or composite rate
method, and (ii) the taxpayer's books and underlying records do
not contain the vintage account data necessary to apply the
average rate assumption method,\392\ the taxpayer is treated as
using a normalization method of accounting if, with respect to
such jurisdiction, the taxpayer uses the alternative method for
public utility property that is subject to the regulatory
authority for that jurisdiction.\393\ Under the alternative
method, the taxpayer (i) computes the excess tax reserve on all
public utility property included in the plant account based on
the weighted average life or composite rate used to compute
depreciation for regulatory purposes, and (ii) reduces the
excess tax reserve ratably over the remaining regulatory life
of the property.\394\
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\392\ See sec. 2.05 of Rev. Proc. 88-12, 1988-1 C.B. 637.
\393\ If a taxpayer is subject to the jurisdiction of more than one
regulatory body, the determination of the adequacy of the vintage
accounting records for each asset or group of assets shall be
determined on a jurisdiction-by-jurisdiction basis. See sec. 3 of Rev.
Proc. 88-12, 1988-1 C.B. 637.
\394\ See, e.g., sec. 4 of Rev. Proc. 88-12, 1988-1 C.B. 637.
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
B. Reduction in Dividends-Received Deduction to Reflect Lower Corporate
Income Tax Rates (sec. 13002 of the Act and sec. 243 of the Code)
Prior Law
Corporations are allowed a deduction with respect to
dividends received from other taxable domestic
corporations.\395\ The amount of the deduction is generally
equal to 70 percent of the dividend received.
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\395\ Sec. 243(a). These dividends are taxed at a maximum rate of
10.5 percent (30 percent of the top corporate tax rate of 35 percent).
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In the case of any dividend received from a 20-percent
owned corporation, the amount of the deduction is equal to 80
percent of the dividend received.\396\ The term ``20-percent
owned corporation'' means any corporation if 20 percent or more
of the stock of such corporation (by vote and value) is owned
by the taxpayer. For this purpose, certain preferred stock is
not taken into account.
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\396\ Sec. 243(c). These dividends are taxed at a maximum rate of
seven percent (20 percent of the top corporate tax rate of 35 percent).
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In the case of a dividend received from a corporation that
is a member of the same affiliated group, a corporation is
generally allowed a deduction equal to 100 percent of the
dividend received.\397\
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\397\ Secs. 243(a)(3) and (b)(1). For this purpose, the term
``affiliated group'' generally has the meaning given such term by
section 1504(a). Sec. 243(b)(2).
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Explanation of Provision
The provision reduces the 70 percent dividends-received
deduction to 50 percent and the 80 percent dividends-received
deduction to 65 percent.\398\
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\398\ These dividends would be taxed at a maximum rate of 10.5
percent (50 percent of the top corporate tax rate of 21 percent) and
7.35 percent (35 percent of the top corporate tax rate of 21 percent),
respectively.
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
PART II--SMALL BUSINESS REFORMS
A. Modifications of Rules for Expensing Depreciable Business Assets
(sec. 13101 of the Act and sec. 179 of the Code)
Prior Law
A taxpayer generally must capitalize the cost of property
used in a trade or business or held for the production of
income and recover such cost over time through annual
deductions for depreciation or amortization.\399\ The period
for depreciation or amortization generally begins when the
asset is placed in service by the taxpayer.\400\ Tangible
property generally is depreciated under the modified
accelerated cost recovery system (``MACRS''), which determines
depreciation for different types of property based on an
assigned applicable depreciation method, recovery period,\401\
and convention.\402\
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\399\ See secs. 263(a) and 167. In general, only the tax owner of
property (i.e., the taxpayer with the benefits and burdens of
ownership) is entitled to claim tax benefits such as cost recovery
deductions with respect to the property. In addition, where property is
not used exclusively in a taxpayer's business, the amount eligible for
a deduction must be reduced by the amount related to personal use. See,
e.g., sec. 280A.
\400\ See Treas. Reg. secs. 1.167(a)-10(b), -3, -14, and 1.197-
2(f). See also Treas. Reg. sec. 1.167(a)-11(e)(1)(i).
\401\ The applicable recovery period for an asset is determined in
part by statute and in part by historic Treasury guidance. Exercising
authority granted by Congress, the Secretary issued Rev. Proc. 87-56,
1987-2 C.B. 674, laying out the framework of recovery periods for
enumerated classes of assets. The Secretary clarified and modified the
list of asset classes in Rev. Proc. 88-22, 1988-1 C.B. 785. In November
1988, Congress revoked the Secretary's authority to modify the class
lives of depreciable property. Rev. Proc. 87-56, as modified, remains
in effect except to the extent that the Congress has, since 1988,
statutorily modified the recovery period for certain depreciable
assets, effectively superseding any administrative guidance with regard
to such property.
\402\ Sec. 168.
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Election to expense certain depreciable business assets
A taxpayer may elect under section 179 to deduct (or
``expense'') the cost of qualifying property, rather than to
recover such costs through depreciation deductions, subject to
limitation. The maximum amount a taxpayer may expense is
$500,000 of the cost of qualifying property placed in service
for the taxable year.\403\ The $500,000 amount is reduced (but
not below zero) by the amount by which the cost of qualifying
property placed in service during the taxable year exceeds
$2,000,000.\404\ The $500,000 and $2,000,000 amounts are
indexed for inflation for taxable years beginning after
2015.\405\
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\403\ Sec. 179(b)(1).
\404\ Sec. 179(b)(2).
\405\ Sec. 179(b)(6). For taxable years beginning in 2017, the
total amount that may be expensed is $510,000 ($545,000 for qualified
enterprise zone property under section 1397A), and the phase-out
threshold amount is $2,030,000. See Section 3.25 of Rev. Proc. 2016-55,
2016-45 I.R.B. 707. For example, assume that during 2017 a calendar
year taxpayer purchases and places in service $2,500,000 of section 179
property. The $510,000 section 179(b)(1) dollar amount for 2017 is
reduced by the excess section 179 property cost amount of $470,000
($2,500,000 - $2,030,000). The taxpayer's 2017 section 179 expensing
limitation is $40,000 ($510,000 - $470,000). Note, however, that the
taxpayer's remaining basis in the property may be eligible for bonus
depreciation under section 168(k). See Treas. Reg. sec. 1.168(k)-
1(a)(2)(iii). For a discussion of changes made to section 168(k) by the
Act, see the description of section 13201 of the Act (Temporary 100-
Percent Expensing for Certain Business Assets).
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In general, qualifying property is defined as depreciable
tangible personal property \406\ that is purchased for use in
the active conduct of a trade or business. Qualifying property
also includes off-the-shelf computer software and qualified
real property (i.e., qualified leasehold improvement property,
qualified restaurant property, and qualified retail improvement
property).\407\ Qualifying property excludes any property
described in section 50(b) (i.e., certain property not eligible
for the investment tax credit).\408\
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\406\ For example, qualifying property includes a portable air
conditioning or heating unit (such as a window air conditioning unit or
portable plug-in unit heater), but generally excludes any component of
a central air conditioning or heating system of a building as such
property represents real property (i.e., is a structural component of a
building). See Treas. Reg. sec. 1.48-1(e)(2) and sec. 3.03(1) of Rev.
Proc. 2017-33, 2017-19 I.R.B. 1236.
\407\ Sec. 179(d)(1)(A)(ii) and (f), as in effect prior to the
enactment of the Consolidated Appropriations Act, 2018, Pub. L. No.
115-141, sec. 401(b)(15), March 23, 2018, which, as part of repealing
general deadwood-related provisions, struck former subsection (e)
(relating to special rules for qualified disaster assistance property)
and redesignated ``subsection (f)'' as ``subsection (e)''. Thus, if a
component of a central air conditioning or heating system of a building
meets the definition of qualified real property under section 179
(e.g., constitutes qualified restaurant property), the component may
qualify as section 179 property if the taxpayer so elects. See sec.
3.03(2) of Rev. Proc. 2017-33.
\408\ Sec. 179(d)(1) flush language. Property described in section
50(b) is generally property used outside the United States, certain
property used for lodging, property used by certain tax-exempt
organizations, and property used by governmental units and foreign
persons or entities.
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Passenger automobiles subject to the section 280F
limitation are eligible for section 179 expensing only to the
extent of the dollar limitations in section 280F.\409\ For
sport utility vehicles above the 6,000 pound weight rating and
not more than the 14,000 pound weight rating, which are not
subject to the limitation under section 280F, the maximum cost
that may be expensed for any taxable year under section 179 is
$25,000 (the ``sport utility vehicle limitation'').\410\
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\409\ For a discussion of changes made to section 280F by the Act,
see the description of section 13202 of the Act (Modifications to
Depreciation Limitations on Luxury Automobiles and Personal Use
Property).
\410\ Sec. 179(b)(5). For this purpose, a sport utility vehicle is
defined to exclude any vehicle that: (1) is designed for more than nine
individuals in seating rearward of the driver's seat; (2) is equipped
with an open cargo area, or a covered box not readily accessible from
the passenger compartment, of at least six feet in interior length; or
(3) has an integral enclosure, fully enclosing the driver compartment
and load carrying device, does not have seating rearward of the
driver's seat, and has no body section protruding more than 30 inches
ahead of the leading edge of the windshield.
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The amount eligible to be expensed for a taxable year may
not exceed the taxable income for such taxable year that is
derived from the active conduct of a trade or business
(determined without regard to this provision).\411\ Any amount
that is not allowed as a deduction because of the taxable
income limitation may be carried forward to succeeding taxable
years (subject to limitations).
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\411\ Sec. 179(b)(3).
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Amounts expensed under section 179 are allowed for both
regular tax and the alternative minimum tax.\412\ However, no
general business credit under section 38 is allowed with
respect to any amount for which a deduction is allowed under
section 179.\413\ In addition, if a corporation makes an
election under section 179 to deduct expenditures, the full
amount of the deduction does not reduce earnings and profits.
Rather, the expenditures that are deducted under section 179
reduce corporate earnings and profits ratably over a five-year
period.\414\
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\412\ See the Senate Finance Committee Report to Accompany H.R.
3838, Tax Reform Act of 1986, S. Rep. No. 99-313, May 29, 1985, p. 522.
See also the Instructions for Form 6251, Alternative Minimum Tax -
Individuals (2017), p. 6.
\413\ Sec. 179(d)(9).
\414\ Sec. 312(k)(3)(B).
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An expensing election is made under rules prescribed by the
Secretary.\415\ In general, any election made under section
179, and any specification contained therein, may be revoked by
the taxpayer with respect to any property without the consent
of the Commissioner.\416\ Such revocation, once made, is
irrevocable.
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\415\ Sec. 179(c)(1). Such election may be made on an amended
return. See sec. 3.02 of Rev. Proc. 2017-33.
\416\ Sec. 179(c)(2).
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Explanation of Provision
The provision increases the maximum amount a taxpayer may
expense under section 179 to $1,000,000, and increases the
phase-out threshold amount to $2,500,000. Thus, the provision
provides that the maximum amount a taxpayer may expense for
taxable years beginning after 2017 is $1,000,000 of the cost of
section 179 property placed in service for the taxable year.
The $1,000,000 amount is reduced (but not below zero) by the
amount by which the cost of section 179 property placed in
service during the taxable year exceeds $2,500,000.\417\ The
$1,000,000 and $2,500,000 amounts, as well as the $25,000 sport
utility vehicle limitation (amount unchanged by the Act), are
indexed for inflation for taxable years beginning after 2018.
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\417\ For example, assume that during 2018 a calendar-year taxpayer
purchases and places in service $3,000,000 of section 179 property. The
$1,000,000 section 179(b)(1) dollar amount for 2018 is reduced by the
excess section 179 property cost amount of $500,000 ($3,000,000 -
$2,500,000). The taxpayer's 2018 section 179 expensing limitation is
$500,000 ($1,000,000 - $500,000). Note, however, that the taxpayer's
remaining basis in the property may be eligible for bonus depreciation
under section 168(k). See Treas. Reg. sec. 1.168(k)-1(a)(2)(iii). For a
discussion of changes made to section 168(k) by the Act, see the
description of section 13201 of the Act (Temporary 100-Percent
Expensing for Certain Business Assets).
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The provision expands the definition of section 179
property to include certain depreciable tangible personal
property used predominantly to furnish lodging or in connection
with furnishing lodging.\418\
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\418\ As defined in section 50(b)(2). Property used predominantly
to furnish lodging or in connection with furnishing lodging generally
includes, for example, beds and other furniture, refrigerators, ranges,
and other equipment used in the living quarters of a lodging facility
such as an apartment house, dormitory, or any other facility (or part
of a facility) where sleeping accommodations are provided and let. See
Treas. Reg. sec. 1.48-1(h).
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As a conforming amendment to the elimination by the Act of
the separate definitions of qualified leasehold improvement
property, qualified restaurant property, and qualified retail
improvement property under section 168,\419\ the provision
replaces the references in section 179(f) \420\ to qualified
leasehold improvement property, qualified restaurant property,
and qualified retail improvement property within the definition
of qualified real property with a reference to qualified
improvement property. Thus, for example, the provision allows
section 179 expensing for qualified improvement property
without regard to whether the improvements are property subject
to a lease, placed in service more than three years after the
date the building was first placed in service, or made to a
restaurant building. Restaurant building property placed in
service after December 31, 2017, that does not meet the
definition of qualified improvement property is not eligible
for section 179 expensing.
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\419\ See the description of section 13204 of the Act (Applicable
Recovery Period for Real Property).
\420\ As in effect prior to the enactment of the Consolidated
Appropriations Act, 2018, Pub. L. No. 115-141, sec. 401(b)(15), March
23, 2018, which, as part of repealing general deadwood-related
provisions, struck former subsection (e) (relating to special rules for
qualified disaster assistance property) and redesignated ``subsection
(f)'' as ``subsection (e)''.
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The provision also expands the definition of qualified real
property eligible for section 179 expensing to include any of
the following improvements made by the taxpayer \421\ to
nonresidential real property and placed in service after the
date such nonresidential real property was first placed in
service: roofs; heating, ventilation, and air-conditioning
property; \422\ fire protection and alarm systems; and security
systems. Thus, such improvements do not need to meet the
definition of qualified improvement property to be eligible for
section 179 expensing.
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\421\ A technical correction may be necessary to reflect this
intent.
\422\ Heating, ventilation, and air-conditioning property includes
all components (whether in, on, or adjacent to the building) of a
central air conditioning or heating system, including motors,
compressors, pipes and ducts. Treas. Reg. sec. 1.48-1(e)(2).
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Effective Date
The provision applies to property placed in service in
taxable years beginning after December 31, 2017.
B. Small Business Accounting Method Reform and Simplification (sec.
13102 of the Act and secs. 263A, 448, 460, and 471 of the Code)
Prior Law
General rule for methods of accounting
Section 446 generally allows a taxpayer to select the
method of accounting to be used to compute taxable income,
provided that such method clearly reflects the income of the
taxpayer. The term ``method of accounting'' includes not only
the overall method of accounting used by the taxpayer, but also
the accounting treatment of any one item.\423\ Permissible
overall methods of accounting include the cash receipts and
disbursements method (``cash method''), an accrual method, or
any other method (including a hybrid method) permitted under
regulations prescribed by the Secretary.\424\ Examples of any
one item for which an accounting method may be adopted include
cost recovery,\425\ revenue recognition,\426\ and the timing of
deductions.\427\ For each separate trade or business, a
taxpayer is entitled to adopt any permissible method, subject
to certain restrictions.\428\
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\423\ Treas. Reg. sec. 1.446-1(a)(1).
\424\ Sec. 446(c).
\425\ See, e.g., secs. 167 and 168.
\426\ See, e.g., secs. 451 and 460.
\427\ See, e.g., secs. 461 and 467.
\428\ Sec. 446(d); Treas. Reg. sec. 1.446-1(d).
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A taxpayer filing its first return may adopt any
permissible method of accounting in computing taxable income
for such year.\429\ Except as otherwise provided, section
446(e) requires taxpayers to secure the consent of the
Secretary before changing a method of accounting. The
regulations under this section provide rules for determining:
(1) what a method of accounting is, (2) how a method of
accounting is adopted,\430\ and (3) how a change in method of
accounting is effectuated.\431\
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\429\ Treas. Reg. sec. 1.446-1(e)(1).
\430\ See also Rev. Rul. 90-38, 1990-1 C.B. 57 (holding that a
taxpayer adopts a method of accounting (1) when it uses a permissible
method of accounting on a single tax return, or (2) when it uses the
same impermissible method of accounting on two or more consecutive tax
returns).
\431\ Treas. Reg. sec. 1.446-1(e).
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Cash and accrual methods
Taxpayers using the cash method generally recognize items
of income when actually or constructively received and items of
expense when paid. The cash method is administratively easy and
provides the taxpayer flexibility in the timing of income
recognition. It is the method generally used by most individual
taxpayers, including farm and nonfarm sole proprietorships.
Taxpayers using an accrual method generally accrue items of
income when all the events have occurred that fix the right to
receive the income and the amount of the income can be
determined with reasonable accuracy.\432\ Taxpayers using an
accrual method of accounting generally may not deduct items of
expense prior to when all the events have occurred that fix the
obligation to pay the liability, the amount of the liability
can be determined with reasonable accuracy, and economic
performance has occurred.\433\ Accrual methods of accounting
generally result in a more accurate measure of economic income
than does the cash method. The accrual method is often used by
businesses for financial accounting purposes.
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\432\ See, e.g., sec. 451. For a discussion of changes made to
section 451 by the Act, see the description of section 13221 of the Act
(Certain Special Rules for Taxable Year of Inclusion).
\433\ See, e.g., sec. 461.
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A C corporation, a partnership that has a C corporation as
a partner, or a tax-exempt trust or corporation with unrelated
business income generally may not use the cash method.
Exceptions are made for farming businesses, qualified personal
service corporations, and the aforementioned entities to the
extent their average annual gross receipts \434\ do not exceed
$5 million for all prior years (including the prior taxable
years of any predecessor of the entity) (the ``gross receipts
test''). The cash method may not be used by any tax
shelter.\435\ In addition, the cash method generally may not be
used if the purchase, production, or sale of merchandise is an
income producing factor.\436\ Such taxpayers generally are
required to keep inventories and use an accrual method with
respect to inventory items.\437\
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\434\ For this purpose, gross receipts are taken into account in
the taxable year in which they are properly recognized under the
taxpayer's method of accounting used in that taxable year. Gross
receipts include total sales (net of returns and allowances) and all
amounts received for services. In addition, gross receipts include
income from investments, income from incidental or outside sources,
interest (including original issue discount and tax-exempt interest
within the meaning of section 103), dividends, rents, royalties, and
annuities, regardless of whether such amounts are derived in the
ordinary course of the taxpayer's trade or business. Gross receipts are
not reduced by cost of goods sold or by the cost of property sold if
such property is described in section 1221(1), (3), (4), or (5). With
respect to sales of capital assets as defined in section 1221, or sales
of property described in section 1221(2) (relating to property used in
a trade or business), gross receipts are reduced by the taxpayer's
adjusted basis in such property. Gross receipts do not include the
repayment of a loan or similar instrument (e.g., a repayment of the
principal amount of a loan held by a commercial lender). Finally, gross
receipts do not include amounts received by the taxpayer with respect
to sales tax or other similar State and local taxes if, under the
applicable State or local law, the tax is legally imposed on the
purchaser of the good or service, and the taxpayer merely collects and
remits the tax to the taxing authority. If, in contrast, the tax is
imposed on the taxpayer under the applicable law, then gross receipts
include the amounts received that are allocable to the payment of such
tax. See section 448(c)(3)(C) and Treas. Reg. sec. 1.448-1T(f)(2)(iv).
\435\ Secs. 448(a)(3) and (d)(3) and 461(i)(3) and (4). For this
purpose, a tax shelter includes: (1) any enterprise (other than a C
corporation) if at any time interests in such enterprise have been
offered for sale in any offering required to be registered with any
Federal or State agency having the authority to regulate the offering
of securities for sale; (2) any syndicate (within the meaning of
section 1256(e)(3)(B)); or (3) any tax shelter as defined in section
6662(d)(2)(C)(ii). In the case of a farming trade or business, a tax
shelter includes any tax shelter as defined in section
6662(d)(2)(C)(ii) or any partnership or any other enterprise other than
a corporation which is not an S corporation engaged in the trade or
business of farming, (1) if at any time interests in such partnership
or enterprise have been offered for sale in any offering required to be
registered with any Federal or State agency having authority to
regulate the offering of securities for sale or (2) if more than 35
percent of the losses during any period are allocable to limited
partners or limited entrepreneurs. For this purpose, certain holdings
held directly by individuals that are attributable to active farm
management activities are not treated as being held by a limited
partner or a limited entrepreneur. See the second section 461(j)
(relating to farming syndicate defined), as in effect prior to the
enactment of the Consolidated Appropriations Act, 2018, Pub. L. No.
115-141, section 401(a)(117), March 23, 2018, which, as part of
repealing general deadwood-related provisions, redesignated the second
``subsection (j)'' (relating to farming syndicate defined) as
``subsection (k)''.
\436\ Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
\437\ Sec. 471 and Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
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A farming business is defined as a trade or business of
farming, including operating a nursery or sod farm, or the
raising or harvesting of trees bearing fruit, nuts, or other
crops, timber, or ornamental trees (other than evergreen trees
that are more than six years old at the time they are severed
from their roots).\438\ Such farming businesses are not
precluded from using the cash method regardless of whether they
meet the gross receipts test. However, section 447 generally
requires a farming C corporation (and any farming partnership
if a corporation is a partner in such partnership) to use an
accrual method of accounting. Section 447 does not apply to
nursery or sod farms, to the raising or harvesting of trees
(other than fruit and nut trees), nor to farming C corporations
meeting a gross receipts test with a $1 million threshold. For
family farm C corporations, the threshold under the gross
receipts test is $25 million.
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\438\ Secs. 448(d)(1) and 263A(e)(4). See also Treas. Reg. sec.
1.263A-4(a)(4).
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A qualified personal service corporation is a corporation:
(1) substantially all of whose activities involve the
performance of services in the fields of health, law,
engineering, architecture, accounting, actuarial science,
performing arts, or consulting, and (2) substantially all of
the stock of which (by value) is owned by current or former
employees performing such services, their estates, or
heirs.\439\ Qualified personal service corporations are allowed
to use the cash method without regard to whether they meet the
gross receipts test.
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\439\ Sec. 448(d)(2).
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Accounting for inventories
In general, for Federal income tax purposes, taxpayers must
account for inventories if the production, purchase, or sale of
merchandise is an income-producing factor to the taxpayer.\440\
Treasury regulations also provide that in any case in which the
use of inventories is necessary to clearly reflect income, the
accrual method must be used with regard to purchases and
sales.\441\ However, an exception is provided for taxpayers
whose average annual gross receipts do not exceed $1
million.\442\ A second exception is provided for taxpayers in
certain industries whose average annual gross receipts do not
exceed $10 million and that are not otherwise prohibited from
using the cash method under section 448.\443\ Such taxpayers
may account for inventory as materials and supplies that are
not incidental (i.e., ``non-incidental materials and
supplies''').\444\
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\440\ Sec. 471(a) and Treas. Reg. sec. 1.471-1.
\441\ Treas. Reg. sec. 1.446-1(c)(2).
\442\ Rev. Proc. 2001-10, 2001-1 C.B. 272.
\443\ Rev. Proc. 2002-28, 2002-1 C.B. 815.
\444\ Treas. Reg. sec. 1.162-3(a)(1). A deduction is generally
permitted for the cost of non-incidental materials and supplies in the
taxable year in which they are first used or are consumed in the
taxpayer's operations.
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In those circumstances in which a taxpayer is required to
account for inventory, the taxpayer must maintain inventory
records to determine the cost of goods sold during the taxable
period. Cost of goods sold generally is determined by adding
the taxpayer's inventory at the beginning of the period to the
purchases made during the period and subtracting from that sum
the taxpayer's inventory at the end of the period.
Because of the difficulty of accounting for inventories on
an item-by-item basis, taxpayers often use conventions that
assume certain item or cost flows. Among these conventions are
the first-in, first-out (``FIFO'') method, which assumes that
the items in ending inventory are those most recently acquired
by the taxpayer,\445\ and the last-in, first-out (``LIFO'')
method, which assumes that the items in ending inventory are
those earliest acquired by the taxpayer.\446\
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\445\ See Treas. Reg. sec. 1.471-2(d).
\446\ See sec. 472.
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Uniform capitalization
The uniform capitalization rules require certain direct and
indirect costs allocable to real or tangible personal property
produced by the taxpayer to be included in either inventory or
capitalized into the basis of such property, as
applicable.\447\ For real or personal property acquired by the
taxpayer for resale, section 263A generally requires certain
direct and indirect costs allocable to such property to be
included in inventory.
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\447\ Sec. 263A.
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Section 263A provides a number of exceptions to the general
uniform capitalization requirements. One such exception exists
for certain small taxpayers who acquire property for resale and
have $10 million or less of average annual gross receipts;
\448\ such taxpayers are not required to include additional
section 263A costs in inventory. Another exception exists for
taxpayers who raise, harvest, or grow trees.\449\ Under this
exception, section 263A does not apply to trees raised,
harvested, or grown by the taxpayer (other than trees bearing
fruit, nuts, or other crops, or ornamental trees) and any real
property underlying such trees. Similarly, the uniform
capitalization rules do not apply to any plant having a
preproductive period of two years or less or to any animal,
which is produced by a taxpayer in a farming business (unless
the taxpayer is required to use an accrual method of accounting
under section 447 or 448(a)(3)).\450\ Freelance authors,
photographers, and artists also are exempt from section 263A
for any qualified creative expenses.\451\
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\448\ Sec. 263A(b)(2)(B). No exception is available for small
taxpayers who produce property subject to section 263A. However, a de
minimis rule under Treasury regulations treats producers with total
indirect costs of $200,000 or less as having no additional indirect
costs beyond those normally capitalized for financial accounting
purposes. Treas. Reg. sec. 1.263A-2(b)(3)(iv).
\449\ Sec. 263A(c)(5).
\450\ Sec. 263A(d).
\451\ Sec. 263A(h). Qualified creative expenses are defined as
amounts paid or incurred by an individual in the trade or business of
being a writer, photographer, or artist (other than as an employee).
However, such term does not include any expense related to printing,
photographic plates, motion picture films, video tapes, or similar
items.
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Accounting for long-term contracts
In general, in the case of a long-term contract, the
taxable income from the contract is determined under the
percentage-of-completion method.\452\ Under this method, the
taxpayer must include in gross income for the taxable year an
amount equal to the product of (1) the gross contract price and
(2) the percentage of the contract completed during the taxable
year.\453\ The percentage of the contract completed during the
taxable year is determined by comparing costs allocated to the
contract and incurred before the end of the taxable year with
the estimated total contract costs.\454\ Costs allocated to the
contract typically include all costs (including depreciation)
that directly benefit or are incurred by reason of the
taxpayer's long-term contract activities.\455\ The allocation
of costs to a contract is made in accordance with
regulations.\456\ Costs incurred with respect to the long-term
contract are deductible in the year incurred, subject to
general accrual method of accounting principles and
limitations.\457\
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\452\ Sec. 460(a).
\453\ See Treas. Reg. sec. 1.460-4. This calculation is done on a
cumulative basis. Thus, the amount included in gross income in a
particular year is that proportion of the expected contract price that
the amount of costs incurred through the end of the taxable year bears
to the total expected costs, reduced by the amounts of gross contract
price included in gross income in previous taxable years.
\454\ Sec. 460(b)(1).
\455\ Sec. 460(c).
\456\ Treas. Reg. sec. 1.460-5.
\457\ Treas. Reg. secs. 1.460-4(b)(2)(iv) and 1.460-1(b)(8).
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There are a number of types of long-term contracts excepted
from the requirements to use the percentage-of-completion
method to compute taxable income. One such exception is
provided for certain construction contracts performed by small
contractors (``small construction contracts'').\458\ Contracts
within this exception are those contracts for the construction
or improvement of real property if the contract: (1) is
expected (at the time such contract is entered into) to be
completed within two years of commencement of the contract and
(2) is performed by a taxpayer whose average annual gross
receipts for the prior three taxable years do not exceed $10
million.\459\ Thus, long-term contract income from small
construction contracts must be reported consistently using the
taxpayer's exempt contract method.\460\ Permissible exempt
contract methods include the completed contract method, the
exempt-contract percentage-of-completion method, the
percentage-of-completion method, or any other permissible
method.\461\
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\458\ Other exceptions are provided for home construction
contracts, residential construction contracts, qualified ship
construction contracts, and qualified naval ship contracts. See sec.
460(e); Treas. Reg. secs. 1.460-2(d), 1.460-3(b) and (c), and 1.460-
4(e); and sec. 708 of the American Jobs Creation Act of 2004, Pub. L.
No. 108-357 (2004).
\459\ Secs. 460(e)(1)(B) and (4).
\460\ Since such contracts involve the construction of real
property, they are subject to the interest capitalization rules without
regard to their duration. See Treas. Reg. sec. 1.263A-8.
\461\ Treas. Reg. sec. 1.460-4(c)(1).
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Explanation of Provision
The provision expands the universe of taxpayers that may
use the cash method of accounting. Under the provision, the
cash method of accounting may be used by taxpayers, other than
tax shelters, that satisfy the gross receipts test, regardless
of whether the purchase, production, or sale of merchandise is
an income-producing factor. The gross receipts test allows
taxpayers with average annual gross receipts \462\ that do not
exceed $25 million for the three prior taxable-year period (the
``$25 million gross receipts test'') to use the cash method.
The $25 million amount is indexed for inflation for taxable
years beginning after 2018.
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\462\ For purposes of the gross receipts test, items included in
gross receipts are intended to be consistent with prior law. See
section 448(c)(3)(C) and Treas. Reg. sec. 1.448-1T(f)(2)(iv).
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The provision expands the universe of farming C
corporations (and farming partnerships with a C corporation
partner) that may use the cash method to include any farming C
corporation (or farming partnership with a C corporation
partner) that meets the $25 million gross receipts test.
The provision retains the exceptions from the required use
of the accrual method for qualified personal service
corporations and taxpayers other than C corporations. Thus,
qualified personal service corporations, partnerships without C
corporation partners, S corporations, and other passthrough
entities are allowed to use the cash method without regard to
whether they meet the $25 million gross receipts test, so long
as the use of such method clearly reflects income.\463\
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\463\ Consistent with prior and present law, the cash method
generally may not be used by taxpayers, other than those that meet the
$25 million gross receipts test, if the purchase, production, or sale
of merchandise is an income-producing factor.
---------------------------------------------------------------------------
In addition, the provision exempts certain taxpayers from
the requirement to keep inventories. Specifically, taxpayers
that meet the $25 million gross receipts test are not required
to account for inventories under section 471,\464\ but rather
may use a method of accounting for inventories that either (1)
treats inventories as non-incidental materials and
supplies,\465\ or (2) conforms to the taxpayer's financial
accounting treatment of inventories.\466\
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\464\ In the case of a sole proprietorship, the $25 million gross
receipts test is applied as if the sole proprietorship is a corporation
or partnership.
\465\ Consistent with prior and present law, a deduction is
generally permitted for the cost of non-incidental materials and
supplies in the taxable year in which they are first used or are
consumed in the taxpayer's operations. See Treas. Reg. sec. 1.162-
3(a)(1). As the provision allows a taxpayer to treat inventories as
non-incidental materials and supplies, a taxpayer may also be able to
elect to deduct such non-incidental materials and supplies in the
taxable year the amount is paid under the de minimis safe harbor
election of Treas. Reg. sec. 1.263(a)-1(f). Under such election, a
taxpayer with an applicable financial statement that has written
accounting procedures in place that treat as an expense amounts paid
for property costing less than a specified dollar amount may deduct
amounts paid for non-incidental materials and supplies at the time of
payment if the amount paid for the property does not exceed $5,000 per
invoice (or per item as substantiated by the invoice). In addition, a
taxpayer without an applicable financial statement that has accounting
procedures in place that treat as an expense amounts paid for property
costing less than a specified dollar amount may deduct amounts paid for
non-incidental materials and supplies at the time of payment if the
amount paid for the property does not exceed $500 per invoice (or per
item as substantiated by the invoice). However, in either case, the
taxpayer is not eligible to deduct inventory treated as non-incidental
materials and supplies under this provision under the de minimis safe
harbor election unless the taxpayer is also treating the amounts paid
for such items as an expense in its applicable financial statement or
its books and records, if the taxpayer does not have an applicable
financial statement (i.e., the taxpayer is not eligible to apply the de
minimis safe harbor if the amounts paid for such items are treated as
inventory for financial reporting purposes). See Treas. Reg. sec.
1.263(a)-1(f)(1)(i)(C) and (ii)(C). If a taxpayer elects to apply the
de minimis safe harbor, the taxpayer must apply such safe harbor to all
materials and supplies that otherwise meet the requirements of Treas.
Reg. sec. 1.263(a)-1(f).
\466\ The taxpayer's financial accounting treatment of inventories
is determined by reference to the method of accounting used in the
taxpayer's applicable financial statement (as defined in section 13221
of the Act (Certain Special Rules for Taxable Year of Inclusion)) or,
if the taxpayer does not have an applicable financial statement, the
method of accounting used in the taxpayer's books and records prepared
in accordance with the taxpayer's accounting procedures.
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The provision expands the exception for small taxpayers
from the uniform capitalization rules. Under the provision, any
producer or reseller that meets the $25 million gross receipts
test is exempted from the application of section 263A.\467\ The
provision retains the exemptions from the uniform
capitalization rules that are not based on a taxpayer's gross
receipts.
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\467\ In the case of a sole proprietorship, the $25 million gross
receipts test is applied as if the sole proprietorship is a corporation
or partnership.
---------------------------------------------------------------------------
Finally, the provision expands the exception for small
construction contracts from the requirement to use the
percentage-of-completion method. Under the provision, contracts
within this exception are those contracts for the construction
or improvement of real property if the contract (1) is expected
(at the time such contract is entered into) to be completed
within two years of commencement of the contract, and (2) is
performed by a taxpayer that (for the taxable year in which the
contract was entered into) meets the $25 million gross receipts
test.\468\
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\468\ In the case of a sole proprietorship, the $25 million gross
receipts test is applied as if the sole proprietorship is a corporation
or partnership.
---------------------------------------------------------------------------
Under the provision, a taxpayer who fails the $25 million
gross receipts test for a taxable year is not eligible for any
of the aforementioned exceptions (i.e., from the accrual
method, from keeping inventories, from applying the uniform
capitalization rules, or from using the percentage-of-
completion method) for such taxable year.
Application of any of the above provisions is a change in
the taxpayer's method of accounting for purposes of section
481. Application of the exception for small construction
contracts from the requirement to use the percentage-of-
completion method is implemented on a cutoff basis for all
similarly classified contracts (hence there is no adjustment
under section 481(a) for contracts entered into before January
1, 2018). In addition, any change in method of accounting due
to application of the above provisions is treated as initiated
by the taxpayer and made with the consent of the
Secretary.\469\ For example, such change is made with the
consent of the Secretary for any taxable year in which the
taxpayer fails to meet the gross receipts test if the taxpayer
met such test in the prior taxable year, and the taxpayer is
changing from the cash method to an accrual method. In
addition, such change is made with the consent of the Secretary
for any taxable year in which the taxpayer meets the gross
receipts test if the taxpayer failed to meet such test in the
prior taxable year and the taxpayer is changing from an accrual
method to the cash method.
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\469\ See sections 263A(i)(3), 448(d)(7), 460(e)(2)(B), and
471(c)(4), all as amended by the Act.
The Treasury Department has issued published guidance
addressing this provision.\470\
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\470\ See Rev. Proc. 2018-40, 2018-34 I.R.B. 320, August 20, 2018.
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Effective Date
The provisions to expand the universe of taxpayers,
including farming C corporations, eligible to use the cash
method, exempt certain taxpayers from the requirement to keep
inventories, and expand the exception from the uniform
capitalization rules apply to taxable years beginning after
December 31, 2017. Application of these rules is a change in
the taxpayer's method of accounting for purposes of section
481.
The provision to expand the exception for small
construction contracts from the requirement to use the
percentage-of-completion method applies to contracts entered
into after December 31, 2017, in taxable years ending after
such date. Application of this rule is a change in the
taxpayer's method of accounting for purposes of section 481.
Application of the exception for small construction contracts
from the requirement to use the percentage-of-completion method
is implemented on a cutoff basis for all similarly classified
contracts (hence there is no adjustment under section 481(a)
for contracts entered into before January 1, 2018).
PART III--COST RECOVERY AND ACCOUNTING METHODS
SUBPART A--COST RECOVERY
A. Temporary 100-Percent Expensing for Certain Business Assets (sec.
13201 of the Act and sec. 168(k) of the Code)
Prior Law
A taxpayer generally must capitalize the cost of property
used in a trade or business or held for the production of
income and recover such cost over time through annual
deductions for depreciation or amortization.\471\ The period
for depreciation or amortization generally begins when the
asset is placed in service by the taxpayer.\472\
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\471\ See secs. 263(a) and 167. In general, only the tax owner of
property (i.e., the taxpayer with the benefits and burdens of
ownership) is entitled to claim tax benefits such as cost recovery
deductions with respect to the property. In addition, where property is
not used exclusively in a taxpayer's business, the amount eligible for
a deduction must be reduced by the amount related to personal use. See,
e.g., sec. 280A.
\472\ See Treas. Reg. secs. 1.167(a)-10(b), -3, -14, and 1.197-
2(f). See also Treas. Reg. sec. 1.167(a)-11(e)(1)(i).
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Tangible property
Tangible property generally is depreciated under the
modified accelerated cost recovery system (``MACRS''), which
determines depreciation for different types of property based
on an assigned applicable depreciation method, recovery
period,\473\ and convention.\474\
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\473\ The applicable recovery period for an asset is determined in
part by statute and in part by historic Treasury guidance. Exercising
authority granted by Congress, the Secretary issued Rev. Proc. 87-56,
1987-2 C.B. 674, laying out the framework of recovery periods for
enumerated classes of assets. The Secretary clarified and modified the
list of asset classes in Rev. Proc. 88-22, 1988-1 C.B. 785. In November
1988, Congress revoked the Secretary's authority to modify the class
lives of depreciable property. Rev. Proc. 87-56, as modified, remains
in effect except to the extent that the Congress has, since 1988,
statutorily modified the recovery period for certain depreciable
assets, effectively superseding any administrative guidance with regard
to such property.
\474\ Sec. 168.
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Bonus depreciation
An additional first-year depreciation deduction is allowed
equal to 50 percent of the adjusted basis of qualified property
acquired and placed in service before January 1, 2020 (January
1, 2021, for certain property with a recovery period of at
least 10 years or certain transportation property,\475\ and
certain aircraft \476\).\477\ The 50-percent allowance is
phased down for property placed in service after December 31,
2017 (after December 31, 2018, for longer production period
property and certain aircraft). The bonus depreciation
percentage rates are as follows.
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\475\ Property qualifying for the extended placed-in-service date
must have a recovery period of at least 10 years or constitute
transportation property, have an estimated production period exceeding
one year, and have a cost exceeding $1 million. Transportation property
generally is defined as tangible personal property used in the trade or
business of transporting persons or property. Section 168(k)(2)(B).
Property defined in section 168(k)(2)(B) is hereinafter collectively
referred to as ``longer production period property.''
\476\ Certain aircraft which is not transportation property, other
than for agricultural or firefighting uses, also qualifies for the
extended placed-in-service date, if at the time of the contract for
purchase, the purchaser made a nonrefundable deposit of the lesser of
10 percent of the cost or $100,000, and which has an estimated
production period exceeding four months and a cost exceeding $200,000.
Sec. 168(k)(2)(C).
\477\ Sec. 168(k). The additional first-year depreciation deduction
is generally subject to the rules regarding whether a cost must be
capitalized under section 263A. For a discussion of changes made to
section 263A by the Act, see the description of section 13102 of the
Act (Small Business Accounting Method Reform and Simplification).
\478\ In the case of longer production period property placed in
service in 2018, 50 percent applies to the entire adjusted basis.
Similarly, in the case of longer production period property placed in
service in 2019, 40 percent applies to the entire adjusted basis.
\479\ In the case of longer production period property described in
section 168(k)(2)(B) and placed in service in 2020, 30 percent applies
to the adjusted basis attributable to manufacture, construction, or
production before January 1, 2020, and the remaining adjusted basis
does not qualify for bonus depreciation. Thirty percent applies to the
entire adjusted basis of certain aircraft described in section
168(k)(2)(C) and placed in service in 2020.
------------------------------------------------------------------------
Bonus Depreciation Percentage
---------------------------------------
Longer Production
Placed in Service Year Qualified Property Period Property
in General and Certain
Aircraft
------------------------------------------------------------------------
2017............................ 50 percent........ 50 percent
2018............................ 40 percent........ 50 percent \478\
2019............................ 30 percent........ 40 percent
2020............................ None.............. 30 percent \479\
------------------------------------------------------------------------
The additional first-year depreciation deduction is allowed
for both the regular tax and the alternative minimum tax
(``AMT''),\480\ but is not allowed in computing earnings and
profits.\481\ The basis of the property and the depreciation
allowances in the year of purchase and later years are
appropriately adjusted to reflect the additional first-year
depreciation deduction.\482\ The amount of the additional
first-year depreciation deduction is not affected by a short
taxable year.\483\ The taxpayer may elect out of the additional
first-year depreciation for any class of property for any
taxable year.\484\
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\480\ Sec. 168(k)(2)(G). See also Treas. Reg. sec. 1.168(k)-1(d).
\481\ Sec. 312(k)(3) and Treas. Reg. sec. 1.168(k)-1(f)(7).
\482\ Sec. 168(k)(1)(B).
\483\ Ibid.
\484\ Sec. 168(k)(7). For the definition of a class of property,
see Treas. Reg. sec. 1.168(k)-1(e)(2).
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The interaction of the additional first-year depreciation
allowance with the otherwise applicable depreciation allowance
may be illustrated as follows. Assume that in 2017 a taxpayer
purchases new depreciable property and places it in
service.\485\ The property's cost is $10,000, and it is five-
year property subject to the 200 percent declining balance
method and half-year convention. The amount of additional
first-year depreciation allowed is $5,000. The remaining $5,000
of the cost of the property is depreciable under the rules
applicable to five-year property. Thus, $1,000 also is allowed
as a depreciation deduction in 2017.\486\ The total
depreciation deduction with respect to the property for 2017 is
$6,000. The remaining $4,000 adjusted basis of the property
generally is recovered through otherwise applicable
depreciation rules.
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\485\ Assume that the cost of the property is not eligible for
expensing under section 179 or Treas. Reg. sec. 1.263(a)-1(f).
\486\ $1,000 results from the application of the half-year
convention and the 200 percent declining balance method to the
remaining $5,000.
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Qualified property
Property qualifying for the additional first-year
depreciation deduction must meet all of the following
requirements: \487\
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\487\ Requirements relating to actions taken before 2008 are not
described herein since they have little (if any) remaining effect. For
a description of these actions, see Joint Committee on Taxation,
General Explanation of Tax Legislation Enacted in the 110th Congress
(JCS-1-09), March 2009, pp. 81-84.
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The property must be: (1) property to which
MACRS applies with an applicable recovery period of 20
years or less; (2) water utility property; \488\ (3)
computer software other than computer software covered
by section 197; or (4) qualified improvement property;
\489\
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\488\ As defined in section 168(e)(5).
\489\ The additional first-year depreciation deduction is not
available for any property that is required to be depreciated under the
alternative depreciation system of MACRS. Sec. 168(k)(2)(D)(i).
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The original use \490\ of the property must
commence with the taxpayer; \491\ and
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\490\ The term ``original use'' means the first use to which the
property is put, whether or not such use corresponds to the use of such
property by the taxpayer. If in the normal course of its business a
taxpayer sells fractional interests in property to unrelated third
parties, then the original use of such property begins with the first
user of each fractional interest (i.e., each fractional owner is
considered the original user of its proportionate share of the
property). Treas. Reg. sec. 1.168(k)-1(b)(3).
\491\ A special rule applies in the case of certain leased
property. In the case of any property that is originally placed in
service by a person and that is sold to the taxpayer and leased back to
such person by the taxpayer within three months after the date that the
property was placed in service, the property would be treated as
originally placed in service by the taxpayer not earlier than the date
that the property is used under the leaseback. If property is
originally placed in service by a lessor, such property is sold within
three months after the date that the property was placed in service,
and the user of such property does not change, then the property is
treated as originally placed in service by the taxpayer not earlier
than the date of such sale. Sec. 168(k)(2)(E)(ii) and (iii).
---------------------------------------------------------------------------
The property must be placed in service
before January 1, 2020. However, as noted above, an
extension of the placed-in-service date of one year
(i.e., before January 1, 2021) is provided for longer
production period property and certain aircraft.
In the case of longer production period property and
certain aircraft, the property must also be acquired (1) before
January 1, 2020, or (2) pursuant to a written binding contract
which was entered into before January 1, 2020. With respect to
such property that is manufactured, constructed, or produced by
the taxpayer for use by the taxpayer, the taxpayer must begin
the manufacture, construction, or production of the property
before January 1, 2020.\492\ Additionally, a special rule
limits the amount of costs eligible for the additional first-
year depreciation. With respect to such property, only the
portion of the basis that is properly attributable to the costs
incurred before January 1, 2020 (``progress expenditures'') is
eligible for the additional first-year depreciation
deduction.\493\
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\492\ Sec. 168(k)(2)(E)(i).
\493\ Sec. 168(k)(2)(B)(ii). For purposes of determining the amount
of eligible progress expenditures, rules similar to section 46(d)(3) as
in effect prior to the Tax Reform Act of 1986 apply.
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For purposes of identifying qualified property, qualified
improvement property is any improvement to an interior portion
of a building that is nonresidential real property if such
improvement is placed in service by the taxpayer after the date
such building was first placed in service by any taxpayer.\494\
Qualified improvement property does not include any improvement
for which the expenditure is attributable to the enlargement of
the building, any elevator or escalator, or the internal
structural framework of the building.
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\494\ Sec. 168(k)(3). See also section 4.02 of Rev. Proc. 2017-33,
2017-19 I.R.B. 1236. Qualified improvement property must also meet the
requirements of section 168(k)(2)(A)(ii) and (iii) (i.e., the original
use and placed in service date requirements) to be eligible for bonus
depreciation.
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Election to accelerate AMT credits in lieu of bonus
depreciation
A corporation otherwise eligible for additional first-year
depreciation may elect to claim additional AMT credits in lieu
of claiming additional depreciation with respect to qualified
property.\495\ In the case of a corporation making this
election, the straight line method is used for the regular tax
and the AMT with respect to qualified property.\496\
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\495\ Sec. 168(k)(4).
\496\ Sec. 168(k)(4)(A)(ii).
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A corporation making an election increases the tax
liability limitation on the use of minimum tax credits under
section 53(c) by the bonus depreciation amount. The aggregate
increase in credits allowable by reason of the increased
limitation is treated as refundable.
The bonus depreciation amount generally is equal to 20
percent of bonus depreciation for qualified property that could
be claimed as a deduction absent an election under this
provision.\497\ As originally enacted, the bonus depreciation
amount for all taxable years was limited to the lesser of (1)
$30 million or (2) six percent of the minimum tax credits
allowable to the adjusted net minimum tax imposed for taxable
years beginning before January 1, 2006. However, extensions of
this provision have provided that this limitation applies
separately to property subject to each extension.
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\497\ For this purpose, bonus depreciation is the difference
between (i) the aggregate amount of depreciation determined if section
168(k)(1) applied to all qualified property placed in service during
the taxable year and (ii) the amount of depreciation that would be so
determined if section 168(k)(1) did not so apply. This determination is
made using the most accelerated depreciation method and the shortest
life otherwise allowable for each property.
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For taxable years ending after December 31, 2015, the bonus
depreciation amount for a taxable year (as defined under prior
law with respect to all qualified property) is limited to the
lesser of (1) 50 percent of the minimum tax credit for the
first taxable year ending after December 31, 2015 (determined
before the application of any tax liability limitation) or (2)
the minimum tax credit for the taxable year allowable to the
adjusted net minimum tax imposed for taxable years ending
before January 1, 2016 (determined before the application of
any tax liability limitation and determined on a first-in,
first-out basis).
All corporations treated as a single employer under section
52(a) are treated as one taxpayer for purposes of the
limitation, as well as for electing the application of this
provision.\498\
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\498\ Sec. 168(k)(4)(B)(iii).
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In the case of a corporation making an election which is a
partner in a partnership, for purposes of determining the
electing partner's distributive share of partnership items,
bonus depreciation does not apply to any qualified property and
the straight line method is used with respect to that
property.\499\
---------------------------------------------------------------------------
\499\ Sec. 168(k)(4)(D)(ii).
---------------------------------------------------------------------------
In the case of a partnership having a single corporate
partner owning (directly or indirectly) more than 50 percent of
the capital and profits interests in the partnership, each
partner takes into account its distributive share of
partnership depreciation in determining its bonus depreciation
amount.\500\
---------------------------------------------------------------------------
\500\ Sec. 168(k)(4)(D)(iii).
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Special rules
Passenger automobiles
The limitation under section 280F on the amount of
depreciation deductions allowed with respect to certain
passenger automobiles is increased in the first year by $8,000
for automobiles that qualify (and for which the taxpayer does
not elect out of the additional first-year deduction).\501\ The
$8,000 amount is phased down from $8,000 by $1,600 per calendar
year beginning in 2018. Thus, the section 280F increase amount
for property placed in service during 2018 is $6,400, and
during 2019 is $4,800. While the underlying section 280F
limitation is indexed for inflation,\502\ the section 280F
increase amount is not indexed for inflation. The increase does
not apply to a taxpayer who elects to accelerate AMT credits in
lieu of bonus depreciation for a taxable year.
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\501\ Sec. 168(k)(2)(F).
\502\ Sec. 280F(d)(7).
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Certain plants bearing fruits and nuts
A special election is provided for certain plants bearing
fruits and nuts.\503\ Under the election, the applicable
percentage of the adjusted basis of a specified plant which is
planted or grafted after December 31, 2015, and before January
1, 2020, is deductible for regular tax and AMT purposes in the
year planted or grafted by the taxpayer (rather than in the
year the specified plant is placed in service by the taxpayer
\504\), and the adjusted basis is reduced by the amount of the
deduction.\505\ The percentage is 50 percent for 2017, 40
percent for 2018, and 30 percent for 2019. A specified plant is
any tree or vine that bears fruits or nuts, and any other plant
that will have more than one crop or yield of fruits or nuts
and generally has a preproductive period of more than two years
from the time of planting or grafting to the time it begins
bearing a marketable crop or yield of fruits or nuts.\506\ If
the election is made with respect to any specified plant, such
plant is not treated as qualified property eligible for bonus
depreciation in the subsequent taxable year in which it is
placed in service.\507\ Once made, the election is revocable
only with the consent of the Secretary.\508\
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\503\ See sec. 168(k)(5). Section 4.05 of Rev. Proc. 2017-33
provides the procedures for making a section 168(k)(5) election.
\504\ In the case of any tree or vine bearing fruits or nuts, the
placed in service date generally does not occur until the tree or vine
first reaches an income-producing stage. See Treas. Reg. sec. 1.46-
3(d)(2). See also, Rev. Rul. 80-25, 1980-1 C.B. 65; and Rev. Rul. 69-
249, 1969-1 C.B. 31.
\505\ Any amount deducted under this election is not subject to
capitalization under section 263A.
\506\ A specified plant does not include any property that is
planted or grafted outside of the United States.
\507\ However, when placed in service, the remaining adjusted basis
of the specified plant may be eligible for expensing under section 179.
See section 4.05(3) of Rev. Proc. 2017-33. For a discussion of changes
made to section 179 by the Act, see the description of section 13101 of
the Act (Modification of Rules for Expensing).
\508\ See section 4.05(2) of Rev. Proc. 2017-33 for guidance on
revoking a section 168(k)(5) election.
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Long-term contracts
In general, in the case of a long-term contract, the
taxable income from the contract is determined under the
percentage-of-completion method.\509\ Solely for purposes of
determining the percentage-of-completion under section
460(b)(1)(A), the cost of qualified property with a MACRS
recovery period of seven years or less is taken into account as
a cost allocated to the contract as if bonus depreciation had
not been enacted for property placed in service before January
1, 2020 (January 1, 2021, in the case of longer production
period property).\510\
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\509\ Sec. 460.
\510\ Sec. 460(c)(6). Other dates involving prior years are not
described herein.
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Intangible property
Section 197 intangibles
Under section 197, when a taxpayer acquires intangible
assets held in connection with a trade or business, any value
properly attributable to a ``section 197 intangible'' is
amortizable on a straight-line basis over 15 years.\511\ No
other depreciation or amortization deduction (such as bonus
depreciation under section 168(k)) is allowable with respect to
any section 197 intangible.\512\ Such intangibles include:
goodwill; going concern value; workforce in place including its
composition and terms and conditions (contractual or otherwise)
of its employment; business books and records, operating
systems, or other information base; any patent, copyright,
formula, process, design, pattern, knowhow, format, or similar
item; customer-based intangibles; supplier-based intangibles;
and any other similar item.\513\ The definition of a section
197 intangible also includes: any license, permit, or other
rights granted by governmental units (even if the right is
granted for an indefinite period or is reasonably expected to
be renewed indefinitely); \514\ any covenant not to compete;
and any franchise,\515\ trademark, or trade name.\516\
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\511\ Secs. 197(a) and (c).
\512\ Sec. 197(b).
\513\ Sec. 197(d)(1).
\514\ Sec. 197(d)(1)(D). Examples include a liquor license, a taxi-
cab medallion, an airport landing or take-off right, a regulated
airline route, or a television or radio broadcasting license. Renewals
of such governmental rights are treated as the acquisition of a new 15-
year asset. Treas. Reg. sec. 1.197-2(b)(8). A license, permit, or other
right granted by a governmental unit is a franchise if it otherwise
meets the definition of a franchise. Treas. Reg. sec. 1.197-2(b)(10).
Section 197 intangibles do not include certain rights granted by a
government not considered part of the acquisition of a trade or
business. Sec. 197(e)(4)(B) and Treas. Reg. sec. 1.197-2(c)(13).
\515\ A franchise is defined as ``an agreement which gives one of
the parties to the agreement the right to distribute, sell, or provide
goods, services, or facilities, within a specified area.'' Secs.
197(f)(4) and 1253(b)(1). Thus, for example, 15-year amortization under
section 197 generally applies to acquired sports franchises, including
any intangible assets acquired in connection with the acquisition of
such a franchise (including player contracts). See Joint Committee on
Taxation, General Explanation of Tax Legislation Enacted in the 108th
Congress (JCS-5-05), May 2005, pp. 479-480. As section 197 intangibles,
such assets are not eligible for bonus depreciation under section
168(k).
\516\ Sec. 197(d)(1)(F).
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Section 197 does not apply to certain intangible property,
including certain property produced by the taxpayer or any
interest in a film, sound recording, video tape, book or
similar property not acquired in a transaction (or a series of
related transactions) involving the acquisition of assets
constituting a trade or business or substantial portion
thereof.\517\
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\517\ Secs. 197(c)(2) and (e)(4)(A).
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Films, videos, and sound recordings
MACRS does not apply to certain property, including any
motion picture film, video tape, or sound recording, or to any
other property if the taxpayer elects to exclude such property
from MACRS and the taxpayer properly applies a unit-of-
production method or other method of depreciation not expressed
in a term of years.\518\ Thus, the recovery of the cost of a
film, video tape, or similar property that is produced by the
taxpayer or is acquired on a ``stand-alone'' basis by the
taxpayer may not be determined under either the MACRS
depreciation provisions or under the section 197 amortization
provisions. The cost recovery of such property is determined
under section 167, which allows a depreciation deduction for
the reasonable allowance for the exhaustion, wear and tear, or
obsolescence of the property if it is used in a trade or
business or held for the production of income. In addition, the
costs of motion picture films, video tapes, sound recordings,
copyrights, books, and patents are eligible to be recovered
using the income forecast method of depreciation once the
property is placed in service.\519\
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\518\ Secs. 168(f)(1), (3) and (4).
\519\ Sec. 167(g)(6).
---------------------------------------------------------------------------
Under the income forecast method, a property's depreciation
deduction for a taxable year is determined by multiplying the
adjusted basis of the property by a fraction, the numerator of
which is the gross income generated by the property during the
year, and the denominator of which is the total forecasted or
estimated gross income expected to be generated prior to the
close of the tenth taxable year after the year the property is
placed in service. Any costs that are not recovered by the end
of the tenth taxable year after the property is placed in
service may be taken into account as depreciation in that
year.\520\
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\520\ Sec. 167(g)(1). In general, the adjusted basis of property
that may be taken into account under the income forecast method only
includes amounts that have been incurred under the economic performance
requirements of section 461(h). An exception to this rule applies to
participations and residuals. Specifically, solely for purposes of
computing the allowable deduction for property under the income
forecast method of depreciation, participations and residuals may be
included in the adjusted basis of the property beginning in the year
such property is placed in service (even if economic performance has
not yet occurred) if such participations and residuals relate to income
to be derived from the property before the close of the tenth taxable
year following the year the property is placed in service. For this
purpose, participations and residuals are defined as costs the amount
of which, by contract, varies with the amount of income earned in
connection with such property. See sec. 167(g)(7).
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Expensing of certain qualified film, television, and live
theatrical productions
Under section 181, a taxpayer may elect \521\ to deduct up
to $15 million of the aggregate production costs of any
qualified film, television, or live theatrical production,
commencing prior to January 1, 2017,\522\ in the year the costs
are paid or incurred by the taxpayer, in lieu of capitalizing
the costs and recovering them through depreciation allowances
once the production is placed in service.\523\ The dollar
limitation is increased to $20 million if a significant amount
of the production costs are incurred in areas eligible for
designation as a low-income community or eligible for
designation by the Delta Regional Authority as a distressed
county or isolated area of distress.\524\
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\521\ See Treas. Reg. sec. 1.181-2 for rules on making (and
revoking) an election under section 181.
\522\ Subsequent to the enactment of Pub. L. No. 115-97, section
181 was extended for productions commencing after December 31, 2016,
and before January 1, 2018, by the Bipartisan Budget Act of 2018, Pub.
L. No. 115-123, sec. 40308, February 9, 2018. For purposes of
determining whether a production is eligible for section 181 expensing,
a qualified film or television production is treated as commencing on
the first date of principal photography. See the Conference Report to
accompany H.R. 4520, American Jobs Creation Act of 2004, H.R. Rep. No.
108-755, October 7, 2004, p. 372. See also Joint Committee on Taxation,
General Explanation of Tax Legislation Enacted in the 108th Congress
(JCS-5-05), May 2005, p. 210. The date on which a qualified live
theatrical production commences is the date of the first public
performance of such production for a paying audience. See the
Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113,
sec. 169(d), December 18, 2015. See also Joint Committee on Taxation,
General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16),
March 2016, p. 187.
\523\ Sec. 181(a)(2)(A). See Treas. Reg. sec. 1.181-1 for rules on
determining eligible production costs. Eligible production costs under
section 181 include participations and residuals paid or incurred.
Treas. Reg. sec. 1.181-1(a)(3)(i). The special rule in section
167(g)(7) that allows taxpayers using the income forecast method of
depreciation to include participations and residuals that have not met
the economic performance requirements in the adjusted basis of the
property for the taxable year the property is placed in service does
not apply for purposes of section 181. Treas. Reg. sec. 1.181-1(a)(8).
Thus, under section 181, a taxpayer may only include participations and
residuals actually paid or incurred in eligible production costs.
Further, production costs do not include the cost of obtaining a
production after its initial release or broadcast. See Treas. Reg. sec.
1.181-1(a)(3). For this purpose, ``initial release or broadcast'' means
the first commercial exhibition or broadcast of a production to an
audience. Treas. Reg. sec. 1.181-1(a)(7). Thus, for example, a taxpayer
may not expense the purchase of an existing film library under section
181. See T.D. 9551, 76 Fed. Reg. 64816, October 19, 2011.
\524\ Sec. 181(a)(2)(B).
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A section 181 election may only be made by an owner of the
production.\525\ An owner of a production is any person that is
required under section 263A to capitalize the costs of
producing the production into the cost basis of the production,
or that would be required to do so if section 263A applied to
that person.\526\ In addition, the aggregate production costs
of a qualified production that is co-produced include all
production costs, regardless of funding source, in determining
if the applicable dollar limit is exceeded. Thus, the term
``aggregate production costs'' means all production costs paid
or incurred by any person, whether paid or incurred directly by
an owner or indirectly on behalf of an owner.\527\ The costs of
the production in excess of the applicable dollar limitation
are capitalized and recovered under the taxpayer's method of
accounting for the recovery of such property once placed in
service.\528\
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\525\ Treas. Reg. sec. 1.181-1(a).
\526\ Treas. Reg. sec. 1.181-1(a)(2)(i). For a discussion of the
changes made to section 263A by the Act, see the description of section
13102 of the Act (Small Business Accounting Method Reform and
Simplification).
\527\ Treas. Reg. sec. 1.181-1(a)(4). See Treas. Reg. sec. 1.181-
2(c)(3) for the information required to be provided to the Internal
Revenue Service when more than one person will claim deductions under
section 181 for a production (to ensure that the applicable deduction
limitation is not exceeded).
\528\ See Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in the 110th Congress (JCS-1-09), March 2009, p.
448; and Treas. Reg. sec. 1.181-1(c)(2). A production is generally
considered to be placed in service at the time of initial release,
broadcast, or live staged performance (i.e., at the time of the first
commercial exhibition, broadcast, or live staged performance of a
production to an audience). See, e.g., Rev. Rul. 79-285, 1979-2 C.B.
91; and Priv. Ltr. Rul. 9010011, March 9, 1990. See also, Treas. Reg.
sec. 1.181-1(a)(7). However, a production generally may not be
considered to be placed in service if it is only exhibited,
broadcasted, or performed for a limited test audience in advance of the
commercial exhibition, broadcast, or performance to general audiences.
See Priv. Ltr. Rul. 9010011 and Treas. Reg. sec. 1.181-1(a)(7).
---------------------------------------------------------------------------
A qualified film, television, or live theatrical production
means any production of a motion picture (whether released
theatrically or directly to video cassette or any other
format), television program, or live staged play if at least 75
percent of the total compensation expended on the production is
for services performed in the United States by actors,
directors, producers, and other relevant production
personnel.\529\ Solely for purposes of this rule, the term
``compensation'' does not include participations and residuals
(as defined in section 167(g)(7)(B)).\530\
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\529\ Sec. 181(d)(3)(A).
\530\ Sec. 181(d)(3)(B). Participations and residuals are defined
as, with respect to any property, costs the amount of which by contract
varies with the amount of income earned in connection with such
property. See also Treas. Reg. sec. 1.181-3(c).
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Each episode of a television series is treated as a
separate production, and only the first 44 episodes of a
particular series qualify under the provision.\531\ Qualified
productions do not include sexually explicit productions as
referenced by section 2257 of title 18 of the U.S. Code.\532\
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\531\ Sec. 181(d)(2)(B).
\532\ Sec. 181(d)(2)(C).
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A qualified live theatrical production is defined as a live
staged production of a play (with or without music) which is
derived from a written book or script and is produced or
presented by a commercial entity in any venue which has an
audience capacity of not more than 3,000, or a series of venues
the majority of which have an audience capacity of not more
than 3,000.\533\ In addition, qualified live theatrical
productions include any live staged production which is
produced or presented by a taxable entity no more than 10 weeks
annually in any venue which has an audience capacity of not
more than 6,500.\534\ In general, in the case of multiple live-
staged productions, each such live-staged production is treated
as a separate production. Similar to the exclusion for sexually
explicit productions from the definition of qualified film or
television productions, qualified live theatrical productions
do not include stage performances that would be excluded by
section 2257(h)(1) of title 18 of the U.S. Code, if such
provision were extended to live stage performances.\535\
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\533\ Sec. 181(e)(2)(A).
\534\ Sec. 181(e)(2)(D).
\535\ Sec. 181(e)(2)(E).
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For purposes of recapture under section 1245, any deduction
allowed under section 181 is treated as if it were a deduction
allowable for amortization.\536\ Thus, the deduction under
section 181 may be subject to recapture as ordinary income in
the taxable year in which (i) the taxpayer revokes a section
181 election, (ii) the production fails to meet the
requirements of section 181, or (iii) the taxpayer sells or
otherwise disposes of the production.\537\
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\536\ Sec. 1245(a)(2)(C). For a discussion of the recapture rules
applicable to depreciation and amortization deductions, see Joint
Committee on Taxation, Background and Present Law Relating to Cost
Recovery and Domestic Production Activities (JCX-19-12), February 27,
2012, pp. 45-46.
\537\ See Treas. Reg. sec. 1.181-4.
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Explanation of Provision
In general
The provision extends and modifies the additional first-
year depreciation deduction through 2026 (through 2027 for
longer production period property and certain aircraft). The
50-percent allowance is increased to 100 percent for property
acquired and placed in service after September 27, 2017, and
before January 1, 2023 (January 1, 2024, for longer production
period property and certain aircraft), as well as for specified
plants planted or grafted after September 27, 2017, and before
January 1, 2023. The 100-percent allowance is phased down by 20
percent per calendar year for property acquired after September
27, 2017, and placed in service, and specified plants planted
or grafted, in taxable years beginning after 2022 (after 2023
for longer production period property and certain aircraft).
The provision retains the prior-law phase down of bonus
depreciation for property acquired before September 28, 2017,
and placed in service after September 27, 2017.\538\
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\538\ A technical correction may be necessary to reflect this
intent due to the effective date of the provision.
\539\ In the case of specified plants, this is the year of planting
or grafting.
\540\ Thirty percent applies to the adjusted basis attributable to
manufacture, construction, or production before January 1, 2020, and
the remaining adjusted basis does not qualify for bonus depreciation.
Thirty percent applies to the entire adjusted basis of certain aircraft
described in section 168(k)(2)(C) and placed in service in 2020.
---------------------------------------------------------------------------
Under the provision, the bonus depreciation percentage
rates are as follows.
------------------------------------------------------------------------
Bonus Depreciation Percentage
---------------------------------------
Longer Production
Placed in Service Year \539\ Qualified Property Period Property
in General/ and Certain
Specified Plants Aircraft
------------------------------------------------------------------------
Portion of Basis of Qualified Property Acquired before Sept. 28, 2017
Sept. 28, 2017-Dec. 31, 2017.... 50 percent........ 50 percent
2018............................ 40 percent........ 50 percent
2019............................ 30 percent........ 40 percent
2020............................ None.............. 30 percent \540\
2021 and thereafter............. None.............. None
------------------------------------------------------------------------
Portion of Basis of Qualified Property Acquired after Sept. 27, 2017
Sept. 28, 2017-Dec. 31, 2022.... 100 percent....... 100 percent
2023............................ 80 percent........ 100 percent
2024............................ 60 percent........ 80 percent
2025............................ 40 percent........ 60 percent
2026............................ 20 percent........ 40 percent
2027............................ None.............. 20 percent \541\
2028 and thereafter............. None.............. None
------------------------------------------------------------------------
Special rules
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\541\ Twenty percent applies to the adjusted basis attributable to
manufacture, construction, or production before January 1, 2027, and
the remaining adjusted basis does not qualify for bonus depreciation.
Twenty percent applies to the entire adjusted basis of certain aircraft
described in section 168(k)(2)(C) and placed in service in 2027.
---------------------------------------------------------------------------
The provision maintains the prior-law section 280F increase
amount of $8,000 for passenger automobiles placed in service
after December 31, 2017. However, the provision also maintains
the prior-law phase down of the section 280F increase amount
for passenger automobiles acquired before September 28, 2017,
and placed in service after September 27, 2017. Thus, the
section 280F increase amount for passenger automobiles acquired
before September 28, 2017, and placed in service after
September 27, 2017, is $8,000 for 2017, $6,400 for 2018, and
$4,800 for 2019.
The provision extends the special rule under the
percentage-of-completion method for the allocation of bonus
depreciation to a long-term contract for property placed in
service before January 1, 2027 (January 1, 2028, in the case of
longer production period property).
Application to used property
The provision expands the definition of qualified property
to include certain qualified property for which the original
use did not commence with the taxpayer. Thus, the provision
applies to purchases of used as well as new items. However,
qualified property only includes used property if such property
was not previously used by the taxpayer prior to
acquisition.\542\ To avoid potential abuses, the additional
first-year depreciation deduction applies only to property
purchased in an arm's-length transaction. It does not apply to
property received as a gift or from a decedent.\543\ In the
case of trade-ins, like-kind exchanges, or involuntary
conversions, it applies only to any money paid in addition to
the traded-in property or in excess of the adjusted basis of
the replaced property.\544\ It does not apply to property
acquired in a nontaxable exchange such as a reorganization, to
property acquired from a member of the taxpayer's family,
including a spouse, ancestors, and lineal descendants, or from
another related entity as defined in section 267, nor to
property acquired from a person who controls, is controlled by,
or is under common control with, the taxpayer.\545\ Thus it
does not apply, for example, if one member of an affiliated
group of corporations purchases property from another member,
or if an individual who controls a corporation purchases
property from that corporation.
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\542\ For purposes of determining whether an asset has been
previously used by a taxpayer, it is intended that the term ``used''
means that the taxpayer previously had a depreciable interest in the
asset (as determined for purposes of sections 167 and 168).
\543\ By reference to section 179(d)(2)(C). See also Treas. Reg.
sec. 1.179-4(c)(1)(iv).
\544\ By reference to section 179(d)(3). See also Treas. Reg. sec.
1.179-4(d).
\545\ By reference to section 179(d)(2)(A) and (B). See also Treas.
Reg. sec. 1.179-4(c).
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Application to qualified film, television, and live theatrical
productions
The provision expands the definition of qualified property
eligible for the additional first-year depreciation allowance
to include the production costs of qualified film, television,
and live theatrical productions \546\ placed in service after
September 27, 2017, and before January 1, 2027, for which a
deduction otherwise would have been allowable under section 181
without regard to the dollar limitation or termination of such
section.\547\ For purposes of this provision, a qualified
production is considered placed in service, and thus eligible
for the additional first-year depreciation allowance, at the
time of initial release, broadcast, or live staged performance
(i.e., at the time of the first commercial exhibition,
broadcast, or live staged performance of a production to an
audience).
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\546\ As defined in section 181(d) and (e).
\547\ For example, similar to section 181, participations and
residuals are only included in eligible production costs under section
168(k) to the extent such amounts are actually paid or incurred.
Similarly, the taxpayer must be the owner of the qualified production
to be eligible to claim the additional first-year depreciation
allowance. Thus, for example, a taxpayer that acquires only a limited
license or right to exploit a production prior to its initial release,
broadcast, or live staged performance is not eligible to claim the
additional first-year depreciation allowance for any production costs
attributable to such production. See Treas. Reg. sec. 1.181-1(a)(2).
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Election to accelerate AMT credits in lieu of bonus depreciation
As a conforming amendment to the repeal of the corporate
AMT, the election to accelerate AMT credits in lieu of bonus
depreciation is repealed.\548\
---------------------------------------------------------------------------
\548\ See the description of section 12001 of the Act (Repeal of
Tax for Corporations).
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Exception for certain businesses not subject to limitation on interest
expense
The provision excludes from the definition of qualified
property any property placed in service in taxable years
beginning after December 31, 2017,\549\ which is primarily used
in the trade or business of the furnishing \550\ or sale of (1)
electrical energy, water, or sewage disposal services, (2) gas
or steam through a local distribution system, or (3)
transportation of gas or steam by pipeline, if the rates for
such furnishing or sale, as the case may be, have been
established or approved by a State or political subdivision
thereof, by any agency or instrumentality of the United States,
by a public service or public utility commission or other
similar body of any State or political subdivision thereof, or
by the governing or ratemaking body of an electric
cooperative.\551\
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\549\ A technical correction may be necessary to reflect this
intent.
\550\ The term ``furnishing'' includes generation, transmission,
and distribution activities.
\551\ See section 163(j)(7)(A)(iv) and the description of section
13301 of the Act (Limitation on Deduction for Interest). It is intended
that this exception only apply to regulated public utility or electric
cooperative trades or businesses excluded from the interest limitation
under section 163(j)(7)(A)(iv). For example, property leased by a
leasing trade or business to a regulated public utility would not be
precluded by section 168(k)(9)(A) from claiming bonus depreciation on
its qualified property because the leasing trade or business is not
excluded from the interest limitation by section 163(j)(7)(A)(iv).
However, if the leasing trade or business qualifies as an electing real
property trade or business described in section 163(j)(7)(B), and the
taxpayer elects to have such business excluded from the interest
limitation, then the leasing trade or business is required to use ADS
recovery periods, instead of MACRS recovery periods, for certain real
property. See the description of section 13204 of the Act (Applicable
Recovery Period for Real Property).
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In addition, the provision excludes from the definition of
qualified property any property used in a trade or business
that has had floor plan financing indebtedness \552\ if the
floor plan financing interest related to such indebtedness was
taken into account to increase the taxpayer's interest
limitation under section 163(j)(1)(C),\553\ unless the taxpayer
with such trade or business is not a tax shelter prohibited
from using the cash method and is exempt from the interest
limitation rules in section 13301 of the Act by meeting the $25
million gross receipts test of section 448(c).\554\ Once a
trade or business has taken floor plan financing interest into
account under section 163(j)(1)(C) for a taxable year, any
qualified property placed in service by that trade or business
in such taxable year and subsequent taxable years is not
eligible for bonus depreciation.
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\552\ As defined in section 163(j)(9). See the description of
section 13301 of the Act (Limitation on Deduction for Interest).
\553\ As modified by section 13301 of the Act (Limitation on
Deduction for Interest).
\554\ As modified by section 13102 of the Act (Small Business
Accounting Method Reform and Simplification).
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For example, assume that for 2018 a motor vehicle dealer
does not meet the $25 million gross receipts test and has $20
of business interest income, $150 of business interest, $50 of
floor plan financing interest, and $650 of adjusted taxable
income.\555\ Because the $150 of business interest is less than
the $215 interest limitation ($20 + ($650 * 30 percent))
determined without regard to the floor plan financing interest,
the floor plan financing interest need not be taken into
account under section 163(j)(1)(C) to increase the interest
limitation because all business interest is deductible based on
the interest limitation otherwise applicable. As a result,
qualified property placed in service by the motor vehicle
dealer's trade or business during 2018 is eligible for bonus
depreciation.
---------------------------------------------------------------------------
\555\ Determined as provided under section 13301 of the Act
(Limitation on Deduction for Interest).
---------------------------------------------------------------------------
Alternatively, assume the same facts as previously stated,
except that the motor vehicle dealer has adjusted taxable
income of $50. The interest limitation, determined without
taking into account floor plan financing interest under section
163(j)(1)(C), is $35 ($20 + ($50 * 30 percent)). If the
taxpayer limits the business interest deduction to $35 for
2018, qualified property placed in service during 2018 remains
eligible for bonus depreciation. However, if the taxpayer
increases the interest limitation by taking into account the
$50 floor plan financing interest under section 163(j)(1)(C)
and deducts $85 of business interest for 2018, any property
placed in service by the motor vehicle dealer's trade or
business during 2018 and subsequent taxable years is not
eligible for bonus depreciation.\556\
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\556\ Note, however, that the motor vehicle dealer's property may
be eligible for expensing under section 179. For a discussion of
changes made to section 179 by the Act, see the description of section
13101 of the Act (Modification of Rules for Expensing).
The Treasury Department has issued proposed regulations
addressing this provision.\557\
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\557\ See REG-104397-18, 83 Fed. Reg. 39292, August 8, 2018.
---------------------------------------------------------------------------
Effective Date
The provision generally applies to property acquired and
placed in service after September 27, 2017, and to specified
plants planted or grafted after such date. The provision
retaining the prior-law phase down of bonus depreciation
applies to property acquired before September 28, 2017, and
placed in service after September 27, 2017.\558\ To determine
the date of acquisition for purposes of applying these
effective dates, any property acquired pursuant to a written
binding contract (including property that is manufactured,
constructed, or produced for the taxpayer by another person
under a written binding contract) may not be treated as
acquired after the date on which such contract is entered into.
For example, property acquired by a taxpayer pursuant to a
written binding contract that was entered into on September 1,
2017, will be subject to prior law when placed in service.
---------------------------------------------------------------------------
\558\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
A transition rule provides that for a taxpayer's first
taxable year ending after September 27, 2017, and beginning
before January 1, 2018,\559\ the taxpayer may elect to apply a
50-percent allowance instead of the 100-percent allowance.\560\
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\559\ A technical correction may be necessary to reflect this
intent.
\560\ Such election shall be made at such time and in such form and
manner as prescribed by the Secretary.
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B. Modifications to Depreciation Limitations on Luxury Automobiles and
Personal Use Property (sec. 13202 of the Act and sec. 280F of the Code)
Prior Law
Section 280F(a) limits the annual cost recovery deduction
with respect to certain passenger automobiles. This limitation
is commonly referred to as the ``luxury automobile depreciation
limitation'' or the ``section 280F limitation.'' For passenger
automobiles placed in service in 2017, and for which the
additional first-year depreciation deduction under section
168(k) is not claimed, the maximum amount of allowable
depreciation is $3,160 for the year in which the vehicle is
placed in service, $5,100 for the second year, $3,050 for the
third year, and $1,875 for the fourth and later years in the
recovery period.\561\ This limitation is indexed for inflation
and applies to the aggregate deduction provided for
depreciation and section 179 expensing. Hence, passenger
automobiles subject to section 280F are eligible for section
179 expensing only to the extent of the applicable limits
contained in section 280F.\562\ For passenger automobiles
eligible for the additional first-year depreciation allowance
in 2017, the first-year limitation is increased by an
additional $8,000.\563\
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\561\ Rev. Proc. 2017-29, Table 3, 2017-14 I.R.B. 1065.
\562\ For a discussion of changes made to section 179 by the Act,
see the description of section 13101 of the Act (Modifications of Rules
for Expensing Depreciable Business Assets).
\563\ Sec. 168(k)(2)(F). For a discussion of changes made to
section 168(k) by the Act, see the description of section 13201 of the
Act (Temporary 100-Percent Expensing for Certain Business Assets).
---------------------------------------------------------------------------
For purposes of the section 280F limitation, passenger
automobiles are defined broadly to include any four-wheeled
vehicles that are manufactured primarily for use on public
streets, roads, and highways and which are rated at 6,000
pounds unloaded gross vehicle weight or less.\564\ In the case
of a truck or a van, the section 280F limitation applies to
vehicles that are rated at 6,000 pounds gross vehicle weight or
less. Sport utility vehicles are treated as a truck for the
purpose of applying the section 280F limitation.
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\564\ Sec. 280F(d)(5). Exceptions are provided for any ambulance,
hearse, or combination ambulance-hearse used by the taxpayer directly
in a trade or business, or any vehicle used by the taxpayer directly in
the trade or business of transporting persons or property for
compensation or hire.
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Basis not recovered in the recovery period of a passenger
automobile is allowable as an expense in subsequent taxable
years.\565\ The expensed amount is limited in each such
subsequent taxable year to the amount of the limitation in the
fourth year in the recovery period.
---------------------------------------------------------------------------
\565\ Sec. 280F(a)(1)(B).
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Listed property
In the case of certain listed property, special rules
apply. Listed property generally is defined as: (1) any
passenger automobile; (2) any other property used as a means of
transportation; \566\ (3) any property of a type generally used
for purposes of entertainment, recreation, or amusement; (4)
any computer or peripheral equipment; \567\ and (5) any other
property of a type specified in Treasury regulations.\568\
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\566\ Property substantially all of the use of which is in a trade
or business of providing transportation to unrelated persons for hire
is not considered other property used as a means of transportation.
Sec. 280F(d)(4)(C).
\567\ Computer or peripheral equipment used exclusively at a
regular business establishment and owned or leased by the person
operating such establishment, however, is not listed property. Sec.
280F(d)(4)(B).
\568\ Sec. 280F(d)(4)(A).
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First, if for the taxable year in which the property is
placed in service, the use of the property for trade or
business purposes does not exceed 50 percent of the total use
of the property, then the depreciation deduction with respect
to such property is determined under the alternative
depreciation system.\569\ The alternative depreciation system
generally requires the use of the straight-line method and a
recovery period equal to the class life of the property.\570\
Second, if an individual owns or leases listed property that is
used by the individual in connection with the performance of
services as an employee, no depreciation deduction, expensing
allowance, or deduction for lease payments is available with
respect to such use unless the use of the property is for the
convenience of the employer and required as a condition of
employment.\571\ Both limitations apply for purposes of section
179 expensing.
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\569\ Sec. 280F(b)(1). If for any taxable year after the year in
which the property is placed in service the use of the property for
trade or business purposes decreases to 50 percent or less of the total
use of the property, then the amount of depreciation allowed in prior
years in excess of the amount of depreciation that would have been
allowed for such prior years under the alternative depreciation system
is recaptured (i.e., included in gross income) for such taxable year.
\570\ Sec. 168(g).
\571\ Sec. 280F(d)(3).
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For listed property, no deduction is allowed unless the
taxpayer adequately substantiates the expense and business
usage of the property.\572\ A taxpayer must substantiate the
elements of each expenditure or use of listed property,
including (1) the amount (e.g., cost) of each separate
expenditure and the amount of business or investment use, based
on the appropriate measure (e.g., mileage for automobiles), and
the total use of the property for the taxable period, (2) the
date of the expenditure or use, and (3) the business purposes
for the expenditure or use.\573\ The level of substantiation
for business or investment use of listed property varies
depending on the facts and circumstances. In general, the
substantiation must contain sufficient information as to each
element of every business or investment use.\574\
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\572\ Sec. 274(d)(4).
\573\ Temp. Treas. Reg. sec. 1.274-5T(b)(6).
\574\ Temp. Treas. Reg. sec. 1.274-5T(c)(2)(ii)(C).
---------------------------------------------------------------------------
Explanation of Provision
The provision increases the depreciation limitations under
section 280F that apply to passenger automobiles. Specifically,
for passenger automobiles placed in service after December 31,
2017, and for which the additional first-year depreciation
deduction under section 168(k) is not claimed, the maximum
amount of allowable depreciation is $10,000 for the year in
which the vehicle is placed in service, $16,000 for the second
year, $9,600 for the third year, and $5,760 for the fourth and
later years in the recovery period. The limitations are indexed
for inflation for passenger automobiles placed in service after
2018.
The provision also removes computer or peripheral equipment
from the definition of listed property. Such property is
therefore not subject to the heightened substantiation
requirements that apply to listed property.
The Treasury Department has issued published guidance
addressing this provision for passenger automobiles placed in
service during calendar year 2018.\575\
---------------------------------------------------------------------------
\575\ See Rev. Proc. 2018-25, 2018-18 I.R.B. 543.
---------------------------------------------------------------------------
Effective Date
The provision is effective for property placed in service
after December 31, 2017, in taxable years ending after such
date.
C. Modifications of Treatment of Certain Farm Property (sec. 13203 of
the Act and sec. 168 of the Code)
Prior Law
In general
A taxpayer generally must capitalize the cost of property
used in a trade or business or held for the production of
income and recover such cost over time through annual
deductions for depreciation or amortization.\576\ The period
for depreciation or amortization generally begins when the
asset is placed in service by the taxpayer.\577\ Tangible
property generally is depreciated under the modified
accelerated cost recovery system (``MACRS''), which determines
depreciation for different types of property based on an
assigned applicable depreciation method, recovery period, and
convention.\578\
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\576\ See secs. 263(a) and 167. In general, only the tax owner of
property (i.e., the taxpayer with the benefits and burdens of
ownership) is entitled to claim tax benefits such as cost recovery
deductions with respect to the property. In addition, where property is
not used exclusively in a taxpayer's business, the amount eligible for
a deduction must be reduced by the amount related to personal use. See,
e.g., sec. 280A.
\577\ See Treas. Reg. secs. 1.167(a)-10(b), -3, -14, and 1.197-
2(f). See also Treas. Reg. sec. 1.167(a)-11(e)(1)(i). In the case of
any tree or vine bearing fruits or nuts, the placed in service date
generally does not occur until the tree or vine first reaches an
income-producing stage. See Treas. Reg. sec. 1.46-3(d)(2). See also
Rev. Rul. 80-25, 1980-1 C.B. 65; and Rev. Rul. 69-249, 1969-1 C.B. 31.
\578\ Sec. 168.
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The applicable recovery period for an asset is determined
in part by statute and in part by historic Treasury
guidance.\579\ The ``type of property'' of an asset is used to
determine the ``class life'' of the asset, which in turn
dictates the applicable recovery period for the asset.
---------------------------------------------------------------------------
\579\ Exercising authority granted by Congress, the Secretary
issued Rev. Proc. 87-56, 1987-2 C.B. 674, laying out the framework of
recovery periods for enumerated classes of assets. The Secretary
clarified and modified the list of asset classes in Rev. Proc. 88-22,
1988-1 C.B. 785. In November 1988, Congress revoked the Secretary's
authority to modify the class lives of depreciable property. Rev. Proc.
87-56, as modified, remains in effect except to the extent that the
Congress has, since 1988, statutorily modified the recovery period for
certain depreciable assets, effectively superseding any administrative
guidance with regard to such property.
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The MACRS recovery periods applicable to most tangible
personal property range from three to 20 years. The
depreciation methods generally applicable to tangible personal
property are the 200-percent and 150-percent declining balance
methods,\580\ switching to the straight line method for the
first taxable year where using the straight line method with
respect to the adjusted basis as of the beginning of that year
yields a larger depreciation allowance. The recovery periods
for most real property are 39 years for nonresidential real
property and 27.5 years for residential rental property. The
straight line depreciation method is required for the
aforementioned real property.
---------------------------------------------------------------------------
\580\ Under the declining balance method the depreciation rate is
determined by dividing the appropriate percentage (here 150 or 200) by
the appropriate recovery period. This leads to accelerated depreciation
when the declining balance percentage is greater than 100. The table
below illustrates depreciation for an asset with a cost of $1,000 and a
seven-year recovery period under the 200-percent declining balance
method, the 150-percent declining balance method, and the straight line
method.
Recovery method Year 1 Year 2 Year 3 Year 4 Year 5
Year 6 Year 7 Total
200-percent declining balance 285.71 204.08 145.77 104.12 86.77
86.77 86.77 1,000.00
150-percent declining balance 214.29 168.37 132.29 121.26 121.26
121.26 121.26 1,000.00
Straight-line 142.86 142.86 142.86 142.86 142.86
142.86 142.86 1,000.00
* Details may not add to totals due to rounding.
---------------------------------------------------------------------------
Farm property
Property used in a farming business is assigned various
recovery periods in the same manner as other business property.
For these purposes, the term ``farming business'' means a trade
or business involving the cultivation of land or the raising or
harvesting of any agricultural or horticultural commodity
(e.g., the trade or business of operating a nursery or sod
farm; the raising or harvesting of trees bearing fruit, nuts,
or other crops; the raising of ornamental trees (other than
evergreen trees that are more than six years old at the time
they are severed from their roots); and the raising, shearing,
feeding, caring for, training, and management of animals).\581\
A farming business includes processing activities that are
normally incident to the growing, raising, or harvesting of
agricultural or horticultural products.\582\ A farming business
does not include contract harvesting of an agricultural or
horticultural commodity grown or raised by another taxpayer, or
merely buying and reselling plants or animals grown or raised
by another taxpayer.\583\
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\581\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(i).
\582\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(ii).
\583\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(i).
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Farm recovery periods
Farm property that is generally assigned a three-year
recovery period includes, for example, breeding hogs, breeding
and working horses more than 12 years old when placed in
service, and over-the-road tractor units.\584\ Examples of
five-year farm property include dairy or breeding cattle,
breeding goats and sheep, and trucks.\585\ Farm property
assigned a recovery period of seven years includes machinery
and equipment, grain bins, and fences (but no other land
improvements), that are used in the production of crops or
plants, vines, and trees; livestock; the operation of farm
dairies, nurseries, greenhouses, sod farms, mushrooms cellars,
cranberry bogs, apiaries, and fur farms; and the performance of
agriculture, animal husbandry, and horticultural services.\586\
Cotton ginning assets and breeding and working horses 12 years
old or less when placed in service are also assigned a recovery
period of seven years.\587\ Any single purpose agricultural or
horticultural structure,\588\ and any tree or vine bearing
fruit or nuts are assigned a recovery period of 10 years.\589\
Land improvements such as drainage facilities, paved lots, and
water wells are assigned a recovery period of 15 years.\590\
Farm buildings that do not meet the definition of a single
purpose agricultural or horticultural structure are assigned a
recovery period of 20 years.\591\
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\584\ See Rev. Proc. 87-56, asset class 01.23, Hogs, Breeding;
asset class 01.222, any breeding or work horse that is more than 12
years old at the time it is placed in service; and asset class 00.26,
Tractor Units for Use Over-the-Road.
\585\ See Rev. Proc. 87-56, asset class 01.21, Cattle, Breeding or
Dairy; asset class 01.24, Sheep and Goats, Breeding; asset class
00.241, Light General Purpose Trucks; and asset class 00.242, Heavy
General Purpose Trucks.
\586\ Rev. Proc. 87-56, asset class 01.1, Agriculture.
\587\ Rev. Proc. 87-56, asset class 01.11, Cotton ginning assets;
and asset class 01.221, any breeding or work horse that is 12 years old
or less at the time it is placed in service.
\588\ A single purpose agricultural (livestock) structure is any
enclosure or structure specifically designed, constructed, and used for
(i) housing, raising, and feeding a particular type of livestock
(including poultry) and their produce, and (ii) housing the equipment
(including any replacements) necessary for the housing, raising, and
feeding of such livestock. Sec. 168(i)(13)(B)(i) and (iv). For example,
a single purpose agricultural structure includes a structure used to
breed chicken or hogs, produce milk from dairy cattle, or produce
feeder cattle or pigs, broiler chickens, or eggs, if an integral part
of the structure is the equipment necessary to house, raise, and feed
the livestock. See IRS Publication 225, Farmer's Tax Guide (2017). A
single purpose horticultural structure is (i) a greenhouse specifically
designed, constructed and used for the commercial production of plants,
and (ii) a structure specifically designed, constructed, and used for
the commercial production of mushrooms. Sec. 168(i)(13)(B)(ii). If a
structure includes work space, the work space must be solely for (i)
the stocking, caring for, or collecting of livestock or plants (as the
case may be) or their produce, (ii) the maintenance of the enclosure or
structure, and (iii) the maintenance or replacement of the equipment or
stock enclosed or housed therein. Sec. 168(i)(13)(B)(iii). See also
Rev. Proc. 87-56, asset class 01.4, Single purpose agricultural or
horticultural structures.
\589\ Sec. 168(e)(3)(D)(i) and (ii).
\590\ Rev. Proc. 87-56, asset class 00.3, Land improvements. See
also IRS Publication 225, Farmer's Tax Guide (2017).
\591\ Rev. Proc. 87-56, asset class 01.3, Farm buildings except
structures included in asset class 01.4.
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A five-year recovery period was assigned to new farm
machinery or equipment (other than any grain bin, cotton
ginning asset, fence, or other land improvement) which was used
in a farming business (as defined above), the original use of
which commenced with the taxpayer after December 31, 2008, and
which was placed in service before January 1, 2010.\592\
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\592\ Sec. 168(e)(3)(B)(vii).
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Any property used in a farming business (other than
nonresidential real property,\593\ residential rental
property,\594\ and trees or vines bearing fruits or nuts \595\)
is subject to the 150-percent declining balance method.\596\
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\593\ Sec. 168(b)(3)(A).
\594\ Sec. 168(b)(3)(B).
\595\ Sec. 168(b)(3)(E).
\596\ Sec. 168(b)(2)(B).
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Under a special accounting rule, certain taxpayers engaged
in the business of farming who elect to deduct preproductive
period expenditures of plants produced in such business are
required to depreciate all farming assets using the alternative
depreciation system (i.e., using longer recovery periods and
the straight line method).\597\
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\597\ Secs. 263A(d)(3) and (e)(2), and 168(g)(2). For a discussion
of changes made to the applicability of section 263A by the Act, see
the description of section 13102 of the Act (Small Business Accounting
Method Reform and Simplification).
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Explanation of Provision
The provision shortens the recovery period from seven to
five years for any machinery or equipment (other than any grain
bin, cotton ginning asset, fence, or other land improvement)
used in a farming business,\598\ the original use of which
commences with the taxpayer and which is placed in service
after December 31, 2017.
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\598\ For purposes of the provision, ``farming business'' is
defined consistent with prior law (i.e., under section 263A(e)(4)).
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The provision also repeals the required use of the 150-
percent declining balance method for certain property used in a
farming business (i.e., for three-, five-, seven-, and 10-year
property), allowing such property to use the 200-percent
declining balance method. The 150-percent declining balance
method will continue to apply to any 15-year or 20-year
property used in a farming business to which the straight line
method does not apply, or to property for which the taxpayer
elects the use of the 150-percent declining balance method.
Effective Date
The provision is effective for property placed in service
after December 31, 2017, in taxable years ending after such
date.
D. Applicable Recovery Period for Real Property (sec. 13204 of the Act
and sec. 168 of the Code)
Prior Law
In general
A taxpayer generally must capitalize the cost of property
used in a trade or business or held for the production of
income and recover such cost over time through annual
deductions for depreciation or amortization.\599\ The period
for depreciation or amortization generally begins when the
asset is placed in service by the taxpayer.\600\ Tangible
property generally is depreciated under the modified
accelerated cost recovery system (``MACRS''), which determines
depreciation for different types of property based on an
assigned applicable depreciation method, recovery period, and
convention.\601\
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\599\ See secs. 263(a) and 167. In general, only the tax owner of
property (i.e., the taxpayer with the benefits and burdens of
ownership) is entitled to claim tax benefits such as cost recovery
deductions with respect to the property. In addition, where property is
not used exclusively in a taxpayer's business, the amount eligible for
a deduction must be reduced by the amount related to personal use. See,
e.g., sec. 280A.
\600\ See Treas. Reg. secs. 1.167(a)-10(b), -3, -14, and 1.197-
2(f). See also Treas. Reg. sec. 1.167(a)-11(e)(1)(i).
\601\ Sec. 168.
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Recovery periods and depreciation methods
The applicable recovery period for an asset is determined
in part by statute and in part by historic Treasury
guidance.\602\ The ``type of property'' of an asset is used to
determine the ``class life'' of the asset, which in turn
dictates the applicable recovery period for the asset.
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\602\ Exercising authority granted by Congress, the Secretary
issued Rev. Proc. 87-56, 1987-2 C.B. 674, laying out the framework of
recovery periods for enumerated classes of assets. The Secretary
clarified and modified the list of asset classes in Rev. Proc. 88-22,
1988-1 C.B. 785. In November 1988, Congress revoked the Secretary's
authority to modify the class lives of depreciable property. Rev. Proc.
87-56, as modified, remains in effect except to the extent that the
Congress has, since 1988, statutorily modified the recovery period for
certain depreciable assets, effectively superseding any administrative
guidance with regard to such property.
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The MACRS recovery periods applicable to most tangible
personal property range from three to 20 years. The
depreciation methods generally applicable to tangible personal
property are the 200-percent and 150-percent declining balance
methods,\603\ switching to the straight line method for the
first taxable year where using the straight line method with
respect to the adjusted basis as of the beginning of that year
yields a larger depreciation allowance. The recovery periods
for most real property are 39 years for nonresidential real
property and 27.5 years for residential rental property. The
straight line depreciation method is required for the
aforementioned real property.
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\603\ Under the declining balance method the depreciation rate is
determined by dividing the appropriate percentage (here 150 or 200) by
the appropriate recovery period. This leads to accelerated depreciation
when the declining balance percentage is greater than 100. The table
below illustrates depreciation for an asset with a cost of $1,000 and a
seven-year recovery period under the 200-percent declining balance
method, the 150-percent declining balance method, and the straight line
method.
Recovery method Year 1 Year 2 Year 3 Year 4 Year 5
Year 6 Year 7 Total
200-percent declining balance 285.71 204.08 145.77 104.12 86.77
86.77 86.77 1,000.00
150-percent declining balance 214.29 168.37 132.29 121.26 121.26
121.26 121.26 1,000.00
Straight-line 142.86 142.86 142.86 142.86 142.86
142.86 142.86 1,000.00
* Details may not add to totals due to rounding.
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Placed-in-service conventions
Depreciation of an asset begins when the asset is deemed to
be placed in service under the applicable convention.\604\
Under MACRS, nonresidential real property, residential rental
property, and any railroad grading or tunnel bore generally are
subject to the mid-month convention, which treats all property
placed in service during any month (or disposed of during any
month) as placed in service (or disposed of) on the mid-point
of such month.\605\ All other property generally is subject to
the half-year convention, which treats all property placed in
service during any taxable year (or disposed of during any
taxable year) as placed in service (or disposed of) on the mid-
point of such taxable year to reflect the assumption that
assets are placed in service ratably throughout the year.\606\
However, if substantial property is placed in service during
the last three months of a taxable year, a special rule
requires use of the mid-quarter convention,\607\ designed to
prevent the recognition of disproportionately large amounts of
first-year depreciation under the half-year convention.
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\604\ Treas. Reg. sec. 1.167(a)-10(b).
\605\ Secs. 168(d)(2) and (4)(B).
\606\ Secs. 168(d)(1) and (4)(A).
\607\ The mid-quarter convention treats all property placed in
service (or disposed of) during any quarter as placed in service (or
disposed of) on the mid-point of such quarter. Sec. 168(d)(3) and
(4)(C).
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Depreciation of additions or improvements to property
The recovery period for any addition or improvement to real
or personal property begins on the later of (1) the date on
which the addition or improvement is placed in service, or (2)
the date on which the property with respect to which such
addition or improvement is made is placed in service.\608\ Any
MACRS deduction for an addition or improvement to any property
is to be computed in the same manner as the deduction for the
underlying property would be if such property were placed in
service at the same time as such addition or improvement. Thus,
for example, the cost of an improvement to a building that
constitutes nonresidential real property is recovered over 39
years using the straight line method and mid-month convention.
However, exceptions apply to certain leasehold improvements.
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\608\ Sec. 168(i)(6).
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Depreciation of leasehold improvements
Generally, depreciation allowances for improvements made on
leased property are determined under MACRS, even if the MACRS
recovery period assigned to the property is longer than the
term of the lease.\609\ This rule applies regardless of whether
the lessor or the lessee places the leasehold improvements in
service. If a leasehold improvement constitutes an addition or
improvement to nonresidential real property already placed in
service, the improvement generally is depreciated using the
straight-line method over a 39-year recovery period, beginning
in the month the addition or improvement was placed in service.
However, exceptions to the 39-year recovery period exist for
certain qualified leasehold improvement property, qualified
restaurant property, and qualified retail improvement property.
---------------------------------------------------------------------------
\609\ Sec. 168(i)(8).
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Qualified leasehold improvement property
Section 168(e)(3)(E)(iv) provides a statutory 15-year
recovery period for qualified leasehold improvement property.
Qualified leasehold improvement property is any improvement to
an interior portion of a building that is nonresidential real
property, provided certain requirements are met.\610\ The
improvement must be made under or pursuant to a lease either by
the lessee (or sublessee), or by the lessor, of that portion of
the building to be occupied exclusively by the lessee (or
sublessee). The improvement must be placed in service more than
three years after the date the building was first placed in
service. Qualified leasehold improvement property does not
include any improvement for which the expenditure is
attributable to the enlargement of the building, any elevator
or escalator, any structural component benefiting a common
area, or the internal structural framework of the building. If
a lessor makes an improvement that qualifies as qualified
leasehold improvement property, such improvement does not
qualify as qualified leasehold improvement property to any
subsequent owner of such improvement. An exception to the rule
applies in the case of death and certain transfers of property
that qualify for nonrecognition treatment.
---------------------------------------------------------------------------
\610\ Sec. 168(e)(6).
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Qualified leasehold improvement property is generally
recovered using the straight-line method and a half-year
convention,\611\ and is eligible for the additional first-year
depreciation deduction if the other requirements of section
168(k) are met.\612\
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\611\ Secs. 168(b)(3)(G) and (d).
\612\ Secs. 168(k)(2)(A)(i)(IV) and (3), prior to amendment by
section 13201 of the Act (Temporary 100-Percent Expensing for Certain
Business Assets).
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Qualified restaurant property
Section 168(e)(3)(E)(v) provides a statutory 15-year
recovery period for qualified restaurant property. Qualified
restaurant property is any section 1250 property \613\ that is
a building or an improvement to a building, if more than 50
percent of the building's square footage is devoted to the
preparation of, and seating for on-premises consumption of,
prepared meals.\614\ Qualified restaurant property is recovered
using the straight-line method and a half-year convention.\615\
Additionally, qualified restaurant property is not eligible for
the additional first-year depreciation deduction unless it also
satisfies the definition of qualified improvement
property.\616\
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\613\ Depreciable real property, other than that included within
the definition of section 1245 property, is known as section 1250
property. Sec. 1250(c). Section 1250 property includes, for example, a
building or its structural components. Treas. Reg. sec. 1.1250-1(e)(3).
Depreciable real property that may be classified as section 1245
property includes, for example, real property that performs specific
functions in a business, but does not include buildings or structural
components of buildings. Sec. 1245(a)(3).
\614\ Sec. 168(e)(7).
\615\ Secs. 168(b)(3)(H) and (d).
\616\ Sec. 168(e)(7)(B).
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Qualified retail improvement property
Section 168(e)(3)(E)(ix) provides a statutory 15-year
recovery period for qualified retail improvement property.
Qualified retail improvement property is any improvement to an
interior portion of a building which is nonresidential real
property if such portion is open to the general public \617\
and is used in the retail trade or business of selling tangible
personal property to the general public, and such improvement
is placed in service more than three years after the date the
building was first placed in service.\618\ Qualified retail
improvement property does not include any improvement for which
the expenditure is attributable to the enlargement of the
building, any elevator or escalator, any structural component
benefiting a common area, or the internal structural framework
of the building.\619\ In the case of an improvement made by the
owner of such improvement, the improvement is a qualified
retail improvement only so long as the improvement is held by
such owner.\620\
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\617\ Improvements to portions of a building not open to the
general public (e.g., stock room in back of retail space) do not
qualify under the provision.
\618\ Sec. 168(e)(8).
\619\ Sec. 168(e)(8)(C).
\620\ Sec. 168(e)(8)(B). Rules similar to section 168(e)(6)(B)
apply in the case of death and certain transfers of property that
qualify for nonrecognition treatment.
---------------------------------------------------------------------------
Retail establishments that qualify for the 15-year recovery
period include those primarily engaged in the sale of goods.
Examples of these retail establishments include, but are not
limited to, grocery stores, clothing stores, hardware stores,
and convenience stores. Establishments primarily engaged in
providing services, such as professional services, financial
services, personal services, health services, and
entertainment, do not qualify. Generally, it is intended that
businesses defined as a store retailer under the current North
American Industry Classification System (industry subsectors
441 through 453) qualify while those in other industry classes
do not qualify.\621\
---------------------------------------------------------------------------
\621\ Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in the 110th Congress (JCS-1-09), March 2009, p.
402.
---------------------------------------------------------------------------
Qualified retail improvement property is recovered using
the straight-line method and a half-year convention,\622\ and
is eligible for the additional first-year depreciation
deduction if the other requirements of section 168(k) are
met.\623\
---------------------------------------------------------------------------
\622\ Secs. 168(b)(3)(I) and (d).
\623\ Secs. 168(k)(2)(A)(i)(IV) and (3), prior to amendment by
section 13301 of the Act (Temporary 100-Percent Expensing for Certain
Business Assets).
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Expensing of certain improvements
Improvements that meet the definition of qualified
leasehold improvement property, qualified restaurant property,
or qualified retail improvement property (as defined above) are
eligible for section 179 expensing.\624\ Similarly,
improvements that constitute ``qualified improvement property''
are eligible for the additional first-year depreciation
deduction if the other requirements of section 168(k) are
met.\625\
---------------------------------------------------------------------------
\624\ Sec. 179(f), as in effect prior to amendment by section 13101
of the Act (Modifications of Rules for Expensing) and the enactment of
the Consolidated Appropriations Act, 2018, Pub. L. No. 115-141, sec.
401(b)(15), March 23, 2018, which, as part of repealing general
deadwood-related provisions, struck former subsection (e) (relating to
special rules for qualified disaster assistance property) and
redesignated ``subsection (f)'' as ``subsection (e)''.
\625\ Secs. 168(k)(2)(A)(i)(IV) and (3), prior to amendment by
section 13201 of the Act (Temporary 100-Percent Expensing for Certain
Business Assets). Note that the amount of the additional first-year
depreciation deduction is determined after basis adjustments for any
section 179 expensing. See Treas. Reg. sec. 1.168(k)-1(a)(2)(iii).
---------------------------------------------------------------------------
Qualified improvement property is any improvement to an
interior portion of a building that is nonresidential real
property if such improvement is placed in service by the
taxpayer after the date such building was first placed in
service by any taxpayer.\626\ Qualified improvement property
does not include any improvement for which the expenditure is
attributable to the enlargement of the building, any elevator
or escalator, or the internal structural framework of the
building.
---------------------------------------------------------------------------
\626\ Sec. 168(k)(3). See also section 4.02 of Rev. Proc. 2017-33,
2017-19 I.R.B. 1236. Qualified improvement property must also meet the
requirements of section 168(k)(2)(A)(ii) and (iii) (i.e., the original
use and placed in service date requirements) to be eligible for the
additional first-year depreciation deduction.
---------------------------------------------------------------------------
Alternative depreciation system
The alternative depreciation system (``ADS'') is required
to be used for tangible property used predominantly outside the
United States, certain tax-exempt use property, tax-exempt bond
financed property, and certain imported property covered by an
Executive order.\627\ An election to use ADS is available to
taxpayers for any class of property for any taxable year.\628\
Under ADS, all property is depreciated using the straight line
method over recovery periods which generally are equal to the
class life of the property, with certain exceptions.\629\ For
example nonresidential real and residential rental property
have a 40-year ADS recovery period, while qualified leasehold
improvement property, qualified restaurant property, and
qualified retail improvement property have a 39-year ADS
recovery period.\630\
---------------------------------------------------------------------------
\627\ Sec. 168(g).
\628\ Sec. 168(g)(7).
\629\ Secs. 168(g)(2) and (3).
\630\ Sec. 168(g)(3).
---------------------------------------------------------------------------
Explanation of Provision
The provision eliminates the separate definitions of
qualified leasehold improvement property, qualified restaurant
property, and qualified retail improvement property,\631\ and
provides a general 15-year recovery period \632\ for qualified
improvement property made by the taxpayer \633\ and a 20-year
ADS recovery period for such property.\634\ Thus, for example,
qualified improvement property placed in service after December
31, 2017, is generally depreciable over 15 years using the
straight line method and half-year convention, without regard
to whether the improvements are property subject to a lease,
placed in service more than three years after the date the
building was first placed in service, or made to a restaurant
building. Restaurant building property placed in service after
December 31, 2017, that does not meet the definition of
qualified improvement property is depreciable over 39 years as
nonresidential real property, using the straight line method
and the mid-month convention.
---------------------------------------------------------------------------
\631\ For a description of a conforming amendment made to section
179 to provide that qualified improvement property (in lieu of
qualified leasehold improvement property, qualified restaurant
property, and qualified retail improvement property) is eligible for
section 179 expensing, see the description of section 13101 of the Act
(Modifications of Rules for Expensing Depreciable Business Assets).
\632\ A technical correction may be necessary to reflect this
intent. Note that as 15-year property, qualified improvement property
is generally eligible for the additional first-year depreciation
deduction under section 168(k). For a discussion of changes made to
section 168(k) by the Act, see the description of section 13201 of the
Act (Temporary 100-Percent Expensing for Certain Business Assets).
\633\ A technical correction may be necessary to reflect this
intent.
\634\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
The provision also requires a real property trade or
business \635\ electing out of the interest limitation under
section 163(j) to use ADS to depreciate any of its
nonresidential real property, residential rental property,
qualified improvement property, qualified leasehold improvement
property, qualified restaurant property, and qualified retail
improvement property.\636\
---------------------------------------------------------------------------
\635\ As defined in section 163(j)(7)(B), by cross reference to
section 469(c)(7)(C) (i.e., any real property development,
redevelopment, construction, reconstruction, acquisition, conversion,
rental, operation, management, leasing, or brokerage trade or
business). Note that a mortgage broker who is a broker of financial
instruments is not in a real property trade or business for this
purpose. See, e.g., CCA 201504010 (December 17, 2014). For a discussion
of changes made to section 163(j) by the Act, see the description of
section 13301 of the Act (Limitation on Deduction for Interest).
\636\ A technical correction may be necessary to reflect that an
electing real property trade or business is also required to use ADS to
depreciate its qualified leasehold improvement property, qualified
restaurant property, and qualified retail improvement property (as
defined under prior law) that was placed in service prior to 2018 and
is owned by the taxpayer as of the beginning of the year of the
election out of the interest limitation. Congress intends that an
election out of the interest limitation and resulting required use of
ADS be treated as a change in use of the property. See sec. 168(i)(5)
and Treas. Reg. sec. 1.168(i)-4.
---------------------------------------------------------------------------
In addition, the provision shortens the ADS recovery period
for residential rental property from 40 years to 30 years.
Effective Date
The provision is generally effective for property placed in
service after December 31, 2017.
The provision relating to electing real property trades or
businesses applies to taxable years beginning after December
31, 2017.
E. Use of Alternative Depreciation System for Electing Farming
Businesses (sec. 13205 of the Act and sec. 168 of the Code)
Prior Law
In general
A taxpayer generally must capitalize the cost of property
used in a trade or business or held for the production of
income and recover such cost over time through annual
deductions for depreciation or amortization.\637\ The period
for depreciation or amortization generally begins when the
asset is placed in service by the taxpayer.\638\ Tangible
property generally is depreciated under the modified
accelerated cost recovery system (``MACRS''), which determines
depreciation for different types of property based on an
assigned applicable depreciation method, recovery period, and
convention.\639\
---------------------------------------------------------------------------
\637\ See secs. 263(a) and 167. In general, only the tax owner of
property (i.e., the taxpayer with the benefits and burdens of
ownership) is entitled to claim tax benefits such as cost recovery
deductions with respect to the property. In addition, where property is
not used exclusively in a taxpayer's business, the amount eligible for
a deduction must be reduced by the amount related to personal use. See,
e.g., sec. 280A.
\638\ See Treas. Reg. secs. 1.167(a)-10(b), -3, -14, and 1.197-
2(f). See also Treas. Reg. sec. 1.167(a)-11(e)(1)(i). In the case of
any tree or vine bearing fruits or nuts, the placed in service date
generally does not occur until the tree or vine first reaches an
income-producing stage. See Treas. Reg. sec. 1.46-3(d)(2). See also,
Rev. Rul. 80-25, 1980-1 C.B. 65; and Rev. Rul. 69-249, 1969-1 C.B. 31.
\639\ Sec. 168.
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The applicable recovery period for an asset is determined
in part by statute and in part by historic Treasury
guidance.\640\ The ``type of property'' of an asset is used to
determine the ``class life'' of the asset, which in turn
dictates the applicable recovery period for the asset.
---------------------------------------------------------------------------
\640\ Exercising authority granted by Congress, the Secretary
issued Rev. Proc. 87-56, 1987-2 C.B. 674, laying out the framework of
recovery periods for enumerated classes of assets. The Secretary
clarified and modified the list of asset classes in Rev. Proc. 88-22,
1988-1 C.B. 785. In November 1988, Congress revoked the Secretary's
authority to modify the class lives of depreciable property. Rev. Proc.
87-56, as modified, remains in effect except to the extent that the
Congress has, since 1988, statutorily modified the recovery period for
certain depreciable assets, effectively superseding any administrative
guidance with regard to such property.
---------------------------------------------------------------------------
The MACRS recovery periods applicable to most tangible
personal property range from three to 20 years. The
depreciation methods generally applicable to tangible personal
property are the 200-percent and 150-percent declining balance
methods,\641\ switching to the straight line method for the
first taxable year where using the straight line method with
respect to the adjusted basis as of the beginning of that year
yields a larger depreciation allowance. The recovery periods
for most real property are 39 years for nonresidential real
property and 27.5 years for residential rental property. The
straight line depreciation method is required for the
aforementioned real property.
---------------------------------------------------------------------------
\641\ Under the declining balance method the depreciation rate is
determined by dividing the appropriate percentage (here 150 or 200) by
the appropriate recovery period. This leads to accelerated depreciation
when the declining balance percentage is greater than 100. The table
below illustrates depreciation for an asset with a cost of $1,000 and a
seven-year recovery period under the 200-percent declining balance
method, the 150-percent declining balance method, and the straight line
method.
Recovery method Year 1 Year 2 Year 3 Year 4 Year 5
Year 6 Year 7 Total
200-percent declining balance 285.71 204.08 145.77 104.12 86.77
86.77 86.77 1,000.00
150-percent declining balance 214.29 168.37 132.29 121.26 121.26
121.26 121.26 1,000.00
Straight-line 142.86 142.86 142.86 142.86 142.86
142.86 142.86 1,000.00
* Details may not add to totals due to rounding.
---------------------------------------------------------------------------
Farm property
Property used in a farming business is assigned various
recovery periods in the same manner as other business property.
For these purposes, the term ``farming business'' means a trade
or business involving the cultivation of land or the raising or
harvesting of any agricultural or horticultural commodity
(e.g., the trade or business of operating a nursery or sod
farm; the raising or harvesting of trees bearing fruit, nuts,
or other crops; the raising of ornamental trees (other than
evergreen trees that are more than six years old at the time
they are severed from their roots); and the raising, shearing,
feeding, caring for, training, and management of animals).\642\
A farming business includes processing activities that are
normally incident to the growing, raising, or harvesting of
agricultural or horticultural products.\643\ A farming business
does not include contract harvesting of an agricultural or
horticultural commodity grown or raised by another taxpayer, or
merely buying and reselling plants or animals grown or raised
by another taxpayer.\644\
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\642\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(i).
\643\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(ii).
\644\ Sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4)(i).
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Farm property recovery periods
Farm property that is generally assigned a three-year
recovery period includes, for example, breeding hogs, breeding
and working horses more than 12 years old when placed in
service, and over-the-road tractor units.\645\ Examples of
five-year farm property include dairy or breeding cattle,
breeding goats and sheep, and trucks.\646\ Farm property
assigned a recovery period of seven years includes machinery
and equipment, grain bins, and fences (but no other land
improvements), that are used in the production of crops or
plants, vines, and trees; livestock; the operation of farm
dairies, nurseries, greenhouses, sod farms, mushrooms cellars,
cranberry bogs, apiaries, and fur farms; and the performance of
agriculture, animal husbandry, and horticultural services.\647\
Cotton ginning assets and breeding and working horses 12 years
old or less when placed in service are also assigned a recovery
period of seven years.\648\ Any single purpose agricultural or
horticultural structure,\649\ and any tree or vine bearing
fruit or nuts are assigned a recovery period of 10 years.\650\
Land improvements such as drainage facilities, paved lots, and
water wells are assigned a recovery period of 15 years.\651\
Farm buildings that do not meet the definition of a single
purpose agricultural or horticultural structure are assigned a
recovery period of 20 years.\652\
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\645\ See Rev. Proc. 87-56, asset class 01.23, Hogs, Breeding;
asset class 01.222, any breeding or work horse that is more than 12
years old at the time it is placed in service; and asset class 00.26,
Tractor Units for Use Over-the-Road.
\646\ See Rev. Proc. 87-56, asset class 01.21, Cattle, Breeding or
Dairy; asset class 01.24, Sheep and Goats, Breeding; asset class
00.241, Light General Purpose Trucks; and asset class 00.242, Heavy
General Purpose Trucks.
\647\ Rev. Proc. 87-56, asset class 01.1, Agriculture.
\648\ Rev. Proc. 87-56, asset class 01.11, Cotton ginning assets;
and asset class 01.221, Any breeding or work horse that is 12 years old
or less at the time it is placed in service.
\649\ A single purpose agricultural (livestock) structure is any
enclosure or structure specifically designed, constructed, and used for
(i) housing, raising, and feeding a particular type of livestock
(including poultry) and their produce, and (ii) housing the equipment
(including any replacements) necessary for the housing, raising, and
feeding of such livestock. Sec. 168(i)(13)(B)(i) and (iv). For example,
a single purpose agricultural structure includes a structure used to
breed chicken or hogs, produce milk from dairy cattle, or produce
feeder cattle or pigs, broiler chickens, or eggs, if an integral part
of the structure is the equipment necessary to house, raise, and feed
the livestock. See IRS Publication 225, Farmer's Tax Guide (2017). A
single purpose horticultural structure is (i) a greenhouse specifically
designed, constructed and used for the commercial production of plants,
and (ii) a structure specifically designed, constructed, and used for
the commercial production of mushrooms. Sec. 168(i)(13)(B)(ii). If a
structure includes work space, the work space must be solely for (i)
the stocking, caring for, or collecting of livestock or plants (as the
case may be) or their produce, (ii) the maintenance of the enclosure or
structure, and (iii) the maintenance or replacement of the equipment or
stock enclosed or housed therein. Sec. 168(i)(13)(B)(iii). See also
Rev. Proc. 87-56, asset class 01.4, Single purpose agricultural or
horticultural structures.
\650\ Secs. 168(e)(3)(D)(i) and (ii).
\651\ Rev. Proc. 87-56, asset class 00.3, Land improvements. See
also IRS Publication 225, Farmer's Tax Guide (2017).
\652\ Rev. Proc. 87-56, asset class 01.3, Farm buildings except
structures included in asset class 01.4.
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A five-year recovery period was assigned to new farm
machinery or equipment (other than any grain bin, cotton
ginning asset, fence, or other land improvement) which was used
in a farming business (as defined above), the original use of
which commenced with the taxpayer after December 31, 2008, and
which was placed in service before January 1, 2010.\653\
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\653\ Sec. 168(e)(3)(B)(vii). However, section 13203 of the Act
(Modifications of Treatment of Certain Farm Property) also shortens the
recovery period from seven to five years for any machinery or equipment
(other than any grain bin, cotton ginning asset, fence, or other land
improvement) which is used in a farming business, the original use of
which commences with the taxpayer and is placed in service after
December 31, 2017.
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Any property used in a farming business (other than
nonresidential real property,\654\ residential rental
property,\655\ and trees or vines bearing fruits or nuts \656\)
is subject to the 150-percent declining balance method.\657\
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\654\ Sec. 168(b)(3)(A).
\655\ Sec. 168(b)(3)(B).
\656\ Sec. 168(b)(3)(E).
\657\ Sec. 168(b)(2)(B). However, section 13203 of the Act
(Modifications of Treatment of Certain Farm Property) repeals the
required use of the 150-percent declining balance method for property
used in a farming business (i.e., for three-, five-, seven-, and 10-
year property). The 150-percent declining balance method will continue
to apply to any 15-year or 20-year property used in the farming
business to which the straight line method does not apply, or to
property for which the taxpayer elects the use of the 150-percent
declining balance method.
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Alternative depreciation system
The alternative depreciation system (``ADS'') is required
to be used for tangible property used predominantly outside the
United States, certain tax-exempt use property, tax-exempt bond
financed property, and certain imported property covered by an
executive order.\658\ An election to use ADS is available to
taxpayers for any class of property for any taxable year.\659\
Under ADS, all property is depreciated using the straight line
method over recovery periods which generally are equal to the
class life of the property, with certain exceptions.\660\ For
example, any single purpose agricultural or horticultural
structure has a 15-year ADS recovery period,\661\ while any
tree or vine bearing fruit or nuts has a 20-year ADS recovery
period.\662\ Similarly, land improvements such as drainage
facilities, paved lots, and water wells have an ADS recovery
period of 20 years.\663\ Farm buildings that do not meet the
definition of a single purpose agricultural or horticultural
structure have an ADS recovery period of 25 years.\664\
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\658\ Sec. 168(g).
\659\ Sec. 168(g)(7).
\660\ Secs. 168(g)(2) and (3).
\661\ Sec. 168(g)(3)(B).
\662\ Sec. 168(g)(3)(B).
\663\ Rev. Proc. 87-56, asset class 00.3, Land improvements.
\664\ Rev. Proc. 87-56, asset class 01.3, Farm buildings except
structures included in asset class 01.4.
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Under a special accounting rule, certain taxpayers engaged
in the business of farming who elect to deduct preproductive
period expenditures of plants produced in such business are
required to depreciate all farming assets using ADS.\665\
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\665\ Secs. 263A(d)(3) and (e)(2), and 168(g)(2). For a discussion
of changes made to the applicability of section 263A by the Act, see
the description of section 13102 of the Act (Small Business Accounting
Method Reform and Simplification).
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Explanation of Provision
The provision requires an electing farming business \666\
(i.e., a farming business electing out of the limitation on the
deduction for interest) \667\ to use ADS to depreciate any
property with a MACRS recovery period of 10 years or more
(e.g., property such as single purpose agricultural or
horticultural structures, trees or vines bearing fruit or nuts,
farm buildings, and certain land improvements).\668\
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\666\ As defined in section 163(j)(7)(C), which defines an electing
farming business as (i) a farming business as defined in section
263A(e)(4), or (ii) any trade or business of a specified agricultural
or horticultural cooperative as defined in section 199A(g)(4) (a
clerical correction may be necessary to correct this reference). See
the description of section 13301 of the Act (Limitation on Deduction
for Interest). Note that the treatment of income relating to
cooperatives under section 199A (as originally enacted December 22,
2017) was modified by the Consolidated Appropriations Act, 2018, Pub.
L. No. 115-141, enacted March 23, 2018. The description of the
modification was originally published as Joint Committee on Taxation,
Technical Explanation of the Revenue Provisions of the House Amendment
to the Senate Amendment to H.R. 1625 (Rules Committee Print 115-66)
(JCX-6-18), March 22, 2018, pages 5-27, which is reproduced in the
Appendix.
\667\ See section 13301 of the Act (Limitation on Deduction for
Interest). Section 13301 of the Act also includes an exception from the
limitation on the deduction for interest for taxpayers meeting the $25
million gross receipts test.
\668\ Congress intends that an election out of the interest
limitation and resulting required use of ADS be treated as a change in
use of the property. See sec. 168(i)(5) and Treas. Reg. sec. 1.168(i)-
4.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
F. Amortization of Research and Experimental Expenditures (sec. 13206
of the Act and sec. 174 of the Code)
Prior Law
Business expenses associated with the development or
creation of an asset having a useful life extending beyond the
current year generally must be capitalized and depreciated over
such useful life.\669\ Taxpayers, however, may elect to deduct
currently the amount of certain reasonable research or
experimental expenditures paid or incurred in connection with a
trade or business.\670\ Taxpayers may elect to forgo a current
deduction, capitalize their research or experimental
expenditures, and recover them ratably over the useful life of
the research, but in no case over a period of less than 60
months.\671\ Taxpayers, alternatively, may elect to amortize
their research or experimental expenditures over a period of 10
years.\672\ Research and experimental expenditures deductible
under section 174 are not subject to capitalization under
either section 263(a) \673\ or section 263A.\674\ In addition,
section 174 deductions are generally reduced by the amount of
the taxpayer's research credit under section 41.\675\
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\669\ Secs. 167 and 263(a).
\670\ Secs. 174(a) and (e).
\671\ Sec. 174(b). Taxpayers generating significant short-term
losses often choose to defer the deduction for their research and
experimental expenditures under this section. Additionally, section 174
amounts are excluded from the definition of ``start-up expenditures''
under section 195 (section 195 generally provides that start-up
expenditures in excess of $5,000 either are not deductible or are
amortizable over a period of not less than 180 months once an active
trade or business begins). So as not to generate significant losses
before beginning its trade or business, a taxpayer may choose to defer
the deduction and amortize its section 174 costs beginning with the
month in which the taxpayer first realizes benefits from the
expenditures (i.e., the month in which its active trade or business
begins).
\672\ Secs. 174(f)(2) and 59(e). This special 10-year election is
available to mitigate the effect of the alternative minimum tax
(``AMT'') adjustment for research expenditures set forth in section
56(b)(2) (for a discussion of the repeal of the corporate AMT, see the
description of section 12001 of the Act (Repeal of Tax for
Corporations)). Taxpayers with significant losses also may elect to
amortize their otherwise deductible research and experimental
expenditures to reduce amounts that could be subject to expiration
under the net operating loss carryforward regime (for changes to
section 172 made by the Act, see the description of section 13302 of
the Act (Modification of Net Operating Loss Deduction)).
\673\ Sec. 263(a)(1)(B).
\674\ Sec. 263A(c)(2).
\675\ Sec. 280C(c). Taxpayers may alternatively elect to claim a
reduced research credit amount under section 41 in lieu of reducing
deductions otherwise allowed. Sec. 280C(c)(3).
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Amounts defined as research or experimental expenditures
under section 174 generally include all costs incurred in the
experimental or laboratory sense related to the development or
improvement of a product.\676\ In particular, qualifying costs
are those incurred for activities intended to discover
information that would eliminate uncertainty concerning the
development or improvement of a product.\677\ Uncertainty
exists when information available to the taxpayer is not
sufficient to ascertain the capability or method for
developing, improving, and/or appropriately designing the
product.\678\ The determination of whether expenditures qualify
as deductible research expenses depends on the nature of the
activity to which the costs relate, not the nature of the
product or improvement being developed or the level of
technological advancement the product or improvement
represents. Examples of qualifying costs include salaries for
those engaged in research or experimentation efforts, amounts
incurred to operate and maintain research facilities (e.g.,
utilities, depreciation, rent, etc.), and expenditures for
materials and supplies used and consumed in the course of
research or experimentation (including amounts incurred in
conducting trials).\679\ In addition, under administrative
guidance, the costs of developing computer software have been
accorded treatment similar to research and experimental
expenditures.\680\
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\676\ Treas. Reg. sec. 1.174-2(a)(1) and (2). Product is defined to
include any pilot model, process, formula, invention, technique,
patent, or similar property, and includes products to be used by the
taxpayer in its trade or business as well as products to be held for
sale, lease, or license. Treas. Reg. sec. 1.174-2(a)(11), Example 10,
provides an example of new process development costs eligible for
section 174 treatment.
\677\ Treas. Reg. sec. 1.174-2(a)(1).
\678\ Ibid.
\679\ See Treas. Reg. sec. 1.174-4(c). The definition of research
and experimental expenditures also includes the costs of obtaining a
patent, such as attorneys' fees incurred in making and perfecting a
patent application. Treas. Reg. sec. 1.174-2(a)(1).
\680\ Rev. Proc. 2000-50, 2000-2 C.B. 601.
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Research or experimental expenditures under section 174 do
not include expenditures for quality control testing;
efficiency surveys; management studies; consumer surveys;
advertising or promotions; the acquisition of another's patent,
model, production or process; or research in connection with
literary, historical, or similar projects.\681\ For purposes of
section 174, quality control testing means testing to determine
whether particular units of materials or products conform to
specified parameters, but does not include testing to determine
if the design of the product is appropriate.\682\
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\681\ Treas. Reg. sec. 1.174-2(a)(6).
\682\ Treas. Reg. sec. 1.174-2(a)(7).
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Generally, no current deduction under section 174 is
allowable for expenditures for the acquisition or improvement
of land or of depreciable or depletable property used in
connection with any research or experimentation.\683\ In
addition, no current deduction is allowed for any expenditure
incurred for the purpose of ascertaining the existence,
location, extent, or quality of any deposit of ore or other
mineral, including oil and gas.\684\
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\683\ Sec. 174(c). However, depreciation and depletion allowances
may be considered section 174 expenditures. Ibid.
\684\ Sec. 174(d). Special rules apply with respect to geological
and geophysical costs (section 167(h)), qualified tertiary injectant
expenses (section 193), intangible drilling costs (sections 263(c) and
291(b)), and mining exploration and development costs (sections 616 and
617).
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Explanation of Provision
Under the provision, amounts defined as specified research
or experimental expenditures are required to be capitalized and
amortized ratably over a five-year period beginning with the
midpoint of the taxable year in which the specified research or
experimental expenditures were paid or incurred. Specified
research or experimental expenditures that are attributable to
research that is conducted outside of the United States \685\
are required to be capitalized and amortized ratably over the
15-year period beginning with the midpoint of the taxable year
in which such expenditures were paid or incurred. Specified
research or experimental expenditures subject to capitalization
include expenditures for software development.
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\685\ For this purpose, the term ``United States'' includes the
United States, the Commonwealth of Puerto Rico, and any possession of
the United States.
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Specified research or experimental expenditures do not
include expenditures for the acquisition or improvement of land
or for depreciable or depletable property used in connection
with the research or experimentation, but do include the
depreciation and depletion allowances of such property. Also
excluded are exploration expenditures incurred for ore or other
minerals (including oil and gas).
In the case of retired, abandoned, or disposed property
with respect to which specified research or experimental
expenditures are paid or incurred, any remaining basis may not
be recovered in the year of retirement, abandonment, or
disposal, but instead must continue to be amortized over the
remaining amortization period.
The application of this rule is treated as a change in the
taxpayer's method of accounting for purposes of section 481
initiated by the taxpayer and made with the consent of the
Secretary. This rule is applied on a cutoff basis to research
or experimental expenditures paid or incurred in taxable years
beginning after December 31, 2021 (hence there is no adjustment
under section 481(a) for research or experimental expenditures
paid or incurred in taxable years beginning before January 1,
2022).
The provision makes conforming changes to sections 41 and
280C.\686\
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\686\ Thus, if a taxpayer's research credit under section 41 for a
taxable year beginning after 2021 exceeds the amount allowed as an
amortization deduction under the provision for such taxable year, the
amount chargeable to capital account under the provision for such
taxable year must be reduced by that excess amount. A taxpayer may
alternatively elect to claim a reduced research credit amount under
section 41 in lieu of reducing its section 174 expenditures for the
taxable year. If such an election is made, the research credit is
reduced by an amount equal to that credit multiplied by the highest
corporate tax rate.
---------------------------------------------------------------------------
Effective Date
The provision applies to amounts paid or incurred in
taxable years beginning after December 31, 2021.
G. Expensing of Certain Costs of Replanting Citrus Plants Lost by
Reason of Casualty (sec. 13207 of the Act and sec. 263A of the Code)
Prior Law
In general
The uniform capitalization rules require certain direct and
indirect costs allocable to real or tangible personal property
produced by the taxpayer to be either capitalized into the
basis of such property or included in inventory, as
applicable.\687\ For real or personal property acquired by the
taxpayer for resale, section 263A generally requires certain
direct and indirect costs allocable to such property to be
either capitalized into the basis of such property or included
in inventory, as applicable.
---------------------------------------------------------------------------
\687\ Sec. 263A. For a discussion of the changes made by the Act to
the applicability of section 263A, see the description of section 13102
of the Act (Small Business Accounting Method Reform and
Simplification).
---------------------------------------------------------------------------
Section 263A generally requires the capitalization of the
direct and indirect costs allocable to the production of any
property in a farming business,\688\ including animals and
plants without regard to the length of their preproductive
period.\689\ The costs of a plant generally required to be
capitalized under section 263(a) include preparatory costs
incurred so that the plant's growing process may begin, such as
the acquisition costs of the seed, seedling, or plant. Under
section 263A, the costs of producing a plant generally required
to be capitalized also include the preproductive period costs
of planting, cultivating, maintaining, and developing the plant
during the preproductive period.\690\ Preproductive period
costs may include management, irrigation, pruning, soil and
water conservation, fertilizing, frost protection, spraying,
harvesting, storage and handling, upkeep, electricity, tax
depreciation and repairs on buildings and equipment used in
raising the plants, farm overhead, taxes, and interest, as
applicable.\691\
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\688\ For purposes of section 263A, the term ``farming business''
means a trade or business involving the cultivation of land or the
raising or harvesting of any agricultural or horticultural commodity
(e.g., the trade or business of operating a nursery or sod farm; the
raising or harvesting of trees bearing fruit, nuts, or other crops; the
raising of ornamental trees (other than evergreen trees that are more
than six years old at the time they are severed from their roots); and
the raising, shearing, feeding, caring for, training, and management of
animals). A farming business includes processing activities that are
normally incident to the growing, raising, or harvesting of
agricultural or horticultural products. A farming business does not
include contract harvesting of an agricultural or horticultural
commodity grown or raised by another taxpayer, or merely buying and
reselling plants or animals grown or raised by another taxpayer. See
sec. 263A(e)(4) and Treas. Reg. sec. 1.263A-4(a)(4).
\689\ Treas. Reg. sec. 1.263A-4(b)(1).
\690\ Treas. Reg. sec. 1.263A-4(b)(1)(i).
\691\ Ibid.
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Special rules for plant farmers
Section 263A provides an exception to the general
capitalization requirements for taxpayers who raise, harvest,
or grow trees.\692\ Under this exception, section 263A does not
apply to trees raised, harvested, or grown by the taxpayer
(other than trees bearing fruit, nuts, or other crops, or
ornamental trees) and any real property underlying such trees.
Similarly, the section 263A rules do not apply to any plant
having a preproductive period of two years or less, that is
produced by a taxpayer in a farming business (unless the
taxpayer is required to use an accrual method of accounting
under section 447 or 448(a)(3)).\693\ Hence, in general, the
section 263A rules apply to the production of plants that have
a preproductive period of more than two years, and to taxpayers
required to use an accrual method of accounting.
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\692\ Sec. 263A(c)(5).
\693\ Sec. 263A(d). For a discussion of the changes made by the Act
to taxpayers allowed to use the cash method rather than an accrual
method, see the description of section 13102 of the Act (Small Business
Accounting Method Reform and Simplification).
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Plant farmers otherwise required to capitalize
preproductive period costs may elect to deduct such costs
currently, provided the alternative depreciation system
described in section 168(g)(2) is used on all farm assets and
the preproductive period costs are recaptured upon disposition
of the product.\694\ The election is not available to taxpayers
required to use the accrual method of accounting. Moreover, the
election is not available with respect to certain costs
attributable to planting, cultivating, maintaining, or
developing citrus or almond groves.
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\694\ Sec. 263A(d)(3), (e)(1), and (e)(2).
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Section 263A does not apply to costs incurred in replanting
edible crops for human consumption following loss or damage due
to freezing temperatures, disease, drought, pests, or
casualty.\695\ The same type of crop as the lost or damaged
crop must be replanted. However, the exception to
capitalization still applies if the replanting occurs on a
parcel of land other than the land on which the damage occurred
provided the acreage of the new land does not exceed that of
the land to which the damage occurred and the new land is
located in the United States. This exception may also apply to
costs incurred by persons other than the taxpayer who incurred
the loss or damage, provided (1) the taxpayer who incurred the
loss or damage retains an equity interest of more than 50
percent in the plants for which the loss or damage occurred at
all times during the taxable year in which the replanting costs
are paid or incurred, and (2) such other person claiming the
deduction holds a minority equity interest and materially
participates in the planting, maintenance, cultivation, or
development of such plants during the taxable year in which the
replanting costs are paid or incurred.\696\
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\695\ Sec. 263A(d)(2). Such replanting costs generally include
costs attributable to the replanting, cultivating, maintaining, and
developing of the plants that were lost or damaged that are incurred
during the preproductive period. Treas. Reg. sec. 1.263A-4(e)(1). The
acquisition costs of the replacement trees or seedlings must still be
capitalized under section 263(a) (see, e.g., T.D. 8897, 65 FR 50638,
Treas. Reg. sec. 1.263A-4(e)(3), Examples 1-3, and TAM 9547002 (July
18, 1995)), potentially subject to the special additional first-year
depreciation deduction in the year of planting under section 168(k)(5).
For a discussion of changes made by the Act to section 168(k), see the
description of section 13201 of the Act (Temporary 100-Percent
Expensing for Certain Business Assets).
\696\ Sec. 263A(d)(2)(B). Material participation for this purpose
is determined in a similar manner as under section 2032A(e)(6)
(relating to qualified use valuation of farm property upon death of the
taxpayer).
---------------------------------------------------------------------------
Explanation of Provision
The provision expands the special rule for costs incurred
by persons (other than the taxpayer who incurred the loss or
damage) in connection with replanting an edible crop for human
consumption following loss or damage due to casualty. Under the
provision, with respect to replanting costs paid or incurred
after December 22, 2017 (i.e., incurred after the date of
enactment), but no later than December 22, 2027 (i.e., the date
which is 10 years after such date of enactment), for citrus
plants lost or damaged due to casualty, such replanting costs
may also be deducted by a person (other than the taxpayer who
incurred the loss or damage) if (1) the taxpayer has an equity
interest of not less than 50 percent in the replanted citrus
plants at all times during the taxable year in which the
replanting costs are paid or incurred and such other person
holds any part of the remaining equity interest, or (2) such
other person acquires all of the taxpayer's equity interest in
the land on which the lost or damaged citrus plants were
located at the time of such loss or damage, and the replanting
is on such land.
The Treasury Department has issued published guidance
addressing this provision.\697\
---------------------------------------------------------------------------
\697\ See Rev. Proc. 2018-31, 2018-22 I.R.B. 637.
---------------------------------------------------------------------------
Effective Date
The provision is effective for costs paid or incurred after
December 22, 2017 (i.e., after the date of enactment).
SUBPART B--ACCOUNTING METHODS
A. Certain Special Rules for Taxable Year of Inclusion (sec. 13221 of
the Act and sec. 451 of the Code)
Prior Law
Realization of gross income
In general
Under section 61(a), gross income generally includes all
income from whatever source derived, except as otherwise
provided in Subtitle A of the Code.\698\ Gross income generally
includes all items that are clearly realized accessions to
wealth in any form.\699\ Gross income is clearly realized when
an item is sufficiently fixed and definite to be treated as
gross income.\700\ Realization generally occurs when a taxpayer
takes the last step by which the economic gain comes to
fruition.\701\ Generally, there must be a transaction involving
the taxpayer for there to be a clearly realized accession to
wealth.\702\ For a transaction involving a capital asset, gross
income is realized at the time the asset is sold, exchanged, or
otherwise disposed.\703\
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\698\ See sections 101 through 140 for items specifically excluded
from gross income.
\699\ Treas. Reg. sec. 1.61-1 and Commissioner v. Glenshaw Glass
Co., 348 U.S. 426, 429-430 (1955).
\700\ Eisner v. Macomber, 252 U.S. 189, 207 (1920).
\701\ Helvering v. Horst, 311 U.S. 112, 115 (1940).
\702\ Baldwin Locomotive Works v. McCoach, 221 Fed. 59, 60 (3d Cir.
1915).
\703\ Sec. 1001.
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Gross income generally includes income realized in any
form, whether in money, property, services, payment of the
taxpayer's indebtedness, or relief from a liability, except to
the extent provided in other sections of the Code.\704\
---------------------------------------------------------------------------
\704\ Treas. Reg. sec. 1.61-1. See also Helvering v. Bruun, 309
U.S. 461, 469 (1940).
---------------------------------------------------------------------------
If the consideration to be received by the taxpayer cannot
be valued at the time of the transaction, a taxpayer is not
required to include any gain in income at that time.\705\
Instead, the transaction remains open until such consideration
is received or can be valued. As a result, open transactions
generally arise in connection with sales or property in
exchange for contingent payments. However, only in rare and
extraordinary circumstances will property be considered not to
have an ascertainable fair market value.\706\ In addition,
Congress has limited a taxpayer's ability to treat a
transaction as an open transaction by enacting rules addressing
the realization and recognition of income from installment
sales, in particular contingent payment installment sales for
which the aggregate selling price cannot be determined by the
close of the taxable year in which such sale or other
disposition occurs.\707\ Under these rules, the taxpayer has a
closed transaction and has realized income at the time the sale
or disposition of the property occurs.
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\705\ Burnet v. Logan, 283 U.S. 404 (1931).
\706\ Simmonds Precision Prods. v. Commissioner, 75 T.C. 103
(1980). See also Treas. Reg. sec. 15A.453-1(d)(2)(iii). In the case of
an arm's-length transaction, an asset with an unascertainable value is
presumed to have a value equal to that of the property for which it was
exchanged. See United States v. Davis, 370 U.S. 65 (1962).
\707\ See section 453 and Treas. Reg. sec. 15A.453-1(c). A taxpayer
may elect out of the installment sale rules under section 453(d).
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Constructive realization
In certain situations, Congress has prescribed the time at
which realization is deemed to occur by requiring taxpayers, or
allowing taxpayers to elect, to include in gross income amounts
that may otherwise be unrealized income or gain. For example,
under the mark to market rules, a taxpayer that is a dealer in
securities who holds as of the end of a taxable year a security
that is not inventory in the hands of the taxpayer must realize
and recognize gain or loss during the year on that security,
even though the taxpayer has not yet sold or disposed of the
security.\708\ To determine the amount of gain or loss, the
taxpayer is deemed to have sold the security for its fair
market value on the last day of the taxable year.\709\ Dealers
in commodities and traders in securities or commodities may
elect to mark to market the commodities or securities they
hold.\710\ Similarly, under the mark to market rules applicable
to a section 1256 contract,\711\ a taxpayer must treat each
section 1256 contract as if it were sold for its fair market
value on the last business day of the taxable year, with any
gain or loss taken into account for the taxable year, even
though the taxpayer has not yet sold or disposed of the
contract.\712\ In addition, in certain situations, a taxpayer
is treated as having made a constructive sale of an appreciated
financial position.\713\ In that case, the taxpayer must
realize and recognize gain as if such position were sold,
assigned, or otherwise terminated at its fair market value on
the date of such constructive sale.\714\
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\708\ Sec. 475(a)(2).
\709\ Sec. 475(a)(2)(A). Adjustments are made in subsequent years
for the amount of any gain or loss previously realized and recognized
by the taxpayer.
\710\ Sec. 475(e) and (f).
\711\ A section 1256 contract is any regulated futures contract,
any foreign currency contract, any nonequity option, any dealer equity
option, and any dealer securities futures contract. Sec. 1256(b)(1). A
section 1256 contract does not include any securities future contract
or option on such a contract unless such contract or option is a dealer
securities futures contract or any interest rate swap, currency swap,
basis swap, interest rate cap, interest rate floor, commodity swap,
equity swap, equity index swap, credit default swap, or similar
agreement. Sec. 1256(b)(2).
\712\ Sec. 1256(a). As under the mark to market rules under section
475, adjustments are made in subsequent years for the amount of any
gain or loss previously realized and recognized by the taxpayer on the
contract.
\713\ Sec. 1259(c).
\714\ Sec. 1259(a). As under sections 475 and 1256, adjustments are
made in subsequent years for the amount of any gain previously realized
and recognized by the taxpayer on the position.
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Special rules govern the timing of realization with respect
to income from debt instruments. For example, amounts received
by a holder upon retirement of any debt instrument are
considered amounts received in exchange therefor.\715\ Such
amounts are not realized any earlier than when the debt
instrument is retired, sold, or exchanged. In addition, gain on
the disposition of any market discount bond is treated as
ordinary income to the extent it does not exceed the accrued
market discount on such bond.\716\ A taxpayer does not realize
such gain, including market discount, until disposition of the
bond or receipt of partial principal payments on the bond.\717\
However, a taxpayer may elect out of these default realization
rules for market discount and instead realize market discount
currently as it accrues.\718\
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\715\ Sec. 1271(a)(1).
\716\ Sec. 1276(a).
\717\ Sec. 1276(a).
\718\ Sec. 1278(b).
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Gross income derived from certain businesses
For businesses involving the sale of property to others
(e.g., manufacturing, merchandising, mining, etc.), gross
income is total sales less the cost of goods sold, plus any
income from investment and from incidental or outside
sources.\719\ Gross income is determined on an annual or
taxable year basis with the amount of each item of gross income
(e.g., total sales) for the taxable year determined under the
taxpayer's method of accounting for each item.\720\ In
determining gross income, the amount of total sales included as
an item of gross income is determined in accordance with the
taxpayer's method of accounting under the income recognition
rules.\721\
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\719\ Treas. Reg. sec. 1.61-3(a).
\720\ See Automobile Club of New York, Inc. v. Commissioner, 32
T.C. 906, 914 (1959), aff'd 304 F.2d 781 (2nd Cir. 1962) (``. . . net
income under the statute is computed on an annual basis, and . . .
there is no necessary correlation in any given year between receipts
and expenses. Expenses with respect to income not yet earned are
deductible when paid or accrued; and conversely, income is reportable
when received or accrued, notwithstanding that some, or even all,
expenses allocable thereto have not yet been incurred''); and Hagen
Advertising Displays, Inc. v. Commissioner, 47 T.C. 139 (1966), aff'd
407 F.2d 1105 (6th Cir. 1969) (``Nothing in [Treas. Reg. sec. 1.61-
3(a)] suggests that an attempt must be made to match a particular
purchase with a particular sale or a particular item in inventory'').
\721\ See, e.g., sec. 451. See discussion below of the income
recognition rules. See also, e.g., line 1a of Form 1120, Form 1120S, or
Form 1065, or line 1 of Schedule C (Form 1040).
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The amount of cost of goods sold included as a subtraction
from total sales is determined in accordance with the
taxpayer's methods of accounting for items included in cost of
goods sold.\722\ An amount may not be taken into account in the
computation of cost of goods sold, and thus reduce total sales,
any earlier than the taxable year in which economic performance
occurs with respect to such amount.\723\ Once economic
performance occurs, amounts may only be taken into account in
the computation of cost of goods sold if they are not required
to be capitalized and are not subject to any other provision of
the Code that requires the deduction to be taken in a taxable
year later than the year when economic performance occurs.\724\
For example, generally a taxpayer must maintain inventories
whenever the production, purchase, or sale of merchandise is an
income-producing factor.\725\ In addition, such merchandise
remains in inventory, and is not included in cost of goods
sold, if title thereto is still vested in the taxpayer.\726\
Section 263A and the regulations thereunder also require that
direct costs and certain indirect costs incurred by the
taxpayer (i.e., costs for which economic performance has
occurred) must be capitalized and included in the basis of
property produced or acquired for resale by the taxpayer with
the capitalized costs recovered by including such amounts in
cost of goods sold when the underlying inventory or property is
sold.\727\
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\722\ Treas. Reg. sec. 1.61-3(a). See, e.g., sections 263A, 461(h),
and 471. See also, e.g., line 2 of Form 1120, Form 1120S, or Form 1065,
or line 4 of Schedule C (Form 1040), as well as Form 1125-A. A
taxpayer's gross profit is generally determined by subtracting returns
and allowances and cost of goods sold from gross receipts or sales. See
line 3 of Form 1120, Form 1120S, or Form 1065, or line 5 of Schedule C
(Form 1040).
\723\ Treas. Reg. secs. 1.61-3(a), 1.263A-1(c)(2)(ii), and 1.446-
1(c)(1)(ii). For a liability that arises out of the provision of
services or property to the taxpayer by another person, economic
performance occurs as the other person provides such services, as the
other person provides such property, or as the taxpayer uses such
property. For a liability that requires the taxpayer to provide
property to others, economic performance occurs as the taxpayer
provides the property to the other person. Sec. 461(h)(2)(A) and (B). A
liability includes any item allowable as a deduction, cost, or expense
for Federal income tax purposes. In addition to allowable deductions,
the term includes any amount otherwise allowable as a capitalized cost,
as a cost taken into account in computing cost of goods sold, as a cost
allocable to a long-term contract, or as any other cost or expense. See
Treas. Reg. secs. 1.446-1(c)(1)(ii)(B) and 1.461-4(c)(1) and T.D. 8408,
1992-1 C.B. 155.
\724\ Conference Report to accompany H.R. 4170, Deficit Reduction
Act of 1984, H.R. Rep. No. 98-861, June 23, 1984, p. 871.
\725\ Sec. 471 and Treas. Reg. sec. 1.471-1.
\726\ Sec. 471 and Treas. Reg. sec. 1.471-1. Whether the
requirement that title be vested in the taxpayer has been met is
generally determined based on whether the taxpayer has the benefits and
burdens of ownership.
\727\ Sec. 263A and Treas. Reg. sec. 1.263A-1(c)(4).
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Income recognition
In general
Once it is determined that gross income is clearly realized
for Federal income tax purposes, section 451 and the
regulations thereunder provide the general rules as to the
timing of when sales, gross receipts, and other items of income
are recognized by including such items in gross income under
the taxpayer's method of accounting.\728\
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\728\ Treas. Reg. sec. 1.61-1(b)(3).
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A taxpayer generally is required to include sales, gross
receipts, or other items of income in gross income no later
than the time of its actual or constructive receipt, unless the
item \729\ is properly accounted for in a different period
under the taxpayer's method of accounting.\730\ If a taxpayer
has an unrestricted right to demand the payment of an amount,
the taxpayer is in constructive receipt of that amount whether
or not the taxpayer makes the demand and actually receives the
payment.\731\
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\729\ Methods of accounting include both the taxpayer's overall
method of accounting (e.g., the cash method and an accrual method), as
well as any special methods of accounting for any ``item'' of income or
expense. See Treas. Reg. sec. 1.446-1(a)(1). Generally, an item is any
income or expense that differs in some way that is relevant to the
determination of taxable income. For example, late fee income is
treated as a separate item from interchange fee income, over-limit
fees, finance charges, and cash advance fees because late fee income is
earned for different reasons than the other types of income. See
Capital One Financial Corp. and Subsidiaries v. Commissioner, 133 T.C.
No. 8 (2009).
\730\ Sec. 451(a).
\731\ See Treas. Reg. sec. 1.451-2.
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In general, for a cash basis taxpayer, sales, gross
receipts, and other items of income are included in gross
income when actually or constructively received.\732\ For an
accrual basis taxpayer, sales, gross receipts, and other items
of income are included in gross income when all the events have
occurred that fix the right to receive such income and the
amount thereof can be determined with reasonable accuracy
(i.e., when the ``all events test'' is met), unless an
exception permits deferral or exclusion or a special method of
accounting applies.\733\ Generally, all the events that fix the
right to receive income occur upon the earlier of when (i)
payment is earned through performance, (ii) payment is due to
the taxpayer, or (iii) payment is received by the
taxpayer.\734\ Amounts are earned upon performance by the
taxpayer. For example, performance takes place when all
services are provided (except for ministerial duties),\735\ the
sale takes place, or, in the case of interest and rent, the use
of money or property is provided. An amount is considered due
based on the terms of the arrangement between the taxpayer and
the other party. The taxpayer does not have to have a legally
enforceable right for an amount to be considered due for
purposes of the all events test.
---------------------------------------------------------------------------
\732\ Treas. Reg. secs. 1.446-1(c)(1)(i) and 1.451-1(a).
\733\ Treas. Reg. secs. 1.446-1(c)(1)(ii) and 1.451-1(a).
\734\ See Rev. Rul. 2003-10, 2003-1 C.B. 288.
\735\ With respect to whether a taxpayer earned income from
unbilled receivables, income from the provision of services generally
accrues when performance is complete, not as the taxpayer engages in
the activity. See, e.g., Decision, Inc. v. Commissioner, 47 T.C. 58, 63
(1966), acq. 1967-2 C.B. 2. However, if services are severable, a
portion of the income is proportionally allocated to each service
provided under the contract. See Rev. Rul. 79-195, 1979-1 C.B. 177, and
Tech. Adv. Mem. 200803017, January 18, 2008, and 200903079, January 16,
2009.
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Advance payments
In general
Various methods of accounting are provided to address
situations in which an accrual method taxpayer receives an
advance payment for goods, services, or other items of income.
An advance payment generally occurs when a taxpayer receives
payment before the taxpayer provides goods, services, or other
items to its customer. These methods of accounting generally
allow taxpayers to either (i) include the advance payment in
gross income in the year of receipt, or (ii) defer the
recognition of the advance payment under various methods of
accounting, with the cost of satisfying the taxpayer's future
obligation to provide goods, services, or other items taken
into account when such costs are incurred at a later date.
However, special rules were also historically provided that
allowed taxpayers to instead accelerate the deduction or
adjustment to gross income for the estimated cost of the goods
or property to be provided in the future and take such
deduction or adjustment generally in the same taxable year for
which the related advance payment was included in gross income
(i.e., generally in the taxable year the advance payment was
received).
Inclusion in gross income in year of receipt
A taxpayer that receives an advance payment for goods,
services, or other items of income may include such amount in
gross income in the year of receipt (i.e., the ``full inclusion
method'').\736\ A taxpayer using the full inclusion method to
account for an advance payment for services does not take an
offsetting deduction for the cost of providing such services
until the taxable year in which the taxpayer provides such
services to the customer and economic performance occurs for
such costs.\737\ Similarly, a taxpayer using the full inclusion
method to account for an advance payment for goods does not
take an offsetting adjustment for its actual or estimated basis
in the goods to be sold until such time that economic
performance occurs for the cost to acquire or produce the goods
and the goods in question have been provided to the
customer.\738\
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\736\ See, e.g., sec. 451(a), Treas. Reg. sec. 1.451-5(b)(1)(i),
and Rev. Proc. 2004-34, 2004-1 C.B. 991, as modified and clarified by
Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and Rev. Proc. 2013-29, 2013-33
I.R.B. 141.
\737\ See sec. 461(h)(2)(B).
\738\ See secs. 263A, 461(h)(2)(B), and 471. See also PLR
200638015, September 22, 2006.
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Deferral of advance payments
A number of exceptions exist that allow taxpayers to defer
the recognition of advance payments from goods, services, and
other items in gross income. These exceptions often allow tax
deferral of the advance payments to mirror the financial
accounting deferral of such payments \739\ (e.g., the advance
payments are included in gross income as the goods are provided
or the services are performed) or limit the initial tax
deferral of the advance payments to the financial accounting
deferral of such payments.\740\ Under each of these exceptions,
a taxpayer receiving an advance payment for services does not
take an offsetting deduction for the cost of providing such
services until the taxable year in which the taxpayer provides
such services to the customer and economic performance occurs
for such costs.\741\ In addition, a taxpayer receiving an
advance payment for goods does not take an offsetting
adjustment for its actual or estimated basis in the goods to be
sold until such time that economic performance occurs for the
cost to acquire or produce the goods and the goods in question
have been provided to the customer.\742\
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\739\ See Treas. Reg. sec. 1.451-5.
\740\ See Rev. Proc. 2004-34, 2004-1 C.B. 991, as modified and
clarified by Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and Rev. Proc.
2013-29, 2013-33 I.R.B. 141.
\741\ See sec. 461(h)(2)(B).
\742\ See secs. 263A, 461(h)(2)(B), and 471. See also Announcement
2004-48, 2004-1 C.B. 998 (``Taxpayers that use the deferral method in
[Rev. Proc. 2004-34] must use the general rules under section 461 and
the regulations thereunder for determining when a liability (including
cost of goods sold) is incurred.''). However, see discussion below for
a limited exception to this treatment for a taxpayer electing a two-
year deferral of an advance payment for inventoriable goods.
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A taxpayer receiving an advance payment for goods,
services, and other items \743\ may elect to include in gross
income in the year of receipt \744\ only the portion of the
advance payment that is included in revenue in the taxpayer's
applicable financial statement \745\ and include the remaining
amount in gross income in the next succeeding taxable year
(i.e., a one-year deferral of the advance payment). If the
taxpayer dies or ceases to exist, or the taxpayer's obligation
with respect to the advance payment is satisfied or otherwise
ends, the taxpayer must include in gross income any portion of
the advance payment not previously recognized.\746\
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\743\ Such other items include advance payments for the use
(including by license or lease) of intellectual property; the occupancy
or use of property if the occupancy or use is ancillary to the
provision of services; the sale, lease or license of computer software;
guaranty or warranty contracts ancillary to any of the preceding items,
as well as services or the sale of goods; subscriptions, whether or not
provided in a tangible or intangible format; memberships in an
organization; or any combination of the preceding items. See sec. 4.01
of Rev. Proc. 2004-34, 2004-1 C.B. 991, as modified and clarified by
Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and Rev. Proc. 2013-29, 2013-33
I.R.B. 141.
\744\ An advance payment is considered received by a taxpayer if it
is actually or constructively received, or if it is due or payable to
the taxpayer. See sec. 4.04 of Rev. Proc. 2004-34, 2004-1 C.B. 991, as
modified and clarified by Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and
Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
\745\ Alternatively, if the taxpayer does not have an applicable
financial statement, the taxpayer includes in gross income in the year
of receipt only the portion of such advance payment that is earned in
that taxable year. See sec. 5.02(3)(b) of Rev. Proc. 2004-34, 2004-1
C.B. 991, as modified and clarified by Rev. Proc. 2011-18, 2011-5
I.R.B. 443, and Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
\746\ See sec. 5.02(5) of Rev. Proc. 2004-34, 2004-1 C.B. 991, as
modified and clarified by Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and
Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
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Taxpayers receiving substantial advance payments for
inventoriable goods may also elect a two-year deferral of the
advance payment.\747\ A taxpayer has received a substantial
advance payment with respect to an agreement if the advance
payments received during the taxable year and preceding taxable
years equal or exceed the total costs and expenditures
reasonably estimated as includible in inventory with respect to
the agreement.\748\ Advance payments for which the goods or
type of goods to be sold are not identifiable in the year the
payment is received, such as gift certificates and gift cards,
are treated as substantial advance payments.\749\ If the
taxpayer (i) receives a substantial advance payment during the
taxable year and (ii) has on hand (or available through the
normal source of supply) goods of substantially similar kind
and in sufficient quantity to satisfy the agreement in such
taxable year, then any advance payments received by the last
day of the second taxable year following the year in which the
substantial advance payment is received are included in gross
income no later than such second taxable year (adjusted for any
amounts previously included in gross income as goods are
provided to customers).\750\ Any additional advance payments
received with respect to the agreement in taxable years
following the second taxable year are included in gross income
in the year of receipt.\751\
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\747\ See Treas. Reg. sec. 1.451-5(c). If the taxpayer receives an
advance payment under an agreement to provide both goods and services,
where the services are not performed as an integral part of providing
the goods, only the portion of the advance payment properly allocable
to the provision of goods is eligible for the two-year deferral.
However, if the portion of the advance payment allocable to the
provision of services is less than five percent of the total contract
price, the advance payment is also eligible for the two year-deferral.
See Treas. Reg. sec. 1.451-5(a)(3).
\748\ Treas. Reg. sec. 1.451-5(c)(3).
\749\ Ibid.
\750\ Treas. Reg. sec. 1.451-5(c)(1)(i).
\751\ Treas. Reg. sec. 1.451-5(c)(2).
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Taxpayers receiving an advance payment for goods may also
apply a multiyear deferral of the advance payment.\752\ For
this purpose, an advance payment for goods includes any amount
received during the taxable year which is (i) for the sale or
other disposition in a future taxable year of goods held by the
taxpayer primarily for sale to customers in the ordinary course
of the trade or business, or (ii) for the building, installing,
constructing, or manufacturing by the taxpayer of items where
the agreement is not completed within such taxable year.\753\
The taxpayer includes such amounts in gross income in (i) the
taxable year in which such amounts are properly included in
gross income under the taxpayer's accrual method of accounting,
or (ii) the taxable year in which such amounts are included in
revenue in the taxpayer's financial statements, whichever
occurs first.\754\ If the taxpayer dies or ceases to exist, or
the taxpayer's obligation with respect to the advance payment
is satisfied or otherwise ends, the taxpayer must include in
gross income any portion of the advance payment not previously
recognized.\755\
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\752\ Treas. Reg. sec. 1.451-5(b)(1)(ii). If the taxpayer receives
an advance payment under an agreement to provide both goods and
services, where the services are not performed as an integral part of
providing the goods, only the portion of the advance payment properly
allocable to the provision of goods is eligible for the multiyear
deferral. However, if the portion of the advance payment allocable to
the provision of services is less than five percent of the total
contract price, such advance payments are also eligible for the
multiyear deferral. See Treas. Reg. sec. 1.451-5(a)(3).
\753\ Treas. Reg. sec. 1.451-5(a)(1).
\754\ Treas. Reg. sec. 1.451-5(b)(1).
\755\ Treas. Reg. sec. 1.451-5(f).
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Acceleration of related deductions or adjustments to gross
income
As noted above, special rules were also historically
provided that allowed taxpayers to instead accelerate the
deduction for the estimated cost of the goods or property to be
provided in the future and take such deduction, or adjustment
to gross income, generally in the same taxable year for which
the related advance payment was included in gross income (i.e.,
generally in the taxable year the advance payment was
received). If an accrual method taxpayer issued trading stamps
or premium coupons with sales, or if an accrual method taxpayer
engaged in the business of selling trading stamps or premium
coupons (i.e., a ``trading stamp company''), and such stamps or
coupons were redeemable by such taxpayer in merchandise, cash,
or other property, the taxpayer was allowed to reduce gross
receipts by the estimated cost of future redemptions of trading
stamps or premium coupons outstanding as of the close of the
taxable year.\756\ To be eligible to use such method, the
taxpayer must have satisfied a book conformity requirement
under which the taxpayer's estimated future redemptions and
estimated average cost of redeeming each stamp or coupon could
be no greater than the estimates that the taxpayer used for
purposes of all reports (including consolidated financial
statements) to shareholders, partners, beneficiaries, other
proprietors, and for credit purposes.\757\
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\756\ Treas. Reg. sec. 1.451-4.
\757\ Treas. Reg. sec. 1.451-4(d). Under prior generally accepted
accounting principles, two approaches were available to account for
customer loyalty programs: (i) incremental cost accrual method (revenue
is generally recognized at the time of initial sale along with the
estimated expense for the anticipated costs of satisfying the award
credits) or (ii) multiple-element revenue model (revenue is allocated
between the goods or services sold and the award credits based on their
relative fair value, with revenue allocable to the award credits
deferred until they are redeemed or expire, with any costs of
redemption also taken into account at the time redemption takes place).
See ASC 605-25, Revenue Recognition--Multiple-Element Arrangements, and
605-50, Revenue Recognition--Customer Payments and Incentives, prior to
their repeal by Accounting Standards Update (``ASU'') No. 2014-09,
Revenue from Contracts with Customers. Accordingly, only taxpayers
using the incremental cost accrual method for financial statement
purposes were previously eligible to use the method provided in Treas.
Reg. sec. 1.451-4 for Federal income tax purposes. Under current
generally accepted accounting principles in ASC 606, Revenue from
Contracts with Customers, if the taxpayer is acting as a principal,
customer loyalty programs are accounted for in a manner similar to the
multiple-element revenue model, with any costs of redemption taken into
account at the time redemption takes place. However, if the taxpayer is
acting as an agent, the taxpayer recognizes fee or commission income
from the exchange at the time redemption takes place. The amount of the
fee or commission is deemed to be equal to the net amount that the
taxpayer retains in the exchange (i.e., the revenue deferred from the
prior sale or issuance of the points less any costs of redemption
incurred at the time redemption takes place). See ASC 606-10-55-36
through 55-40, Revenue from Contracts with Customers--Overall--
Implementation Guidance and Illustrations--Principal versus Agent
Considerations, and ASC 606-10-55-353 through 55-356, Revenue from
Contracts with Customers--Overall--Implementation Guidance and
Illustrations--Example 52-Customer Loyalty Program. As the incremental
cost accrual method is no longer allowed for financial statement
purposes, taxpayers may not be able to meet the book conformity
requirement contained in Treas. Reg. sec. 1.451-4(d) and may no longer
be eligible for the method provided in Treas. Reg. sec. 1.451-4.
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Similarly, section 466 previously allowed taxpayers that
issue discount coupons to deduct the estimated cost of future
redemptions that occurred during the six-month period after the
end of a taxable year.
In addition, a taxpayer electing a two-year deferral of
advance payments for inventoriable goods was provided with a
one-time acceleration of its adjustment to gross income for
estimated cost of goods sold. In particular, a taxpayer
electing a two-year deferral was allowed to reduce gross income
for the second taxable year following the year in which the
substantial advance payment is received (i.e., the taxable year
in which any remaining advance payment is included in gross
income) by the costs and expenditures included in inventory
with respect to the goods to which the remaining advance
payment relates, even though such goods had not yet been
provided to the customer.\758\ In addition, if all or a portion
of the goods to which the remaining advance payment relates are
not on hand by the last day of such taxable year, the taxpayer
could also reduce gross income for such taxable year for the
estimated cost of the goods necessary to satisfy the agreement,
even though such goods had not yet been acquired or produced by
the taxpayer and had not yet been provided to the
customer.\759\ However, the reduction of gross income in such
taxable year by actual or estimated cost of goods to be
provided to the customer in the future was not permitted if the
goods or type of goods with respect to which the advance
payment was received were not identified in the year the
advance payments are required to be included in gross income
(e.g., gift certificates and gift cards).\760\ In addition, if
the taxpayer receives additional advance payments after the
second taxable year following the year in which the substantial
advance payment is received, the reduction of gross income by
actual or estimated cost of goods to be provided to the
customer in the future was also not permitted for estimated
cost of goods sold related to such additional advance payments,
even though the taxpayer is required under the two-year
deferral method to include such advance payments in gross
income in the year received.
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\758\ Treas. Reg. sec. 1.451-5(c)(1)(ii).
\759\ Ibid.
\760\ Treas. Reg. sec. 1.451-5(c)(1)(iii).
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Each of these methods allowing the acceleration of
deductions or adjustments to gross income for the estimated
future costs of providing goods, property, or other items
related to advance payments included in gross income predates
and is inconsistent with the economic performance rules in
section 461(h) \761\ enacted in 1984 and the related repeal of
section 466 \762\ in 1986.\763\ Congress enacted the economic
performance rules in section 461(h) and repealed section 466 to
ensure that no liability is treated as incurred any earlier
than when economic performance takes place.\764\ The economic
performance rules provide that a liability \765\ that requires
the taxpayer to provide property or services to others not be
taken into account any earlier than as the taxpayer provides
the property or services to the other person.\766\ For a
liability that arises out of the provision of services or
property to the taxpayer by another person, economic
performance occurs as the other person provides such services,
as the other person provides such property, or as the taxpayer
uses such property.\767\ If the liability is to pay a rebate,
refund, or similar payment to another person (whether paid in
property, money, or as a reduction in the price of goods or
services to be provided in the future by the taxpayer),
economic performance occurs as payment is made to the person to
which the liability is owed.\768\
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\761\ Deficit Reduction Act of 1984, Pub. L. No. 98-369, sec. 91,
July 18, 1984.
\762\ Tax Reform Act of 1986, Pub. L. No. 99-514, sec. 823, October
22, 1986.
\763\ In addition, the acceleration of adjustments to gross income
for costs and expenditures included in inventory as part of the two-
year deferral method is inconsistent with the requirement to maintain
inventories under section 471 and the requirements of the uniform
capitalization rules under section 263A to capitalize direct costs and
certain indirect costs related to goods produced or acquired for resale
by the taxpayer until such time that the goods are sold to customers
and the benefits and burdens of ownership of such goods are transferred
to the customer.
\764\ Joint Committee on Taxation, General Explanation of the
Revenue Provisions of The Deficit Reduction Act of 1984 (JCS-41-84),
December 1984, pp. 260-261. See also Report to accompany H.R. 3838, Tax
Reform Act of 1986, S. Rpt. No. 99-313, May 29, 1985, pp. 158-159.
\765\ A liability includes any item allowable as a deduction, cost,
or expense for Federal income tax purposes. In addition to allowable
deductions, the term includes any amount otherwise allowable as a
capitalized cost, as a cost taken into account in computing cost of
goods sold, as a cost allocable to a long-term contract, or as any
other cost or expense. See Treas. Reg. secs. 1.446-1(c)(1)(ii)(B) and
1.461-4(c)(1) and T.D. 8408, 1992-1 C.B. 155.
\766\ Sec. 461(h)(2)(B).
\767\ Sec. 461(h)(2)(A).
\768\ Treas. Reg. sec. 1.461-4(g)(3). This rule applies to all
rebates, refunds, and payments or transfers in the nature of a rebate
or refund regardless of whether they are characterized as a deduction
from gross income, an adjustment to gross receipts or total sales, or
an adjustment or addition to cost of goods sold. In the case of a
rebate or refund made as a reduction in the price of goods or services
to be provided in the future by the taxpayer ``payment'' is deemed to
occur as the taxpayer would otherwise be required to recognize income
resulting from a disposition at an unreduced price.
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The economic performance rules were enacted to address
Congressional concerns regarding court decisions that, in some
cases, permitted accrual method taxpayers to deduct expenses
that were not yet economically incurred (i.e., that were
attributable to activities to be performed or amounts to be
paid in the future).\769\ In particular, Congress observed that
allowing a taxpayer to take deductions currently for an amount
to be paid in the future overstates the true cost of the
expense to the extent that the time value of money is not taken
into account.\770\ Accordingly, in order to prevent deductions
for future expenses in excess of their true cost, while
avoiding the complexity of a system of discounted valuation,
Congress believed that expenses should be treated as incurred
only when economic performance occurs.\771\
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\769\ Joint Committee on Taxation, General Explanation of the
Revenue Provisions of The Deficit Reduction Act of 1984 (JCS-41-84),
December 1984, pp. 260-261.
\770\ Ibid.
\771\ Ibid.
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In addition, in repealing section 466 two years later,
Congress noted that ``the provision of prior law allowing a
deduction for discount coupons received for redemption after
the close of the taxable year resulted in an incorrect
measurement of taxable income'' and that prior law
``provided an unwarranted exception to the general
rules of tax accounting. An accrual basis taxpayer
normally is allowed to recognize an expense only when
all events establishing its obligation to pay the
amount claimed as a deduction have occurred, the amount
thereof can be determined with reasonable accuracy, and
there has been economic performance with respect to the
item. Absent the special provision of prior law for
discount coupons, such costs would not have been
considered deductible until the coupons actually were
redeemed.'' \772\
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\772\ Report to accompany H.R. 3838, Tax Reform Act of 1986, S.
Rpt. No. 99-313, May 29, 1985, pp. 158-159.
As a result of the enactment of section 461(h) and the
repeal of section 466 the deduction acceleration provisions
discussed above are no longer consistent with the Code. Under
prior law, taxpayers receiving advance payments could either
account for such items by including the advanced payment in
gross income in the year of receipt or by applying the one-
year, two-year, or multiyear deferral method discussed
above.\773\
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\773\ Upon the enactment of the economic performance rules,
Congress noted that it ``expected that the Treasury Department would
review existing regulations and rulings to determine whether they are
consistent with the policies and principles set forth [in section
461(h)]. Until new regulations are issued under these provisions or the
existing rulings are revoked or clarified, taxpayers may continue to
rely on these rulings to the extent they are not inconsistent with the
general principles of economic performance.'' See Joint Committee on
Taxation, General Explanation of the Revenue Provisions of The Deficit
Reduction Act of 1984 (JCS-41-84), December 1984, p. 266.
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Special methods of accounting
In a number of situations, Congress has prescribed the
proper time for including sales, gross receipts, and other
items of income in gross income by providing special methods of
accounting \774\ for such items in the Code. For example,
Congress has provided special methods of accounting for (i)
amounts received by accrual method taxpayers in the year of the
taxpayer's death, (ii) employee tips, (iii) crop insurance
proceeds and disaster payments, (iv) proceeds from livestock
sold on account of drought, flood, or other weather-related
conditions, (v) income from the sale or furnishing of utility
services, (vi) interest on frozen deposits in certain financial
institutions, (vii) qualified prizes including a cash option,
and (viii) sales or dispositions to implement Federal energy
regulatory commission or State electric restructuring
policy.\775\ Congress has also prescribed the proper time for
including gross profit from installment sales, \776\ prepaid
subscription income, \777\ prepaid membership dues, \778\ and
adjustments for certain returned merchandise \779\ in gross
income. In addition, Congress has prescribed the proper time
for including in gross income any income from certain long-term
contracts \780\ and rental income from certain arrangements for
the use of property or services.\781\
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\774\ Methods of accounting include both the taxpayer's overall
method of accounting, as well as any special methods of accounting for
any ``item'' of income or expense. Examples of overall methods are the
cash receipts and disbursements method, an accrual method, and
combinations of the foregoing with various special methods provided for
the accounting treatment of items of income or expense. Except for
deviations permitted or required by special methods of accounting,
taxable income is computed under the taxpayer's overall method of
accounting (i.e., the cash receipts and disbursements method or an
accrual method). See Treas. Reg. sec. 1.446-1(a)(1).
\775\ See sec. 451(d)-(k), as redesignated by the Act.
\776\ See sec. 453.
\777\ See sec. 455.
\778\ See sec. 456.
\779\ See sec. 458.
\780\ See sec. 460.
\781\ See sec. 467.
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Interest income
A taxpayer generally must include in gross income the
amount of interest received or accrued within the taxable year
on indebtedness held by the taxpayer.\782\
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\782\ Secs. 61(a)(4) and 451.
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Original issue discount
The holder of a debt instrument with original issue
discount (``OID'') generally accrues and includes the OID in
gross income as interest over the term of the instrument,
regardless of when the stated interest (if any) is paid.\783\
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\783\ Sec. 1272.
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The amount of OID with respect to a debt instrument is the
excess of the stated redemption price at maturity over the
adjusted issue price of the debt instrument.\784\ The stated
redemption price at maturity is the sum of all payments
provided by the debt instrument other than qualified stated
interest payments.\785\ The holder includes in gross income an
amount equal to the sum of the daily portions of the OID for
each day during the taxable year the holder held such debt
instrument. The daily portion is determined by allocating to
each day in any accrual period its ratable portion of the
increase during such accrual period in the adjusted issue price
of the debt instrument.\786\ The adjustment to the issue price
is determined by multiplying the adjusted issue price (i.e.,
the issue price increased by adjustments prior to the accrual
period) by the instrument's yield to maturity, and then
subtracting the interest payable during the accrual period.
Thus, to compute the amount of OID and the portion of OID
allocable to a period, the stated redemption price at maturity
and the term must be known. Issuers of OID instruments accrue
and deduct the amount of OID as interest expense in the same
manner as the holder.\787\
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\784\ Sec. 1273(a)(1).
\785\ Sec. 1273(a)(2) and Treas. Reg. sec. 1.1273-1(b).
\786\ Secs. 1272(a)(1) and (3).
\787\ Sec. 163(e).
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Debt instruments subject to acceleration
Special rules for determining the amount of OID allocated
to a period apply to certain instruments that may be subject to
prepayment. If a borrower can reduce the yield on a debt by
exercising a prepayment option, the OID rules assume that the
borrower will prepay the debt.\788\ In addition, in the case of
(1) any regular interest in a real estate mortgage investment
conduit (``REMIC'') or qualified mortgages held by a REMIC, or
(2) any other debt instrument if payments under the instrument
may be accelerated by reason of prepayments of other
obligations securing the instrument, the daily portions of the
OID on such debt instruments are determined by taking into
account an assumption regarding the prepayment of principal for
such instruments.\789\
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\788\ Treas. Reg. sec. 1.1272-1(c)(5).
\789\ Sec. 1272(a)(6).
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The Taxpayer Relief Act of 1997 \790\ extended these rules
to any pool of debt instruments the payments on which may be
accelerated by reason of prepayments.\791\ Thus, if a taxpayer
holds a pool of credit card receivables that require interest
to be paid only if the borrowers do not pay their accounts by a
specified date (``grace-period interest''), the taxpayer is
required to accrue interest or OID on such pool based upon a
reasonable assumption regarding the timing of the payments of
the accounts in the pool. Under these rules, certain amounts
(other than grace-period interest) related to credit card
transactions, such as late-payment fees,\792\ cash-advance
fees,\793\ and interchange fees,\794\ have been determined to
create OID or increase the amount of OID on the pool of credit
card receivables to which the amounts relate.\795\
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\790\ Pub. L. No. 105-34, sec. 1004(a).
\791\ Sec. 1272(a)(6)(C)(iii).
\792\ Rev. Proc. 2004-33, 2004-1 C.B. 989.
\793\ Rev. Proc. 2005-47, 2005-2 C.B. 269.
\794\ Capital One Financial Corp. and Subsidiaries v. Commissioner,
133 T.C. No. 8 (2009); IRS Chief Counsel Notice CC-2010-018, September
27, 2010.
\795\ See also Rev. Proc. 2013-26, 2013-22 I.R.B. 1160, for a safe
harbor method of accounting for OID on a pool of credit card
receivables for purposes of section 1272(a)(6).
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Stripped bonds
Special rules are provided with respect to the buyer and
seller of stripped bonds.\796\ A ``stripped bond'' is defined
as a debt instrument in which there has been a separation in
ownership between the underlying debt instrument and any
interest coupon that has not yet become payable.\797\ In
general, upon the disposition of either the stripped bond or
the detached interest coupons, the retained portion and the
portion that is disposed of are each treated as a new bond that
is purchased at a discount and is payable at a fixed amount on
a future date. Accordingly, both the stripped bond and the
detached interest coupons are treated as individual bonds that
are newly issued with OID on the date of disposition.
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\796\ Sec. 1286.
\797\ Sec. 1286(d)(2), as redesignated by the Consolidated
Appropriations Act, 2018, Pub. L. No. 115-141, March 23, 2018.
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A taxpayer who purchases a stripped bond or one or more
stripped coupons is treated as holding a new bond that is
issued on the purchase date with OID in an amount that is equal
to the excess of the stated redemption price at maturity (or,
in the case of a coupon, the amount payable on the due date)
over the ratable share of the purchase price of the stripped
bond or coupon, determined on the basis of the respective fair
market values of the stripped bond and coupons on the purchase
date.\798\ The OID on the stripped bond or coupon is includible
in gross income under the general OID periodic income inclusion
rules.
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\798\ Sec. 1286(a).
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A taxpayer who strips a bond and disposes of either the
stripped bond or one or more stripped coupons must allocate the
taxpayer's basis, immediately before the disposition, in the
bond (with the coupons attached) between the retained and
disposed items.\799\ Special rules require that interest or
market discount accrued on the bond before such disposition
must be included in the taxpayer's gross income (to the extent
not previously included in gross income) at the time the
stripping occurs, and the taxpayer increases the pre-
disposition basis in the bond by the amount of such accrued
interest or market discount. The adjusted basis (as increased
by any accrued interest or market discount) is then allocated
between the stripped bond and the stripped interest coupons in
relation to their respective fair market values. Amounts
realized from the sale of stripped coupons or bonds constitute
income to the taxpayer only to the extent such amounts exceed
the basis allocated to the stripped coupons or bond. With
respect to retained items (either the detached coupons or
stripped bond), to the extent that the price payable on
maturity, or on the due date of the coupons, exceeds the
portion of the taxpayer's basis allocable to such retained
items, the difference is treated as OID that is required to be
included under the general OID rules.\800\
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\799\ Sec. 1286(b). Similar rules apply in the case of any person
whose basis in any bond or coupon is determined by reference to the
basis in the hands of a person who strips the bond.
\800\ Special rules are provided with respect to stripping
transactions involving tax-exempt obligations that treat OID (computed
under the stripping rules) in excess of OID computed on the basis of
the bond's coupon rate (or higher rate if originally issued at a
discount) as income from a debt instrument that is not tax-exempt (sec.
1286(c), as redesignated by the Consolidated Appropriations Act, 2018,
Pub. L. No. 115-141, March 23, 2018).
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Mortgage servicing rights
Income from ``normal'' mortgage servicing rights is
included in income upon the earlier of when earned or received
under the all events test of section 451 (i.e., not averaged
over the life of the mortgage).\801\ Income from ``excess''
mortgage servicing rights is treated as income from stripped
coupons under section 1286 and therefore subject to the OID
rules.\802\
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\801\ See Rev. Rul. 70-142, 1970-1 C.B. 115.
\802\ See Rev. Rul. 91-46, 1991-2 C.B. 358, and Rev. Proc. 91-50,
1991-2 C.B. 778.
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Nonrecognition rules
Congress has provided that, in certain situations in which
income or gain has been clearly realized by the taxpayer, such
income or gain realized is nonetheless excluded either in whole
or in part from gross income.\803\ To receive nonrecognition
treatment for such income or gain, taxpayers generally must
meet certain requirements and comply with any applicable
restrictions or adjustments to basis.
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\803\ See, e.g., secs. 247(f)(2), 267(d), 311, 332, 336(e)(2), 351,
354, 355, 361, 721, 731, and 1031 through 1045.
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Explanation of Provision
Modification to the all events test for income recognition
The provision revises the rules associated with the timing
of income recognition under the all events test of section 451.
Specifically, the provision requires an accrual method taxpayer
with an applicable or other specified financial statement \804\
that is subject to the all events test to include sales, gross
receipts, and other items of income in gross income no later
than the taxable year in which such income is taken into
account as revenue \805\ in an applicable financial statement
or another financial statement under rules specified by the
Secretary. Under the provision, an accrual method taxpayer with
an applicable or other specified financial statement includes
sales, gross receipts, and other items of income in gross
income upon the earlier of when the all events test is met or
when the taxpayer includes such item in revenue in an
applicable or other specified financial statement (i.e., upon
the earlier of when due, paid, earned, or included in an
applicable or other specified financial statement).
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\804\ For purposes of the provision, the term ``applicable
financial statement'' means: (A) a financial statement which is
certified as being prepared in accordance with generally accepted
accounting principles and which is (i) a 10-K (or successor form), or
annual statement to shareholders, required to be filed by the taxpayer
with the United States Securities and Exchange Commission (``SEC''),
(ii) an audited financial statement of the taxpayer which is used for
(I) credit purposes, (II) reporting to shareholders, partners, or other
proprietors, or to beneficiaries, or (III) any other substantial nontax
purpose, but only if there is no statement of the taxpayer described in
clause (i), or (iii) filed by the taxpayer with any other Federal
agency for purposes other than Federal tax purposes, but only if there
is no statement of the taxpayer described in clause (i) or (ii); (B) a
financial statement which is made on the basis of international
financial reporting standards and is filed by the taxpayer with an
agency of a foreign government which is equivalent to the SEC and which
has reporting standards not less stringent than the standards required
by such Commission, but only if there is no statement of the taxpayer
described in subparagraph (A); or (C) a financial statement filed by
the taxpayer with any other regulatory or governmental body specified
by the Secretary, but only if there is no statement of the taxpayer
described in subparagraph (A) or (B). If the financial results of a
taxpayer are reported on the applicable financial statement for a group
of entities, such statement is treated as the applicable financial
statement of the taxpayer. See sec. 451(b)(3) and (5), as modified by
the Act.
\805\ Accounting Standards Codification (``ASC'') Topics 605,
Revenue Recognition, and 606, Revenue from Contracts with Customers,
provide the accounting rules for determining the amount of revenue to
which a company expects to be entitled (i.e., realization) and the
timing of when such amount is included in revenue in the company's
financial statements (i.e., recognition). The timing of when costs
incurred to fulfill a contract with a customer are included in the
company's financial statements is determined separately from the
inclusion timing of the associated revenue under various ASC topics,
including ASC 330, Inventory, ASC 340-10-25-1 through 25-4, Other
Assets and Deferred Costs-Overall-Recognition-Preproduction Costs
Related to Long-Term Supply Arrangements, ASC 340-40, Other Assets and
Deferred Costs-Contracts with Customers, ASC 350-40, Intangibles--
Goodwill and Other-Internal-Use Software, ASC 360, Property, Plant, and
Equipment, and ASC 985-20, Software--Costs of Software to be Sold,
Leased, or Marketed. See ASC 340-40-15-3.
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In the case of a contract which contains multiple
performance obligations, the provision requires the taxpayer to
allocate the transaction price to each performance obligation
in accordance with the allocation made in the taxpayer's
applicable financial statement.\806\
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\806\ Congress expects that Treasury will provide guidance
regarding whether and how to allocate the transaction price (i) to
performance obligations that are not contractually based (e.g., the
provision of free goods or services to a customer or the provision of a
customary amount of training or support), (ii) for arrangements that
include both income subject to section 451 and long-term contracts
subject to section 460, and (iii) when the income realization event for
Federal income tax purposes differs from the income realization event
for financial statement purposes.
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The provision does not apply to taxpayers without an
applicable or other specified financial statement.\807\
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\807\ See below for further discussion.
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Examples
Example 1.--A taxpayer enters into a one-year contract with
a customer to provide cleaning services twice a month for $100
per cleaning service. The taxpayer invoices the customer and
receives payment of $200 after the end of each month. The
taxpayer provides cleaning services to the customer 10 times
during the last five months of year one and 14 times during the
first seven months of year two. The taxpayer receives payments
from the customer of $800 in year one and $1,600 in year two.
The taxpayer includes in revenue in its financial statements
$1,000 in year one and $1,400 in year two.\808\ Under prior
law, the taxpayer would have included in gross income $1,000 in
year one and $1,400 in year two.\809\ Under the provision, the
taxpayer includes in gross income $1,000 in year one and $1,400
in year two.
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\808\ Because the customer simultaneously receives and consumes the
benefits provided by the taxpayer's performance as the taxpayer
performs the cleaning services, the taxpayer recognizes revenue over
time as it satisfies its performance obligation to provide cleaning
services. See ASC 606-10-25-27(a) and 606-10-55-5.
\809\ Under the all events test, the taxpayer includes amounts in
gross income upon the earlier of when due (i.e., after the end of each
month), earned (i.e., each time cleaning services are provided as such
services are severable), or paid (i.e., after the end of each month).
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Example 2.--A taxpayer provides construction services to a
customer to expand the customer's warehouse facility for
$100,000. The taxpayer begins providing the construction
services in year one and construction is completed during year
two. Under the contract, the taxpayer bills the customer
$50,000 in year one when construction begins and $50,000 in
year two when construction is complete. In addition, the
performance of the construction services is non-severable
(i.e., there are no milestones that have to be met before
payment is due).\810\ While the construction services are being
provided, the customer retains control of the original
warehouse facility and the expansion. The taxpayer includes in
revenue in its financial statements $60,000 in year one and
$40,000 in year two.\811\ Under prior law, the taxpayer would
have included in gross income $50,000 in year one and $50,000
in year two.\812\ Under the provision, the taxpayer includes in
gross income $60,000 in year one and $40,000 in year two.
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\810\ See, e.g., Tech. Adv. Mem. 200903079, October 8, 2008.
\811\ Because the taxpayer's performance creates or enhances an
asset that the customer controls as the asset is created or enhanced,
the taxpayer recognizes revenue over time as it satisfies its
performance obligation to provide construction services. See ASC 606-
10-25-27(b) and 606-10-55-7.
\812\ Under the all events test, the taxpayer includes $50,000 in
gross income for year one upon the earlier of when due (i.e., when
construction begins), earned (i.e., when performance of the
nonseverable services is complete in year two), or paid (i.e., upon
receipt of payment in year one after construction begins). Under the
all events test, the taxpayer includes $50,000 in gross income for year
two (adjusted for amounts previously included in gross income during
year one) upon the earlier of when due (i.e., when construction is
complete), earned (i.e., when performance of the non-severable services
is complete in year two), or paid (i.e., upon receipt of payment in
year two after construction is complete).
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Example 3.--Assume the same facts as in Example 2 except
that, under the contract, the taxpayer bills the customer, and
the customer pays, $75,000 in year one when construction begins
and $25,000 in year two when construction is complete. The
taxpayer includes in revenue in its financial statements
$60,000 in year one and $40,000 in year two.\813\ Under prior
law, the taxpayer would have included in gross income $75,000
in year one and $25,000 in year two.\814\ Under the provision,
the taxpayer includes in gross income $75,000 in year one and
$25,000 in year two.
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\813\ Because the taxpayer's performance creates or enhances an
asset that the customer controls as the asset is created or enhanced,
the taxpayer recognizes revenue over time as it satisfies its
performance obligation to provide construction services. See ASC 606-
10-25-27(b) and 606-10-55-7.
\814\ Under the all events test, the taxpayer includes $75,000 in
gross income for year one upon the earlier of when due (i.e., when
construction begins), earned (i.e., when performance of the non-
severable services is complete in year two), or paid (i.e., upon
receipt of payment in year one after construction begins). Under the
all events test, the taxpayer includes $25,000 in gross income for year
two (adjusted for amounts previously included in gross income during
year one) upon the earlier of when due (i.e., when construction is
complete), earned (i.e., when performance of the non-severable services
is complete in year two), or paid (i.e., upon receipt of payment in
year two after construction is complete). This example assumes that the
taxpayer has not elected to defer advance payments under prior law or
the provision. See below for further discussion of an election to defer
advance payments under the provision.
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Example 4.--A taxpayer enters into a contract with a
customer to build a customized piece of machinery for $50,000.
Because of the customized nature of the machinery, the taxpayer
is unable to sell the machinery to any of its other customers
if the customer defaults or withdraws from the contract. Under
the contract, taxpayer and the customer agree that the taxpayer
will not invoice the customer until the item is delivered to
the customer, the customer accepts the machinery, and title to
the machinery has transferred to the customer. However, the
contract also provides that, if the customer withdraws from the
agreement, the taxpayer has an enforceable right to payment as
the work is performed, even if the contract is not completed
(for reasons other than a failure to perform by the taxpayer).
The taxpayer begins producing the machinery in year one and the
item is delivered to the customer in year two. The taxpayer
invoices the customer for $50,000 and is paid such amount in
year two. The taxpayer includes in revenue in its financial
statements $30,000 in year one and $20,000 in year two.\815\
Under prior law, the taxpayer would not have included any
portion of the $50,000 in gross income in year one and would
have included $50,000 in gross income in year two.\816\ Under
the provision, the taxpayer incudes in gross income $30,000 in
year one and $20,000 in year two.
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\815\ Because the taxpayer's performance does not create an asset
with an alternative use to the taxpayer (i.e., the machinery cannot be
sold to other customers) and the taxpayer has an enforceable right to
payment for performance completed to date, the taxpayer recognizes
revenue over time as it satisfies its performance obligation to
manufacture the item of machinery. See ASC 606-10-25-27(c) and 25-28
through 25-29, as well as ASC 606-10-55-8 through 55-15.
\816\ Under the all events test, the taxpayer includes $50,000 in
gross income for year two upon the earlier of when due (i.e., when the
taxpayer invoices the customer), earned (i.e., when the machinery is
delivered to and accepted by the customer), or paid (i.e., when the
taxpayer receives payment).
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Example 5.--A taxpayer enters into a contract with a
customer to manufacture 500 widgets at a price of $10 each. The
taxpayer receives a prepayment of $5,000 from the customer in
year one. The taxpayer manufactures the widgets during year two
and the widgets are delivered to the customer throughout year
two as production of each widget is complete. The taxpayer does
not include any portion of the prepayment in revenue in its
financial statements in year one and, instead, includes the
$5,000 in revenue in its financial statements in year two.\817\
Under prior law, the taxpayer would have included in gross
income $5,000 in year one and zero in year two.\818\ Under the
provision, the taxpayer includes in gross income $5,000 in year
one and zero in year two.\819\
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\817\ Because the customer simultaneously receives and consumes the
benefits provided by the taxpayer's performance as the taxpayer
delivers the widgets to the customer, the taxpayer recognizes revenue
in year two as it satisfies its performance obligation to provide the
widgets to the customer. See ASC 606-10-25-27(a) and 606-10-55-5.
\818\ Under the all events test, the taxpayer includes $5,000 in
gross income for year one upon the earlier of when due (i.e., when the
widgets are delivered to the customer), earned (i.e., when the widgets
are delivered to the customer), or paid (i.e., when paid by the
customer). This example assumes that the taxpayer accounts for sales of
its product when the product is delivered (see Treas. Reg. sec. 1.446-
1(c)(1)(ii)(C)), and has not elected to defer advance payments under
prior law.
\819\ This example assumes that the taxpayer has not elected to
defer advance payments under the provision. See below for further
discussion of an election to defer advance payments under the
provision.
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Prior law principles which are unchanged by the provision
Congress intends that the provision apply to items of gross
income, such as sales, gross receipts, or other items of
income, for which the timing of income recognition was
determined using the all events test under prior law. Thus, the
provision does not apply to items of gross income the timing of
which is determined under a special method of accounting
provided elsewhere in the Code, including special rules
regarding items of gross income in connection with a mortgage
servicing contract (contained in section 1286 of part V of
subchapter P (special rules for bonds and other debt
instruments)). However, the exception for special methods of
accounting does not apply, and thus the provision is
applicable, to any other income recognition timing rule
contained in part V of subchapter P (special rules for bonds
and other debt instruments).\820\
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\820\ See prior law discussion above regarding special methods of
accounting. See also the discussion below regarding the interaction of
the provision with the special rules for bonds and other debt
instruments in part V of subchapter P.
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Consistent with prior law, the amount of cost of goods sold
included as a subtraction from total sales is determined in
accordance with the taxpayer's methods of accounting for items
included in cost of goods sold.\821\ An amount may not be taken
into account in the computation of cost of goods sold, and thus
reduce total sales, any earlier than the taxable year in which
economic performance occurs with respect to such amount.\822\
Once economic performance occurs, amounts may only be taken
into account in the computation of cost of goods sold if they
are not required to be capitalized and are not subject to any
other provision of the Code that requires the deduction to be
taken in a taxable year later than the year when economic
performance occurs.\823\ For example, generally taxpayers must
maintain inventories whenever the production, purchase, or sale
of merchandise is an income-producing factor.\824\ In addition,
such merchandise remains in inventory and is not included in
cost of goods sold if title thereto is still vested in the
taxpayer.\825\ Section 263A and the regulations thereunder also
require that direct costs and certain indirect costs incurred
by the taxpayer (i.e., costs for which economic performance has
occurred) must be capitalized and included in the basis of
property produced or acquired for resale by the taxpayer with
the capitalized costs recovered by including such amounts in
cost of goods sold when the underlying inventory or property is
sold.\826\
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\821\ Treas. Reg. sec. 1.61-3(a). See, e.g., sections 263A, 461(h),
and 471. See also, e.g., line 2 of Form 1120, Form 1120S, or Form 1065,
or line 4 of Schedule C (Form 1040), as well as Form 1125-A. A
taxpayer's gross profit is generally determined by subtracting returns
and allowances and cost of goods sold from gross receipts or sales. See
line 3 of Form 1120, Form 1120S, or Form 1065, or line 5 of Schedule C
(Form 1040).
\822\ Treas. Reg. secs. 1.61-3(a), 1.263A-1(c)(2)(ii), and 1.446-
1(c)(1)(ii). For a liability that arises out of the provision of
services or property to the taxpayer by another person, economic
performance occurs as the other person provides such services, as the
other person provides such property, or as the taxpayer uses such
property. For a liability that requires the taxpayer to provide
property to others, economic performance occurs as the taxpayer
provides the property to the other person. Sec. 461(h)(2)(A) and (B). A
liability includes any item allowable as a deduction, cost, or expense
for Federal income tax purposes. In addition to allowable deductions,
the term includes any amount otherwise allowable as a capitalized cost,
as a cost taken into account in computing cost of goods sold, as a cost
allocable to a long-term contract, or as any other cost or expense. See
Treas. Reg. secs. 1.446-1(c)(1)(ii)(B) and 1.461-4(c)(1) and T.D. 8408,
1992-1 C.B. 155.
\823\ Conference Report to accompany H.R. 4170, Deficit Reduction
Act of 1984, H.R. Rep. No. 98-861, June 23, 1984, p. 871.
\824\ Sec. 471 and Treas. Reg. sec. 1.471-1.
\825\ Sec. 471 and Treas. Reg. sec. 1.471-1. Whether the
requirement that title be vested in the taxpayer has been met is
generally determined based on whether the taxpayer has the benefits and
burdens of ownership.
\826\ Sec. 263A and Treas. Reg. sec. 1.263A-1(c)(4).
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Consistent with prior law, the provision does not apply to
an item of gross income subject to the nonrecognition rules
provided elsewhere in the Code.\827\
---------------------------------------------------------------------------
\827\ See prior law discussion above regarding nonrecognition
rules.
---------------------------------------------------------------------------
The provision does not revise the rules regarding when an
item is realized for Federal income tax purposes and,
accordingly, does not require the recognition of income in
situations where the Federal income tax realization event has
not yet occurred.\828\ For example, the provision does not
require the recognition of gain or loss from securities that
are marked to market for financial reporting purposes if the
gain or loss from such securities is not realized for Federal
income tax purposes until such time that the taxpayer sells or
otherwise disposes of the investment (because the taxpayer has
not elected to apply, and is thus not subject to, the tax mark
to market rules under section 475). In addition, the provision
does not change any Federal income tax realization rule
prescribed by the Code. For example, the provision does not
apply to the Federal income tax treatment of amounts received
upon the retirement, sale, or exchange of debt instruments
which is governed by section 1271, or to the character of bond
disposition gain where realization does not occur until the
bond has been sold or otherwise disposed of by reason of
section 1276.\829\
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\828\ For example, the provision does not require the
recharacterization of a transaction from sale to lease, or vice versa,
for Federal income tax purposes to conform to how the transaction is
reported in the taxpayer's applicable financial statement. In addition,
income from investments in corporations or partnerships that are
accounted for under the equity method for financial reporting purposes
will not result in the recognition of income for Federal income tax
purposes until such time that the Federal income tax realization event
has occurred (e.g., when the taxpayer receives a dividend from the
corporation in which it owns less than a controlling interest or when
the taxpayer receives its allocable share of income, deductions, gains,
and losses on its Schedule K-1 from the partnership).
\829\ However, see further discussion below for taxpayers that
elect under section 1278(b) to have deemed realization of market
discount as it ratably accrues over the number of days the taxpayer
holds the bond.
---------------------------------------------------------------------------
Examples
Example 6.--A taxpayer enters into a three-year contract to
provide consulting services to a customer and receives payment
as such services are provided. The contract also includes a
performance bonus of $4,500 at the end of year three if certain
material conditions and requirements are met. Because the
taxpayer expects, at the time the contract is entered into,
that all necessary conditions and requirements will be met at
the end of the contract in year three, the taxpayer includes
the $4,500 performance bonus in revenues in its financial
statements ratably over the three-year contract, resulting in
$1,500 included in revenue each year. At the end of the three-
year contract, the taxpayer and the customer agree that the
necessary conditions and requirements were met and the taxpayer
receives the $4,500 performance bonus. For Federal income tax
purposes, the performance bonus is not realized until year
three when the necessary material conditions and requirements
for receipt of the performance bonus have been met and the
taxpayer has a fixed and definite right to receive the income.
Accordingly, the taxpayer includes the $4,500 performance bonus
in gross income in year three.
Example 7.--The taxpayer, an insurance agent, is engaged by
an insurance carrier to sell insurance. For each policy sold to
customers, the taxpayer receives a $50 commission from the
insurance carrier at the time of purchase. The taxpayer also
receives an additional $25 commission each time the policy is
renewed. The taxpayer sells 1,000 one-year policies in year
one, of which 800 are renewed in year two and 700 are renewed
in year three. The taxpayer does not have any ongoing
obligation to provide additional services to the insurance
carrier or the customers after the initial sale of the policy.
The taxpayer includes $86,000 in revenue in its financial
statements for year one, which includes $50,000 of fixed
consideration for policies sold in year one and $36,000 of
variable consideration for the policies expected to be renewed
in years two and three.\830\ For Federal income tax purposes,
the commissions related to policy renewals are not realized
until year two and year three as the customers renew the
policies. Accordingly, under the provision, the taxpayer
includes in gross income commissions of $50,000 ($50 * 1,000)
in year one, $20,000 ($25 * 800) in year two, and $17,500 ($25
* 700) in year three.
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\830\ Under ASC 606-10-32-2, a transaction price includes both
fixed and variable consideration. ASC 606-10-32-5 provides that if
consideration promised in a contract includes a variable amount, the
transaction price includes an estimate of the amount of consideration
expected to be received in exchange for transferring the promised goods
or services to a customer. However, such variable consideration may
only be included in the transaction price to the extent that it is
probable that a significant reversal in the amount of cumulative
revenue recognition will not occur when uncertainty associated with the
variable consideration is subsequently resolved. See ASC 606-10-32-11.
For purposes of this example, at the time the contract is entered into
in year one, the taxpayer estimates that the variable consideration to
be received from policy renewals in year two and year three will be
$36,000.
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Interaction with special rules for bonds and other debt instruments
In addition, the provision directs accrual method taxpayers
with an applicable or other specified financial statement to
apply the income recognition rules under section 451 before
applying any income recognition rules applicable under part V
of subchapter P,\831\ which include the OID rules contained in
section 1272 (including the related provisions contained in
sections 1273 through 1275), the election to include market
discount in income as it ratably accrues,\832\ and the stripped
bond rules contained in section 1286 (including the related
provisions in section 1288). Thus, for example, if a taxpayer
has realized interchange fees on credit card loans that the OID
rules would permit the taxpayer to recognize over time, but the
taxpayer has included those fees in revenue for financial
statement purposes when received (e.g., late-payment fees,
cash-advance fees, or interchange fees), this provision
requires the taxpayer to apply the income recognition
principles under section 451 before applying the OID rules.
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\831\ Secs. 1271-1288. The provisions of part V of subchapter P
provide special rules regarding the income realization and income
recognition for bonds and other debt instruments, as well as the timing
of certain related interest deductions.
\832\ See sec. 1278(b).
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However, the provision provides an exception for income in
connection with a mortgage servicing contract.\833\ Thus, under
the provision, income from mortgage servicing rights continues
to be recognized in accordance with the rules for such items of
gross income (i.e., ``normal'' mortgage servicing rights are
included in income upon the earlier of when earned or received
under the all events test of section 451 (i.e., not averaged
over the life of the mortgage),\834\ and ``excess''' mortgage
servicing rights are treated as stripped coupons under section
1286 and therefore subject to the OID rules).\835\
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\833\ Sec. 451(b)(1)(B)(ii).
\834\ See Rev. Rul. 70-142, 1970-2 C.B. 115.
\835\ See Rev. Rul. 91-46, 1991-2 C.B. 358, and Rev. Proc. 91-50,
1991-2 C.B. 778.
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Advance payments
The provision also codifies the one-year deferral method of
accounting for advance payments for goods, services, and other
specified items provided by the IRS under Revenue Procedure
2004-34.\836\ That is, the provision allows accrual method
taxpayers with an applicable or other specified financial
statement to elect \837\ to defer the inclusion of income
associated with certain advance payments to the end of the tax
year following the tax year of receipt if such income also is
deferred for financial statement purposes.\838\ For purposes of
the provision, an advance payment includes any payment received
\839\ during the taxable year (i) the full inclusion of which
in the gross income of the taxpayer for the taxable year of
receipt is a permissible method of accounting under section 451
(determined without regard to the provision), (ii) any portion
of which is included in revenue by the taxpayer in an
applicable or other specified financial statement for a
subsequent taxable year, and (iii) which is for any goods,
services, or such other items as may be identified by the
Secretary.\840\ However, the provision excludes from eligible
advance payments any payments that are received for certain
items.\841\ Thus, the provision is intended to override the
two-year deferral and multiyear deferral methods of accounting
for advance payments received for goods provided by Treasury
Regulation section 1.451-5.
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\836\ 2004-1 C.B. 991, as modified and clarified by Rev. Proc.
2011-18, 2011-5 I.R.B. 443, and Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
\837\ The election shall be made at such time, in such form and
manner, and with respect to such categories of advance payments as the
Secretary may provide. For these purposes, the recognition of income
under such election is treated as a method of accounting. See sec.
451(c)(2).
\838\ Consistent with prior law, an accrual method taxpayer with an
applicable or other specified financial statement may instead include
the amount of the advance payment in gross income in the year of
receipt under the full inclusion method.
\839\ For purposes of the provision, a payment is received by the
taxpayer if it is actually or constructively received, or if it is due
and payable to the taxpayer. See sec. 451(c)(4)(C).
\840\ Sec. 451(c)(4). See sec. 4.01 of Rev. Proc. 2004-34, 2004-1
C.B. 991, as modified and clarified by Rev. Proc. 2011-18, 2011-5
I.R.B. 443, and Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
\841\ Sec. 451(c)(4)(B). Consistent with prior law, the following
payments are excluded from advance payments: rent, insurance premiums
governed by subchapter L, payments with respect to financial
instruments, payments with respect to warranty or guarantee contracts
under which a third party is the primary obligor, payments subject to
section 871(a), 881, 1441, or 1442, payments in property to which
section 83 applies, and any other payment identified by the Secretary.
For prior law, see sec. 4.02 of Rev. Proc. 2004-34, 2004-1 C.B. 991, as
modified and clarified by Rev. Proc. 2011-18, 2011-5 I.R.B. 443, and
Rev. Proc. 2013-29, 2013-33 I.R.B. 141.
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In the case of advance payments received for a combination
of services, goods, or other specified items, the provision
requires the taxpayer to allocate the transaction price in
accordance with the allocation made in the taxpayer's
applicable financial statement.\842\
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\842\ Sec. 451(c)(4)(D). Congress expects that Treasury will
provide guidance regarding whether and how to allocate the transaction
price (i) to performance obligations that are not contractually based
(e.g., the provision of free goods or services to a customer or the
provision of a customary amount of training or support), (ii) for
arrangements that include both income subject to section 451 and long-
term contracts subject to section 460, and (iii) when the income
realization event for Federal income tax purposes differ from the
income realization event for financial statement purposes.
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The provision requires the inclusion of a deferred advance
payment in gross income if the taxpayer ceases to exist.\843\
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\843\ Sec. 451(c)(3).
---------------------------------------------------------------------------
Consistent with prior law and consistent with the methods
of accounting previously followed by taxpayers applying the
full inclusion method or the one-year deferral method in
Revenue Procedure 2004-34, the amount of cost of goods sold
included as a subtraction from total sales is determined in
accordance with the taxpayer's methods of accounting for items
included in cost of goods sold.\844\ An amount may not be taken
into account in the computation of cost of goods sold, and thus
reduce total sales, any earlier than the taxable year in which
economic performance occurs with respect to such amount.\845\
Once economic performance occurs, amounts may only be taken
into account in the computation of cost of goods sold if they
are not required to be capitalized and are not subject to any
other provision of the Code that requires the deduction to be
taken in a taxable year later than the year when economic
performance occurs.\846\ For example, generally taxpayers must
maintain inventories whenever the production, purchase, or sale
of merchandise is an income-producing factor.\847\ In addition,
such merchandise remains in inventory, and is not included in
cost of goods sold, if title thereto is still vested in the
taxpayer.\848\ Section 263A and the regulations thereunder also
require that direct costs and certain indirect costs incurred
by the taxpayer (i.e., costs for which economic performance has
occurred) must be capitalized and included in the basis of
property produced or acquired for resale by the taxpayer with
the capitalized costs recovered by including such amounts in
cost of goods sold when the underlying inventory or property is
sold.\849\
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\844\ Treas. Reg. sec. 1.61-3(a). See, e.g., sections 263A, 461(h),
and 471. See also, e.g., line 2 of Form 1120, Form 1120S, or Form 1065,
or line 4 of Schedule C (Form 1040), as well as Form 1125-A. A
taxpayer's gross profit is generally determined by subtracting returns
and allowances and cost of goods sold from gross receipts or sales. See
line 3 of Form 1120, Form 1120S, or Form 1065, or line 5 of Schedule C
(Form 1040).
\845\ Treas. Reg. secs. 1.61-3(a), 1.263A-1(c)(2)(ii), and 1.446-
1(c)(1)(ii). For a liability that arises out of the provision of
services or property to the taxpayer by another person, economic
performance occurs as the other person provides such services, as the
other person provides such property, or as the taxpayer uses such
property. For a liability that requires the taxpayer to provide
property to others, economic performance occurs as the taxpayer
provides the property to the other person. Sec. 461(h)(2)(A) and (B). A
liability includes any item allowable as a deduction, cost, or expense
for Federal income tax purposes. In addition to allowable deductions,
the term includes any amount otherwise allowable as a capitalized cost,
as a cost taken into account in computing cost of goods sold, as a cost
allocable to a long-term contract, or as any other cost or expense. See
Treas. Reg. secs. 1.446-1(c)(1)(ii)(B) and 1.461-4(c)(1) and T.D. 8408,
1992-1 C.B. 155.
\846\ Conference Report to accompany H.R. 4170, Deficit Reduction
Act of 1984, H.R. Rep. No. 98-861, June 23, 1984, p. 871.
\847\ Sec. 471 and Treas. Reg. sec. 1.471-1.
\848\ Sec. 471 and Treas. Reg. sec. 1.471-1. Whether the
requirement that title be vested in the taxpayer has been met is
generally determined based on whether the taxpayer has the benefits and
burdens of ownership.
\849\ Sec. 263A and Treas. Reg. sec. 1.263A-1(c)(4).
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Examples
Example 8.--Assume the same facts as Example 3, except that
the taxpayer elects to defer advance payments under section
451(c). Under the provision, the taxpayer includes in gross
income $60,000 in year one and $40,000 in year two.
Example 9.--Assume the same facts as Example 5, except that
the taxpayer elects to defer advance payments under section
451(c). Under the provision, the taxpayer does not include any
portion of the advance payment in gross income in year one and,
instead, includes $5,000 in gross income in year two.
Example 10.--A taxpayer enters into a contract with a
customer to build a customized piece of machinery for $50,000.
The taxpayer receives an advance payment of $35,000 in year one
for which it elected to apply a two-year deferral under prior
law. In addition, the taxpayer elects to defer advance payments
under section 451(c). Due to the customized nature of the
machinery, the taxpayer is unable to sell the good to any of
its other customers if the customer defaults or withdraws from
the contract. Under the contract, the taxpayer and the customer
agree that the taxpayer will not invoice the customer for the
remaining $15,000 until the machinery is delivered to the
customer, the customer accepts the machinery, and title to the
machinery has transferred to the customer. However, if the
customer withdraws from the agreement, the contract also
provides that the taxpayer has an enforceable right to payment
as the work is performed, even if the contract is not completed
(for reasons other than a failure to perform by the taxpayer).
The taxpayer begins producing the machinery in year two and the
machinery is delivered to the customer in year three. The
taxpayer invoices the customer and receives payment for the
remaining $15,000 in year three. The taxpayer includes in
revenue in its financial statements $30,000 in year two and
$20,000 in year three.\850\ Under prior law, the taxpayer would
have not included any portion of the $50,000 in gross income in
year one or year two and would have included $50,000 in gross
income in year three.\851\ Under the provision, the taxpayer
defers including the $35,000 advance payment in gross income
from year one to year two. Accordingly, under the provision,
the taxpayer incudes in gross income $35,000 in year two and
$15,000 in year three.
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\850\ Because the taxpayer's performance does not create an asset
with an alternative use to the taxpayer (i.e., the machinery cannot be
sold to other customers) and the taxpayer has an enforceable right to
payment for performance completed to date, the taxpayer recognizes
revenue over time as it satisfies its performance obligation to
manufacture the item of machinery. See ASC 606-10-25-27(c) and 25-28
through 25-29, as well as ASC 606-10-55-8 through 55-15.
\851\ The $50,000 included in gross income for year three includes
(i) the remaining $15,000 included in gross income under the all events
test in year three upon the earlier of when due (i.e., when the
taxpayer invoices the customer), earned (i.e., when the machinery is
delivered to and accepted by the customer), or paid (i.e., when
taxpayer receives payment) plus (ii) the $35,000 advance payment
deferred from year one and included in gross income for year three
under the two-year deferral method of Treas. Reg. sec. 1.451-5. At the
time prior law was in effect, ASC 606, Revenue from Contracts with
Customers, was not yet applicable to financial statements. Under the
accounting standards previously in effect, the taxpayer would have
included the $50,000 in revenue in its financial statements entirely in
year three; thus, allowing the taxpayer to defer the $35,000 advance
payment to year three under the two-year deferral method of Treas. Reg.
sec. 1.451-5.
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Example 11.--A taxpayer enters into a contract with a
customer to manufacture 500 widgets at a price of $10 each.
Taxpayer receives a prepayment of $5,000 from the customer in
year one for which it elected to apply a two-year deferral
under prior law. In addition, the taxpayer elects to defer
advance payments under section 451(c). Taxpayer manufactures
the widgets during year two and year three and the widgets are
delivered to the customer during year three. The taxpayer does
not include any portion of the advance payment in revenue in
its financial statements in year one or year two and, instead,
includes the $5,000 in revenue in its financial statements in
year three.\852\ Under prior law, the taxpayer would have not
have included any portion of the advance payment in gross
income for year one or year two and, instead, would have
included the entire amount in gross income in year three.\853\
Under the provision, the taxpayer defers including the $5,000
advance payment in gross income from year one to year two.
Accordingly, under the provision, the taxpayer includes the
$5,000 advance payment in gross income in year two.
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\852\ Because the taxpayer's performance obligation is satisfied at
a point in time (i.e., at the time control of the widgets is
transferred to the customer), the taxpayer recognizes revenue at such
point in time. See ASC 606-10-25-23 and 25-30.
\853\ At the time prior law was in effect, ASC 606, Revenue from
Contracts with Customers, was not yet applicable to financial
statements. Under the accounting standards previously in effect, the
taxpayer would have included the $5,000 in revenue in its financial
statements entirely in year three, which allowed the taxpayer to defer
the $5,000 advance payment to year three under the two-year deferral
method of Treas. Reg. sec. 1.451-5.
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Taxpayers without an applicable financial statement
These provisions do not apply to taxpayers that do not have
an applicable or other specified financial statement. Accrual
method taxpayers without an applicable or other specified
financial statement continue to determine the timing for when
sales, gross receipts, and other income are included in gross
income under the all events test (i.e., upon the earlier of
when (i) payment is earned through performance, (ii) payment is
due to the taxpayer, or (iii) payment is received by the
taxpayer),\854\ unless an exception permits deferral or a
special method of accounting applies. In addition, such
taxpayers generally may continue to defer advance payments for
goods, services, and other items using a permissible method of
deferral.\855\
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\854\ See Rev. Rul. 2003-10, 2003-1 C.B. 288.
\855\ As of the date of enactment, taxpayers without an applicable
or other specified financial statement could continue to defer advance
payments using either the one-year, two-year, or multiyear deferral
methods (if the taxpayer is otherwise eligible to use such methods and
to the extent that such methods are consistent with the Code and
subsequent published guidance issued by the Treasury Department).
Consistent with prior law, the related liabilities to provide goods,
services, or other items to customers in exchange for the advance
payments received by the taxpayer are included as an item of gross
income (i.e., as a cost of goods sold adjustment) or as a deduction
taken into account in determining the taxpayer's taxable income in
accordance with the taxpayer's methods of accounting for such items.
See, e.g., secs. 263A, 461(h), and 471. See also Treas. Reg. secs.
1.61-3(a) and 1.446-1(c)(1)(ii)(A).
The Treasury Department has issued published guidance
addressing this provision.\856\
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\856\ REG-104872-18, 83 Fed. Reg. 51904, October 15, 2018; Notice
2018-35, 2018-18 I.R.B. 520, April 30, 2018; Notice 2018-80, 2018-42
I.R.B. 609, October 15, 2018; and Rev. Proc. 2018-60, available at
https://www.irs.gov/pub/irs-drop/rp-18-60.pdf.
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Effective Date
The provision generally applies to taxable years beginning
after December 31, 2017, and the application of these rules is
a change in the taxpayer's method of accounting for purposes of
section 481. In the case of any taxpayer required by this
provision to change its method of accounting for its first
taxable year beginning after December 31, 2017, such change is
treated as initiated by the taxpayer and made with the consent
of the Secretary.
In the case of income from a debt instrument having OID,
the provision applies to taxable years beginning after December
31, 2018, and the related section 481(a) adjustment is taken
into account over six taxable years.
PART IV--BUSINESS-RELATED EXCLUSIONS AND DEDUCTIONS
A. Limitation on Deduction for Interest (sec. 13301 of the Act and sec.
163(j) of the Code)
Prior Law
Interest deduction
Interest paid or accrued by a business generally is
deductible in the computation of taxable income subject to a
number of limitations.\857\
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\857\ Sec. 163(a). In addition to the limitations discussed herein,
other limitations include: denial of the deduction for the disqualified
portion of the original issue discount on an applicable high yield
discount obligation (sec. 163(e)(5)), denial of deduction for interest
on certain obligations not in registered form (sec. 163(f)), reduction
of the deduction for interest on indebtedness with respect to which a
mortgage credit certificate has been issued under section 25 (sec.
163(g)), disallowance of deduction for personal interest (sec. 163(h)),
disallowance of deduction for interest on debt with respect to certain
life insurance contracts (sec. 264), and disallowance of deduction for
interest relating to tax-exempt income (sec. 265). Interest may also be
subject to capitalization. See, e.g., sections 263A(f) and 461(g).
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Interest is generally deducted by a taxpayer as it is paid
or accrued, depending on the taxpayer's method of accounting.
For all taxpayers, if an obligation is issued with original
issue discount (``OID''), a deduction for interest is allowable
over the life of the obligation on a yield to maturity
basis.\858\ Generally, OID arises where interest on a debt
instrument is not calculated based on a qualified rate and
required to be paid at least annually.
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\858\ Sec. 163(e). But see section 267 (dealing in part with
interest paid to a related or foreign party).
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Investment interest expense
In the case of a taxpayer other than a corporation, the
deduction for interest on indebtedness that is allocable to
property held for investment (``investment interest'') is
limited to the taxpayer's net investment income for the taxable
year.\859\ Disallowed investment interest is carried forward to
the next taxable year.
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\859\ Sec. 163(d).
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Net investment income is investment income net of
investment expenses. Investment income generally consists of
gross income from property held for investment, and investment
expense includes all deductions directly connected with the
production of investment income (e.g., deductions for
investment management fees) other than deductions for interest.
The two-percent floor on miscellaneous itemized deductions
allows taxpayers to deduct investment expenses connected with
investment income only to the extent such deductions exceed two
percent of the taxpayer's adjusted gross income.\860\
Miscellaneous itemized deductions \861\ that are not investment
expenses are disallowed first before any investment expenses
are disallowed.\862\
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\860\ Sec. 67(a). For a discussion of changes made to the deduction
of miscellaneous itemized deductions by the Act, see the description of
section 11045 of the Act (Suspension of Miscellaneous Itemized
Deductions).
\861\ Miscellaneous itemized deductions include itemized deductions
of individuals other than certain specific itemized deductions. Sec.
67(b). Miscellaneous itemized deductions generally include, for
example, investment management fees and certain employee business
expenses, but specifically do not include, for example, interest,
taxes, casualty and theft losses, charitable contributions, medical
expenses, or other listed itemized deductions.
\862\ H.R. Rep. No. 841, 99th Cong., 2d Sess., p. II-154, Sept. 18,
1986 (Conf. Rep.) (``In computing the amount of expenses that exceed
the 2-percent floor, expenses that are not investment expenses are
intended to be disallowed before any investment expenses are
disallowed.'').
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Earnings stripping
Section 163(j) may disallow a deduction for disqualified
interest paid or accrued by a corporation in a taxable year if
two threshold tests are satisfied: (1) the payor's debt-to-
equity ratio exceeds 1.5 to 1.0, and (2) the payor's net
interest expense exceeds the sum of 50 percent of its adjusted
taxable income (generally, taxable income computed without
regard to deductions for net interest expense, net operating
losses, domestic production activities under section 199,
depreciation, amortization, and depletion) plus any excess
limitation carryforward (defined below).\863\ Disqualified
interest includes interest paid or accrued to: (1) related
parties when no Federal income tax is imposed with respect to
such interest; \864\ (2) unrelated parties in certain instances
in which a related party guarantees the debt; and (3) a real
estate investment trust (``REIT'') by a taxable REIT subsidiary
of that trust.\865\ The amount disallowed may not exceed the
amount by which the corporation's net interest expense exceeds
50 percent of the corporation's adjusted taxable income.\866\
Interest amounts disallowed under these rules can be carried
forward indefinitely.\867\ In addition, any excess limitation
(i.e., the excess, if any, of 50 percent of the adjusted
taxable income of the payor over the payor's net interest
expense) can be carried forward three years (the ``excess
limitation carryforward'').\868\
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\863\ Secs. 163(j)(2)(A), (2)(B) and (6)(A). For a brief
description of the legislative background of section 163(j), see Joint
Committee on Taxation, Present Law and Background Relating to Tax
Treatment of Business Debt (JCS-41-11), July 11, 2011, pp. 21-23.
\864\ If a tax treaty reduces the rate of tax on interest paid or
accrued by the taxpayer, the interest is treated as interest on which
no Federal income tax is imposed to the extent of the same proportion
of such interest as the rate of tax imposed without regard to the
treaty, reduced by the rate of tax imposed by the treaty, bears to the
rate of tax imposed without regard to the treaty. Sec. 163(j)(5)(B).
\865\ Sec. 163(j)(3).
\866\ Sec. 163(j)(1)(A).
\867\ Sec. 163(j)(1)(B).
\868\ Sec. 163(j)(2)(B)(ii).
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Explanation of Provision
In general
In the case of any taxpayer for any taxable year, the
deduction for business interest is limited to the sum of (1)
business interest income of the taxpayer for the taxable year,
(2) 30 percent of the adjusted taxable income of the taxpayer
for the taxable year (not less than zero), and (3) the floor
plan financing interest of the taxpayer for the taxable year.
The amount of any business interest not allowed as a deduction
for any taxable year may be carried forward indefinitely. The
limitation applies at the taxpayer level (but see a special
carryforward rule for partnerships, described below). In the
case of a group of affiliated corporations that file a
consolidated return, the limitation applies at the consolidated
tax return filing level.
Business interest means any interest paid or accrued on
indebtedness properly allocable to a trade or business. Any
amount treated as interest for purposes of the Code is interest
for purposes of the provision. Business interest income means
the amount of interest includible in the gross income of the
taxpayer for the taxable year which is properly allocable to a
trade or business. Business interest does not include
investment interest, and business interest income does not
include investment income, within the meaning of section
163(d).\869\
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\869\ Section 163(d) applies in the case of a taxpayer other than a
corporation; a corporation has neither investment interest nor
investment income within the meaning of section 163(d). Thus, interest
income and interest expense of a corporation is properly allocable to a
trade or business, unless such trade or business is otherwise
explicitly excluded from the application of the provision. For example,
in the case of an insurance company that for regulatory (i.e.,
statutory accounting) purposes has both underwriting income and expense
and investment interest income and expense, any interest income is
business interest income and any interest expense is business interest
for purposes of section 163(j).
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Adjusted taxable income means the taxable income of the
taxpayer computed without regard to: (1) any item of income,
gain, deduction, or loss that is not properly allocable to a
trade or business; (2) any business interest or business
interest income; (3) the amount of any net operating loss
deduction; and (4) the amount of any deduction allowed under
section 199A.\870\ Additionally, for taxable years beginning
after December 31, 2017 and before January 1, 2022, adjusted
taxable income is computed without regard to any deduction
allowable for depreciation, amortization, or depletion.\871\
For taxable years beginning after December 31, 2021, adjusted
taxable income is computed with regard to deductions allowable
for depreciation, amortization, or depletion. The Secretary may
provide for other adjustments to the computation of adjusted
taxable income.
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\870\ For a discussion of section 199A, see the description of
section 11011 of the Act (Deduction for Qualified Business Income) and
the Appendix.
\871\ Any deduction allowable for depreciation, amortization, or
depletion includes any deduction allowable for any amount treated as
depreciation, amortization, or depletion.
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Floor plan financing interest means interest paid or
accrued on floor plan financing indebtedness. Floor plan
financing indebtedness means indebtedness used to finance the
acquisition of motor vehicles held for sale or lease to retail
customers and secured by the inventory so acquired.\872\ A
motor vehicle means a motor vehicle that is: (1) any self-
propelled vehicle designed for transporting person or property
on a public street, highway, or road; (2) a boat; or (3) farm
machinery or equipment.
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\872\ Property that is held exclusively for lease is not inventory,
but rather property used in a trade or business under section
1221(a)(2). Property simultaneously held for sale or lease is treated
as inventory until such time as it first becomes leased, at which point
it is no longer treated as inventory. See, e.g., Notice 2013-13, 2013-
12 I.R.B. 659, March 18, 2013.
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By including business interest income and floor plan
financing interest in the limitation, the rule operates to
allow (1) business interest up to the amount of business
interest income and (2) floor plan financing interest to be
fully deductible. That is, a deduction for business interest is
permitted to the full extent of business interest income and
any floor plan financing interest.\873\ The deduction for any
remaining business interest is limited to 30 percent of
adjusted taxable income.
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\873\ Note, however, that if the taxpayer takes floor plan
financing interest into account to increase the taxpayer's interest
limitation under section 163(j) for a taxable year, property placed in
service by the taxpayer during such year and subsequent taxable years
is not eligible for the additional first-year depreciation deduction
under section 168(k), as modified by the Act. For a discussion of
changes made to section 168(k) by the Act, including an example of the
interaction of sections 168(k) and 163(j) with regard to taxpayers with
floor plan financing interest, see the description of section 13201 of
the Act (Temporary 100-Percent Expensing for Certain Business Assets).
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It is generally intended that, similar to prior law,
section 163(j) apply after the application of provisions that
subject interest to deferral, capitalization, or other
limitation. Thus, as with prior-law section 163(j), the
provision applies to interest deductions that are deferred, for
example under section 163(e) or section 267(a)(3)(B), in the
taxable year to which such deductions are deferred.\874\ Also
as with prior-law section 163(j), the provision applies after
section 263A is applied to capitalize interest \875\ and after,
for example, section 265 or section 279 is applied to disallow
any interest deduction.\876\ However, the provision applies
before the application of sections 465 and 469 (again, similar
to prior-law section 163(j)(7)).
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\874\ See, e.g., Prop. Treas. Reg. sec. 1.163(j)-7(b)(2) under
prior section 163(j).
\875\ See, e.g., Treas. Reg. sec. 1.263A-9(g)(1)(i).
\876\ See, e.g., Prop. Treas. Reg. sec. 1.163(j)-7(b)(1) under
prior section 163(j).
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Carryforward of disallowed business interest
The amount of any business interest not allowed as a
deduction for any taxable year is treated as business interest
paid or accrued in the succeeding taxable year. Business
interest may be carried forward indefinitely. The provision
contains rules (described below) intended to prevent
trafficking in carryforwards, and it is intended that the
provision be administered consistent with that intent.
With respect to corporations, any carryforward of
disallowed business interest of the corporation is an item
taken into account in the case of certain corporate
acquisitions described in section 381 and is subject to
limitation under section 382.
Application to passthrough entities \877\
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\877\ Technical corrections may be necessary to achieve the
provision's application to passthrough entities as described herein.
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In general
In the case of any partnership, the limitation is applied
at the partnership level. To prevent double counting, there are
special rules for the determination of the business interest
income and adjusted taxable income of each partner of the
partnership. Similarly, to allow for additional interest
deduction by a partner in the case of an excess amount of
either business interest income of the partnership or adjusted
taxable income of the partnership, special rules apply. Similar
rules apply with respect to any S corporation and its
shareholders. Additionally, there is a special rule for
carryforward of disallowed partnership interest that applies
only to partnerships.
Double counting rule
The business interest income and adjusted taxable income of
each partner (or shareholder, as the case may be) is determined
without regard to such partner's distributive share of any
items of income, gain, deduction, or loss of the partnership.
In the absence of such rules, items of business interest income
or adjusted taxable income of a partnership might be viewed as
generating additional interest deductions as the items are
passed through to the partners.
Example 1.--ABC is a partnership owned 50-50 by XYZ
Corporation and an individual. ABC generates $200 of
noninterest income. Its only expense is $60 of business
interest. Under the provision the deduction for business
interest is limited to 30 percent of adjusted taxable income,
that is, 30 percent * $200 = $60. ABC deducts $60 of business
interest and reports ordinary business income of $140. XYZ
Corporation's distributive share of the ordinary business
income of ABC is $70. XYZ Corporation has net taxable income of
zero from its other operations, none of which is attributable
to business interest income, and without regard to its business
interest. XYZ Corporation has business interest of $25. In the
absence of any special rule, the $70 of taxable income from its
interest in ABC might permit the deduction of up to an
additional $21 of interest (30 percent * $70 = $21), resulting
in a deduction disallowance of $4. That is, XYZ Corporation's
$100 share of ABC's adjusted taxable income would generate $51
of interest deductions (i.e., XYZ Corporation's $30 share of
ABC's interest deduction plus XYZ Corporation's interest
deduction of $21). If XYZ Corporation were instead a
passthrough entity, additional deductions might be available at
each tier.
The double counting rule provides that XYZ Corporation has
adjusted taxable income computed without regard to the $70
distributive share of the income of ABC. As a result, XYZ
Corporation has adjusted taxable income of $0. XYZ
Corporation's deduction for business interest is limited to 30
percent * $0 = $0, resulting in a deduction disallowance of
$25.
Additional deduction limit
For purposes of determining the allowable interest
deduction of a partner in a partnership, the partner's business
interest deduction limitation calculated under the provision is
increased to reflect the partner's distributive share of any
business interest income or adjusted taxable income of the
partnership that was not used to generate a business interest
deduction at the partnership level. Specifically, in the
absence of disallowed business interest attributable to the
partnership (see discussion of the partnership carryforward
rule, below), the partner's business interest deduction
limitation is increased by the sum of the partner's
distributive share of the partnership's excess business
interest income and 30 percent of the partnership's excess
taxable income. Excess business interest income with respect to
any partnership is the excess of the business interest income
of the partnership over the business interest, reduced by floor
plan financing interest,\878\ of the partnership. Excess
taxable income with respect to any partnership is the amount
which bears the same ratio to the partnership's adjusted
taxable income as (1) the excess (if any) of (a) 30 percent of
the adjusted taxable income of the partnership over (b) the
amount (if any) by which the business interest of the
partnership, reduced by floor plan financing interest,\879\
exceeds the business interest income of the partnership bears
to (2) 30 percent of the adjusted taxable income of the
partnership. These rules allow a partner of a partnership to
deduct additional business interest that the partner may have
paid or incurred to the extent the partnership could have
deducted more business interest.
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\878\ To the extent the partnership takes floor plan financing
interest into account to increase the amount of interest permitted to
be deducted under section 163(j)(1).
\879\ Again, to the extent the partnership takes floor plan
financing interest into account to increase the amount of interest
permitted to be deducted under section 163(j)(1).
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Example 2.--The facts are the same as in Example 1 except
ABC has only $40 of business interest. As in Example 1, ABC has
a limit on its business interest deduction of $60. The excess
taxable income for ABC is $66.67 ($20/$60 * $200). XYZ
Corporation's distributive share of the excess taxable income
from ABC is $33.33. XYZ Corporation's deduction for business
interest is limited to 30 percent of its adjusted taxable
income plus its distributive share of the excess taxable income
from ABC (30 percent * ($0 + $33.33) = $10). As a result of the
excess taxable income, XYZ Corporation may deduct $10 of
business interest and has a business interest deduction
disallowance of $15 ($25-$10).
Carryforward rule
In the case of a partnership, the general entity-level
carryforward rule does not apply. Instead, any business
interest that is not allowed as a deduction to the partnership
for the taxable year (referred to as ``disallowed business
interest'') is allocated to the partners. Each partner may
deduct its share of the partnership's disallowed business
interest in any future year, but only to the extent of the
partner's distributive share of excess business interest income
and 30 percent of the partner's distributive share of excess
taxable income of the partnership the activities of which gave
rise to the disallowed business interest carryforward. Any
amount that is not allowed as a deduction is carried forward.
For example, if a partner's disallowed business interest from a
prior year of Partnership X is $100, and in the current year
the partner is allocated $100 of excess taxable income and $10
of excess business interest income from X and has $200 of
adjusted taxable income from other sources, the partner may
only deduct $40 of the disallowed business interest in the
current year ($10 excess business interest income + (30 percent
* $100 excess taxable income)). The remaining $60 of disallowed
business interest is carried forward to the subsequent year. To
prevent double counting, any deduction by the partner of
disallowed business interest requires a corresponding reduction
in the partner's distributive share of current-year excess
business interest income and excess taxable income used to
determine the partner's current-year interest limitation.
Additionally, when disallowed business interest is
allocated to a partner, the partner's basis in its partnership
interest is reduced (but not below zero) by the amount of such
allocation, even though the carryforward does not give rise to
a partner deduction in the year of the basis reduction.
However, the partner's deduction in a subsequent year for
disallowed business interest does not reduce the partner's
basis in its partnership interest. In the event the partner
disposes of a partnership interest the basis of which has been
so reduced, the partner's basis in such interest shall be
increased, immediately before such disposition, by the amount
that any such basis reductions exceed any amount of disallowed
business interest that has been deducted by the partner against
excess business interest income or excess taxable income of the
same partnership.\880\
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\880\ The special rule for dispositions also applies to transfers
of a partnership interest (including by reason of death) in
transactions in which gain is not recognized in whole or in part. No
deduction is allowed to the transferor or transferee for any disallowed
business interest resulting in a basis increase under this rule.
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This special carryforward rule does not apply to S
corporations and their shareholders.
Exceptions
The limitation does not apply to any taxpayer (other than a
tax shelter prohibited from using the cash method under section
448(a)(3)) that meets the $25 million gross receipts test of
section 448(c) (i.e., if the average annual gross receipts for
the three-taxable-year period ending with the prior taxable
year does not exceed $25 million).\881\ Aggregation rules apply
to determine the amount of a taxpayer's gross receipts under
the $25 million gross receipts test.
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\881\ In the case of a sole proprietorship, the $25 million gross
receipts test is applied as if the sole proprietorship were a
corporation or partnership. For a discussion of changes made to section
448 by the Act, see the description of section 13102 of the Act (Small
Business Accounting Method Reform and Simplification).
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The trade or business of performing services as an employee
is not treated as a trade or business for purposes of the
limitation.\882\ As a result, for example, the wages of an
employee are not counted in the adjusted taxable income of the
taxpayer for purposes of determining the limitation.
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\882\ The trade or business of performing services as an employee
is also mentioned in section 62(a)(1), among other places, and has the
same meaning here as there.
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At the taxpayer's election, any real property development,
redevelopment, construction, reconstruction, acquisition,
conversion, rental, operation, management, leasing, or
brokerage trade or business (i.e., any electing real property
trade or business) is not treated as a trade or business for
purposes of the limitation, and therefore the limitation does
not apply to such trades or businesses.\883\ Similarly, at the
taxpayer's election, any farming business \884\ or any business
engaged in the trade or business of a specified agricultural or
horticultural cooperative,\885\ is not treated as a trade or
business for purposes of the limitation, and therefore the
limitation does not apply to any such trade or business.\886\
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\883\ Congress intends that any such real property trade or
business, including such a trade or business conducted by a corporation
or REIT, be included. Because this description of a real property trade
or business refers only to the section 469(c)(7)(C) description, and
not to other rules of section 469 (such as the rule of section
469(c)(2) that passive activities include rental activities or the rule
of section 469(a) that a passive activity loss is limited under section
469), the other rules of section 469 are not made applicable by this
reference. It is further intended that a real property operation or a
real property management trade or business includes the operation or
management of a lodging facility, including a lodging facility that
provides some supplemental services, such as an assisted living
facility. In addition, an electing real property trade or business is
required to use the alternative depreciation system (``ADS'') to
depreciate any of its nonresidential real property, residential rental
property, qualified improvement property, qualified leasehold
improvement property, qualified retail improvement property, and
qualified restaurant property. See the description of section 13204 of
the Act (Applicable Recovery Period for Real Property).
\884\ As defined in section 263A(e)(4) (i.e., farming business
means the trade or business of farming and includes the trade or
business of operating a nursery or sod farm, or the raising or
harvesting of trees bearing fruit, nuts, or other crops, or ornamental
trees (other than evergreen trees that are more than six years old at
the time they are severed from their roots)). Treas. Reg. sec. 1.263A-
4(a)(4) further defines a farming business as a trade or business
involving the cultivation of land or the raising or harvesting of any
agricultural or horticultural commodity. Examples of a farming business
include the trade or business of operating a nursery or sod farm; the
raising or harvesting of trees bearing fruit, nuts, or other crops; the
raising of ornamental trees (other than evergreen trees that are more
than six years old at the time they are severed from their roots); and
the raising, shearing, feeding, caring for, training, and management of
animals. A farming business also includes processing activities that
are normally incident to the growing, raising, or harvesting of
agricultural or horticultural products. See Treas. Reg. sec. 1.263A-
4(a)(4)(i) and (ii). A farming business does not include contract
harvesting of an agricultural or horticultural commodity grown or
raised by another taxpayer, or merely buying and reselling plants or
animals grown or raised by another taxpayer. See Treas. Reg. sec.
1.263A-4(a)(4)(i).
\885\ As defined in section 199A(g)(4).
\886\ An electing farming business is required to use ADS to
depreciate any property with a recovery period of 10 years or more. See
the description of section 13205 of the Act (Use of Alternative
Depreciation System for Electing Farming Businesses).
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The limitation does not apply to certain regulated public
utilities. Specifically, the trade or business of the
furnishing or sale of (1) electrical energy, water, or sewage
disposal services, (2) gas or steam through a local
distribution system, or (3) transportation of gas or steam by
pipeline, if the rates for such furnishing or sale, as the case
may be, have been established or approved by a State \887\ or
political subdivision thereof, by any agency or instrumentality
of the United States, by a public service or public utility
commission or other similar body of any State or political
subdivision thereof, or by the governing or ratemaking body of
an electric cooperative is not treated as a trade or business
for purposes of the limitation, and thus any interest paid or
accrued on indebtedness properly allocable to such trades or
businesses is not business interest.\888\
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\887\ The term ``State'' includes the District of Columbia. See
sec. 7701(a)(10) (``The term `State' shall be construed to include the
District of Columbia where such construction is necessary to carry out
provisions of this title'').
\888\ Note, however, that any property primarily used by a
regulated public utility trade or business with a depreciable interest
in the property is not eligible for the additional first-year
depreciation deduction by such utility business under section 168(k),
as modified by the Act. For a discussion of changes made to section
168(k) by the Act, see the description of section 13201 of the Act
(Temporary 100-Percent Expensing for Certain Business Assets).
The Treasury Department and IRS have issued published
guidance addressing this provision.\889\
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\889\ REG-106089-18, November 26, 2018, available at https://
www.irs.gov/pub/irs-drop/REG-106089-18-NPRM.pdf; Rev. Proc. 2018-59,
2018-50 I.R.B. (Nov. 26, 2018); Notice 2018-28, 2018-16 IRB 492 (Apr.
2, 2018).
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017. Congress intends that taxpayers with
disqualified interest disallowed under prior-law section
163(j)(1)(A) for the last taxable year beginning before January
1, 2018, may carry such interest forward as business interest
to the taxpayer's first taxable year beginning after December
31, 2017, and that such business interest carried forward will
be subject to potential disallowance under the provision in the
same manner as any other business interest otherwise paid or
accrued in a taxable year beginning after December 31, 2017.
B. Modification of Net Operating Loss Deduction (sec. 13302 of the Act
and sec. 172 of the Code)
Prior Law
A net operating loss (``NOL'') generally means the amount
by which a taxpayer's business deductions exceed its gross
income.\890\ In general, an NOL may be carried back two taxable
years and carried over 20 taxable years to offset taxable
income in such years (referred to as the ``NOL
deduction'').\891\ NOLs offset taxable income in the order of
the taxable years to which the NOL may be carried.\892\
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\890\ Sec. 172(c).
\891\ Sec. 172(b)(1)(A).
\892\ Sec. 172(b)(2). The amount of the NOL which may be carried to
a taxable year is reduced by the taxable income for prior taxable years
to which the NOL may be carried.
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Different carryback periods apply with respect to NOLs
arising in different circumstances. Extended carryback periods
are allowed for NOLs attributable to specified liability
losses, certain casualty and disaster losses, and farming
losses.\893\ The carryback of excess interest losses
attributable to corporate equity reduction transactions is
limited.\894\ Special rules prohibit carrybacks to or from any
taxable year in which a taxpayer is a real estate investment
trust (a ``REIT'').\895\
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\893\ Sec. 172(b)(1)(C) (10-year carryback for specified liability
losses), (E) (three-year carryback for individual casualty losses,
small business disaster losses, and farming disaster losses), and (F)
(five-year carryback for farming losses).
\894\ Sec. 172(b)(1)(D).
\895\ Sec. 172(b)(1)(B).
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For purposes of the alternative minimum tax, a taxpayer's
NOL deduction generally is limited to 90 percent of alternative
minimum taxable income (determined without regard to the NOL
deduction).\896\
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\896\ Secs. 55 and 56(a)(4) and (d). For a description of the
alternative minimum tax, see the description of sections 12001-12003 of
the Act (Alternative Minimum Tax).
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Explanation of Provision
The provision makes a number of changes with respect to
losses arising in taxable years beginning after December 31,
2017.\897\ First, the provision limits the NOL deduction to 80
percent of taxable income (determined without regard to the NOL
deduction).\898\ Carryovers of such NOLs to other years are
adjusted to take account of this limitation, and may be carried
over indefinitely.
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\897\ In calculating the amount of the NOL arising in a taxable
year, certain deductions are excluded. For example, deductions under
sections 199A and 250 are not allowed. For a description of section
199A, see the description of section 11011 of the Act (Deduction for
Qualified Business Income). For a description of section 250, see the
description of section 14202 of the Act (Deduction for Foreign-Derived
Intangible Income and Global Intangible Low-Taxed Income).
\898\ For this purpose, a REIT is subject to a limit based on 80
percent of its real estate investment trust taxable income (as defined
in section 857(b)(2) but without regard to the deduction for dividends
paid (as defined in section 561). See sec. 172(d)(6)(C).
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In addition, the provision \899\ repeals the two-year
carryback \900\ and the special carryback provisions for
specified liability losses, individual casualty losses, and
small business and farming disaster losses.\901\ In the case of
certain farming losses, the provision shortens the carryback
period from five years to two years.\902\ Finally, a special
rule provides a two-year carryback and 20-year carryover for
NOLs of a property and casualty insurance company (i.e., an
insurance company (as defined in section 816(a)) other than a
life insurance company). Further, the 80-percent limitation
does not apply to the NOLs of such insurance companies.
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\899\ A technical correction may be necessary to reflect that the
changes to carryovers and carrybacks apply to losses arising in taxable
years beginning after December 31, 2017.
\900\ In light of the general repeal of the two-year carryback, the
special rules limiting carrybacks for REITs are repealed.
\901\ Thus, specified liability losses are no longer eligible for a
10-year carryback, and certain individual casualty losses, as well as
small business and farming disaster losses, are no longer eligible for
a three-year carryback under section 172. Under section 165(i),
however, a taxpayer may elect to take certain disaster losses into
account for the taxable year immediately preceding the taxable year in
which the disaster occurred.
\902\ For this purpose, the term ``farming loss'' means the lesser
of (1) the amount which would be the NOL for the taxable year if only
income and deductions attributable to farming businesses (as defined in
section 263A(e)(4)) are taken into account, or (2) the amount of the
NOL for such taxable year. For any loss year, a farming business may
irrevocably elect out of the two-year carryback. Such election must be
made in the manner as prescribed by the Secretary by the due date
(including extensions) of the taxpayer's return for the taxable year of
the NOL.
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NOLs arising in taxable years beginning before January 1,
2018, remain subject to prior law. Accordingly, such NOLs are
not subject to the 80-percent limitation, and remain subject to
the 20-year carryover limitation and to the prior-law carryback
rules.
A taxpayer with NOL carryovers to a taxable year from both
taxable years beginning before 2018 (``pre-2018 NOL
carryovers'') and taxable years beginning after 2017 (``post-
2017 NOL carryovers'') computes its tax liability as follows.
First, the taxpayer is entitled to an NOL deduction in the
amount of its pre-2018 NOL carryovers without limitation.
Second, the taxpayer is entitled to an additional NOL deduction
equal to the lesser of (1) its post-2017 NOL carryovers, or (2)
80 percent of the excess (if any) of the taxpayer's taxable
income (before any NOL deduction attributable to post-2017 NOL
carryovers) over the NOL deduction attributable to pre-2018 NOL
carryovers.\903\
---------------------------------------------------------------------------
\903\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
Examples
Example 1.--The following example illustrates the rules for
carryovers of pre-2018 NOLs and post-2017 NOLs.
Suppose a taxpayer (a calendar-year corporation) has $120
of pre-2018 NOL carryovers and $70 of post-2017 NOL carryovers
to 2019. In 2019, the taxpayer has $100 of taxable income
(before any NOL deduction). The taxpayer is entitled to an NOL
deduction equal to the sum of (i) its pre-2018 NOL carryovers
and (ii) the lesser of its post-2017 carryovers or 80 percent
of its taxable income in 2019 (determined without regard to the
NOL deduction attributable to post-2017 NOL carryovers). In
this case, the taxpayer's pre-2018 NOL carryovers ($120) exceed
its pre-NOL taxable income ($100), so the taxpayer is entitled
to an NOL deduction fully offsetting its taxable income. The
taxpayer will have $20 \904\ of pre-2018 NOL carryovers and $70
of post-2017 NOL carryovers to 2020.
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\904\ $20 is the excess of the $120 of pre-2018 NOL carryovers to
2019 over $100 taxable income for 2019 as computed under section
172(b)(2).
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Suppose, in 2020, the taxpayer again has $100 of taxable
income (before any NOL deduction). The taxpayer is entitled to
an NOL deduction equal to the sum of (i) its pre-2018 NOL
carryovers and (ii) the lesser of its post-2017 carryovers or
80 percent of its taxable income in 2020 (determined without
regard to the NOL deduction attributable to post-2017 NOL
carryovers). In this case, the taxpayer's NOL deduction is $20
plus the lesser of $70 or 80 percent of the taxpayer's taxable
income (before any NOL deduction attributable to post-2017 NOL
carryovers). In this case, 80 percent of taxable income
computed without regard to post-2017 NOL carryovers is $64 (80
percent of $80 ($100 taxable income less the NOL deduction of
$20 attributable to pre-2018 NOL carryovers)). Thus, for 2020,
the taxpayer is entitled to an NOL deduction of $84 ($20 plus
$64). The taxpayer will have $6 ($70 less $64) of post-2017 NOL
carryovers to 2021.
Example 2.--The following example illustrates the
interaction of the 80-percent limitation and the two-year
carryback of certain farming losses.
Suppose, in 2018, a calendar-year taxpayer has a $300
farming loss. The taxpayer has no other NOLs and is not limited
by section 461(l).\905\ Because the provision allows a special
two-year carryback in the case of certain farming losses, the
taxpayer may carry back the farming loss to 2016 or 2017.
However, the NOL deduction for such carryback year will be
limited to 80 percent of taxable income (determined without
regard to the NOL deduction) for such taxable year. If the
taxpayer had $100 of taxable income in 2016 and $200 of taxable
income in 2017 (both without regard to any NOL deduction), the
taxpayer is entitled to an $80 NOL deduction in 2016 (80
percent of $100) and a $160 NOL deduction in 2017 (80 percent
of $200). The taxpayer will have $60 of post-2017 NOL
carryovers to 2019 (i.e., the $300 2018 NOL less (1) the $80
2016 NOL carryback and (2) the $160 2017 NOL carryback).
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\905\ For a discussion of section 461(l), see the description of
section 11012 of the Act (Limitation on Losses for Taxpayers Other Than
Corporations).
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Effective Date
The provision limiting the NOL deduction applies to losses
arising in taxable years beginning after December 31, 2017.
The provision allowing indefinite carryovers and modifying
carrybacks applies to losses arising in taxable years beginning
\906\ after December 31, 2017.
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\906\ A technical correction may be necessary to reflect this
intent.
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C. Like-Kind Exchanges of Real Property (sec. 13303 of the Act and sec.
1031 of the Code)
Prior Law
An exchange of property, like a sale, generally is a
taxable event. However, no gain or loss is recognized if
property held for productive use in a trade or business or for
investment is exchanged for property of a ``like kind'' which
is to be held for productive use in a trade or business or for
investment.\907\ In general, section 1031 does not apply to any
exchange of stock in trade (i.e., inventory) or other property
held primarily for sale; stocks, bonds, or notes; other
securities or evidences of indebtedness or interest; interests
in a partnership; certificates of trust or beneficial
interests; or choses in action.\908\ Section 1031 also does not
apply to certain exchanges involving livestock \909\ or foreign
property.\910\
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\907\ Sec. 1031(a)(1).
\908\ Sec. 1031(a)(2). A chose in action is a right that can be
enforced by legal action.
\909\ Sec. 1031(e).
\910\ Sec. 1031(h).
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For purposes of section 1031, the determination of whether
property is of a ``like kind'' relates to the nature or
character of the property and not its grade or quality, i.e.,
the nonrecognition rules do not apply to an exchange of one
class or kind of property for property of a different class or
kind (e.g., section 1031 does not apply to an exchange of real
property for personal property).\911\ The different classes of
property are: (1) depreciable tangible personal property; \912\
(2) intangible or nondepreciable personal property; \913\ and
(3) real property.\914\ However, the rules with respect to
whether real estate is ``like kind'' are applied more liberally
than the rules governing like-kind exchanges of depreciable,
intangible, or nondepreciable personal property. For example,
improved real estate and unimproved real estate generally are
considered to be property of a ``like kind'' as this
distinction relates to the grade or quality of the real
estate,\915\ while depreciable tangible personal properties
must be either within the same General Asset Class \916\ or
within the same Product Class.\917\
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\911\ Treas. Reg. sec. 1.1031(a)-1(b).
\912\ For example, an exchange of a personal computer classified
under asset class 00.12 of Rev. Proc. 87-56, 1987-2 C.B. 674, for a
printer classified under the same asset class of Rev. Proc. 87-56 would
be treated as property of a like kind. However, an exchange of an
airplane classified under asset class 00.21 of Rev. Proc. 87-56 for a
heavy general purpose truck classified under asset class 00.242 of Rev.
Proc. 87-56 would not be treated as property of a like kind. See Treas.
Reg. sec. 1.1031(a)-2(b)(7).
\913\ For example, an exchange of a copyright on a novel for a
copyright on a different novel would be treated as property of a like
kind. See Treas. Reg. sec. 1.1031(a)-2(c)(3). However, the goodwill or
going concern value of one business is not of a like kind to the
goodwill or going concern value of a different business. See Treas.
Reg. sec. 1.1031(a)-2(c)(2). The IRS has ruled that intangible assets
such as trademarks, trade names, mastheads, and customer-based
intangibles that can be separately described and valued apart from
goodwill qualify as property of a like kind under section 1031. See
Chief Counsel Advice 200911006, February 12, 2009.
\914\ Treas. Reg. sec. 1.1031(a)-1(b) and (c).
\915\ Treas. Reg. sec. 1.1031(a)-1(b).
\916\ Treasury Regulation section 1.1031(a)-2(b)(2) provides the
following list of General Asset Classes, based on asset classes 00.11
through 00.28 and 00.4 of Rev. Proc. 87-56, 1987-2 C.B. 674: (i) Office
furniture, fixtures, and equipment (asset class 00.11), (ii)
Information systems (computers and peripheral equipment) (asset class
00.12), (iii) Data handling equipment, except computers (asset class
00.13), (iv) Airplanes (airframes and engines), except those used in
commercial or contract carrying of passengers or freight, and all
helicopters (airframes and engines) (asset class 00.21), (v)
Automobiles, taxis (asset class 00.22), (vi) Buses (asset class 00.23),
(vii) Light general purpose trucks (asset class 00.241), (viii) Heavy
general purpose trucks (asset class 00.242), (ix) Railroad cars and
locomotives, except those owned by railroad transportation companies
(asset class 00.25), (x) Tractor units for use over-the-road (asset
class 00.26), (xi) Trailers and trailer-mounted containers (asset class
00.27), (xii) Vessels, barges, tugs, and similar water-transportation
equipment, except those used in marine construction (asset class
00.28), and (xiii) Industrial steam and electric generation and/or
distribution systems (asset class 00.4).
\917\ Property within a product class consists of depreciable
tangible personal property that is described in a 6-digit product class
within Sectors 31, 32, and 33 (pertaining to manufacturing industries)
of the North American Industry Classification System (``NAICS''), set
forth in Executive Office of the President, Office of Management and
Budget, North American Industry Classification System, United States,
2002 (NAICS Manual), as periodically updated. Treas. Reg. sec.
1.1031(a)-2(b)(3).
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The nonrecognition of gain in a like-kind exchange applies
only to the extent that like-kind property is received in the
exchange. Thus, if an exchange of property would meet the
requirements of section 1031, but for the fact that the
property received in the transaction consists not only of the
property that would be permitted to be exchanged on a tax-free
basis, but also other non-qualifying property or money
(``additional consideration''), then the gain to the recipient
of the other property or money is required to be recognized,
but not in an amount exceeding the fair market value of such
other property or money.\918\ Additionally, any such gain
realized on a section 1031 exchange as a result of additional
consideration being involved constitutes ordinary income to the
extent that the gain is subject to the recapture provisions of
sections 1245 and 1250.\919\ No losses may be recognized from a
like-kind exchange.\920\
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\918\ Sec. 1031(b). For example, if a taxpayer holding land A
having a basis of $40,000 and a fair market value of $100,000 exchanges
the property for land B worth $90,000 plus $10,000 in cash, the
taxpayer would recognize $10,000 of gain on the transaction, which
would be includable in income. The remaining $50,000 of gain would be
deferred until the taxpayer disposes of land B in a taxable sale or
exchange.
\919\ Secs. 1245(b)(4) and 1250(d)(4). For example, if a taxpayer
holding section 1245 property A with an original cost basis of $11,000,
an adjusted basis of $10,000, and a fair market value of $15,000
exchanges the property for section 1245 property B with a fair market
value of $14,000 plus $1,000 in cash, the taxpayer would recognize
$1,000 of ordinary income on the transaction. The remaining $4,000 of
gain would be deferred until the taxpayer disposes of section 1245
property B in a taxable sale or exchange.
\920\ Sec. 1031(c).
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If section 1031 applies to an exchange of properties, the
basis of the property received in the exchange is equal to the
basis of the property transferred. This basis is increased to
the extent of any gain recognized as a result of the receipt of
other property or money in the like-kind exchange, and
decreased to the extent of any money received by the
taxpayer.\921\ The holding period of qualifying property
received includes the holding period of the qualifying property
transferred, but the nonqualifying property received is
required to begin a new holding period.\922\
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\921\ Sec. 1031(d). Thus, in the example noted above, the
taxpayer's basis in B would be $40,000 (the taxpayer's transferred
basis of $40,000, increased by $10,000 in gain recognized, and
decreased by $10,000 in money received).
\922\ Sec. 1223(1).
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A like-kind exchange also does not require that the
properties be exchanged simultaneously. Rather, the property to
be received in the exchange must be received not more than 180
days after the date on which the taxpayer relinquishes the
original property (but in no event later than the due date
(including extensions) of the taxpayer's income tax return for
the taxable year in which the transfer of the relinquished
property occurs). In addition, the taxpayer must identify the
property to be received within 45 days after the date on which
the taxpayer transfers the property relinquished in the
exchange.\923\
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\923\ Sec. 1031(a)(3).
The Treasury Department has issued regulations \924\ and
revenue procedures \925\ providing guidance and safe harbors
for taxpayers engaging in deferred like-kind exchanges.
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\924\ Treas. Reg. sec. 1.1031(k)-1(a) through (o).
\925\ See Rev. Proc. 2000-37, 2000-40 I.R.B. 308, as modified by
Rev. Proc. 2004-51, 2004-33 I.R.B. 294.
---------------------------------------------------------------------------
Explanation of Provision
The provision limits the provision providing for
nonrecognition of gain or loss in the case of like-kind
exchanges to exchanges of real property not held primarily for
sale.\926\
---------------------------------------------------------------------------
\926\ It is intended that real property eligible for like-kind
exchange treatment under prior law will continue to be eligible for
like-kind exchange treatment under the provision. For example, a like-
kind exchange of real property includes an exchange of shares in a
mutual ditch, reservoir, or irrigation company described in section
501(c)(12)(A) if at the time of the exchange such shares have been
recognized by the highest court or statute of the State in which the
company is organized as constituting or representing real property or
an interest in real property. Similarly, improved real estate and
unimproved real estate are generally considered to be property of a
like kind. See Treas. Reg. sec. 1.1031(a)-1(b).
---------------------------------------------------------------------------
Effective Date
The provision generally applies to exchanges completed
after December 31, 2017. However, an exception is provided for
any exchange if the property disposed of by the taxpayer in the
exchange is disposed of on or before December 31, 2017, or the
property received by the taxpayer in the exchange is received
on or before such date.
D. Limitation on Deduction by Employers of Expenses for Fringe Benefits
(sec. 13304 of the Act and sec. 274 of the Code)
Prior Law
Limitations on employer deductions
No deduction is allowed with respect to (1) an activity
generally considered to be entertainment, amusement, or
recreation (``entertainment''), unless the taxpayer establishes
that the item was directly related to (or, in certain cases,
associated with) the active conduct of the taxpayer's trade or
business, or (2) a facility (e.g., an airplane) used in
connection with such activity.\927\ If the taxpayer establishes
that entertainment expenses are directly related to (or
associated with) the active conduct of its trade or business,
the deduction generally is limited to 50 percent of the amount
otherwise deductible.\928\ Similarly, a deduction for any
expense for food or beverages generally is limited to 50
percent of the amount otherwise deductible.\929\ In addition,
no deduction is allowed for membership dues with respect to any
club organized for business, pleasure, recreation, or other
social purpose.\930\
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\927\ Sec. 274(a)(1).
\928\ Sec. 274(n)(1)(B).
\929\ Sec. 274(n)(1)(A). This includes expenses for food or
beverages (and facilities used in connection therewith) furnished on
the business premises of the taxpayer primarily for the taxpayer's
employees under section 274(e)(1).
\930\ Sec. 274(a)(3).
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There are a number of exceptions to the general rule
disallowing the deduction of entertainment expenses and the
rules limiting deductions to 50 percent of the otherwise
deductible amount. One such exception applies to expenses for
goods, services, and facilities to the extent that the expenses
are reported by the taxpayer as compensation and as wages to an
employee.\931\ Another exception applies to expenses for goods,
services, and facilities to the extent that the expenses are
includible in the gross income of a recipient who is not an
employee (e.g., a nonemployee director) as compensation for
services rendered or as a prize or award.\932\ The exceptions
apply only to the extent that amounts are properly reported by
the company as compensation and wages or otherwise includible
in income. In no event can the amount of the deduction exceed
the amount of the taxpayer's actual cost, even if a greater
amount (i.e., fair market value) is includible in income.\933\
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\931\ Sec. 274(e)(2)(A). See below for a discussion of the
modification of this rule for certain individuals.
\932\ Sec. 274(e)(9).
\933\ Treas. Reg. sec. 1.162-25T(a).
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Other exceptions to the deduction disallowance rules
include the following: expenses paid or incurred by the
taxpayer, in connection with the performance of services for
another person (other than an employer), under a reimbursement
or other expense allowance arrangement if the taxpayer accounts
for the expenses to such person; \934\ expenses for
recreational, social, or similar activities primarily for the
benefit of employees other than certain owners and highly
compensated employees; \935\ entertainment expenses directly
related to business meetings of a taxpayer's employees,
stockholders, agents or directors,\936\ or directly related and
necessary to attendance at business meetings or conventions of
organizations described in section 501(c)(6) and exempt from
taxation under section 501(a); \937\ expenses for goods,
services, and facilities made available by the taxpayer to the
general public; \938\ and expenses for goods or services
(including the use of facilities) which are sold by the
taxpayer in a bona fide transaction for an adequate and full
consideration in money or money's worth.\939\ Other exceptions
from the 50-percent deduction limit include exceptions for food
or beverage expenses excludable from the gross income of the
recipient under section 132(e) (relating to de minimis fringes)
and for food or beverages provided to crew members of certain
commercial vessels and certain oil or gas platform or drilling
rig workers.\940\
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\934\ Sec. 274(e)(3).
\935\ Sec. 274(e)(4).
\936\ Sec. 274(e)(5).
\937\ Sec. 274(e)(6).
\938\ Sec. 274(e)(7).
\939\ Sec. 274(e)(8).
\940\ Secs. 274(n)(2)(B) and (E). The legislative history to the
Tax Reform Act of 1986 (Pub. L. No. 99-514) further provides that a
restaurant or catering firm may deduct 100 percent (rather than the 80-
percent limitation that would otherwise have applied under the Tax
Reform Act of 1986) of its costs for food and beverage items, purchased
in connection with preparing and providing meals to its paying
customers, that are consumed at the worksite by employees of the
restaurant or caterer. Conference Report to accompany H.R. 3838, Tax
Reform Act of 1986, H.R. Rep. No. 99-841, September 18, 1986, p. II-25.
See also Joint Committee on Taxation, General Explanation of the Tax
Reform Act of 1986 (JCS-10-87), May 1987, p. 68, clarifying that this
exception only applies to employees who work in the employer's
restaurant or catering business.
---------------------------------------------------------------------------
Employee compensation
Expenses treated as compensation
Except as otherwise provided, gross income includes
compensation for services, including fees, commissions, fringe
benefits, and similar items.\941\ In general, an employee (or
other service provider) must include in gross income the amount
by which the fair market value of a fringe benefit exceeds the
sum of the amount (if any) paid by the individual and the
amount (if any) specifically excluded from gross income.\942\
Treasury regulations provide detailed rules regarding the
valuation of certain fringe benefits, including flights on an
employer-provided aircraft. In general, the value of a
noncommercial flight generally is determined under the base
aircraft valuation formula, also known as the Standard Industry
Fare Level formula (``SIFL'').\943\ If the SIFL valuation rules
do not apply, the value of a flight on an employer-provided
aircraft generally is equal to the amount that an individual
would have to pay in an arm's-length transaction to charter the
same or a comparable aircraft for that period for the same or a
comparable flight.\944\
---------------------------------------------------------------------------
\941\ Sec. 61(a)(1).
\942\ Treas. Reg. sec. 1.61-21(b)(1).
\943\ Treas. Reg. sec. 1.61-21(g)(5).
\944\ Treas. Reg. sec. 1.61-21(b)(6).
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In the context of an employer providing an aircraft to
employees for nonbusiness (e.g., vacation) flights, the
exception for expenses treated as compensation has been
interpreted as not limiting the company's deduction for
expenses attributable to the operation of the aircraft to the
amount of compensation reportable to its employees.\945\ The
result of that interpretation is often a deduction several
times larger than the amount required to be included in income.
Further, in many cases, the individual including amounts
attributable to personal travel in income directly benefits
from the enhanced deduction, resulting in a net deduction for
the personal use of the company aircraft.
---------------------------------------------------------------------------
\945\ Sutherland Lumber-Southwest, Inc. v. Commissioner, 114 T.C.
197 (2000), aff'd 255 F.3d 495 (8th Cir. 2001) (the ``Sutherland
Lumber-Southwest decision'').
---------------------------------------------------------------------------
Subsequent to the Sutherland Lumber-Southwest decision, the
exceptions for expenses treated as compensation or otherwise
includible income were modified by the American Jobs Creation
Act \946\ for specified individuals such that the exceptions
apply only to the extent of the amount of expenses treated as
compensation or includible in income of the specified
individual.\947\ Specified individuals are individuals who,
with respect to an employer or other service recipient (or a
related party), are subject to the requirements of section
16(a) of the Securities Exchange Act of 1934, or would be
subject to such requirements if the employer or service
recipient (or related party) were an issuer of equity
securities referred to in section 16(a).\948\
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\946\ Pub. L. No. 108-357. See also Conference Report to accompany
H.R. 4520, American Jobs Creation Act of 2004, H.R. Rep. No. 108-755,
October 7, 2004, pp. 797-798.
\947\ Sec. 274(e)(2)(B)(i). See also Treas. Reg. sec. 1.274-9(a).
\948\ Sec. 274(e)(2)(B)(ii). See also Treas. Reg. sec. 1.274-9(b).
---------------------------------------------------------------------------
As a result, in the case of specified individuals, no
deduction is allowed with respect to expenses for (1) a
nonbusiness activity generally considered to be entertainment,
amusement or recreation, or (2) a facility (e.g., an airplane)
used in connection with such activity to the extent that such
expenses exceed the amount treated as compensation or
includible in income to the specified individual. For example,
a company's deduction attributable to aircraft operating costs
and other expenses for a specified individual's vacation use of
a company aircraft is limited to the amount reported as
compensation to the specified individual. However, in the case
of other employees or service providers, the company's
deduction is not limited to the amount treated as compensation
or includible in income.\949\
---------------------------------------------------------------------------
\949\ See Treas. Reg. sec. 1.274-10(a)(2).
---------------------------------------------------------------------------
Excludable fringe benefits
Certain employer-provided fringe benefits are excluded from
an employee's gross income and wages for employment tax
purposes, including, but not limited to, de minimis fringes,
qualified transportation fringes, on-premises athletic
facilities, and meals provided for the ``convenience of the
employer.'' \950\
---------------------------------------------------------------------------
\950\ Secs. 132(a), 119(a), 3121(a)(19) and (20), 3231(e)(5) and
(9), 3306(b)(14) and (16), and 3401(a)(19).
---------------------------------------------------------------------------
A de minimis fringe generally means any property or service
the value of which is (taking into account the frequency with
which similar fringes are provided by the employer) so small as
to make accounting for it unreasonable or administratively
impracticable,\951\ and also includes food or beverages
provided to employees through an eating facility operated by
the employer that is located on or near the employer's business
premises and meets certain requirements.\952\
---------------------------------------------------------------------------
\951\ Sec. 132(e)(1). Examples include occasional personal use of
an employer's copying machine, occasional parties or meals for
employees and their guests, local telephone calls, and coffee,
doughnuts and soft drinks. Treas. Reg. sec. 1.132-6(e)(1).
\952\ Sec. 132(e)(2). Revenue derived from such a facility must
normally equal or exceed the direct operating costs of the facility.
Employees who are entitled, under section 119, to exclude the value of
a meal provided at such a facility are treated as having paid an amount
for the meal equal to the direct operating costs of the facility
attributable to such meal.
---------------------------------------------------------------------------
Qualified transportation fringes provided by an employer
include qualified parking (parking on or near the employer's
business premises or parking on or near a location from which
the employee commutes to work by transit pass, vanpool, or
carpool), transit passes, vanpool benefits (commuter highway
vehicles for travel between the employee's residence and place
of employment), and qualified bicycle commuting
reimbursements.\953\
---------------------------------------------------------------------------
\953\ Secs. 132(f)(1) and (5). The qualified transportation fringe
exclusions are subject to monthly limits. Sec. 132(f)(2).
---------------------------------------------------------------------------
On-premises athletic facilities are gyms or other athletic
facilities located on the employer's premises, operated by the
employer, and substantially all the use of which is by
employees of the employer, their spouses, and their dependent
children.\954\
---------------------------------------------------------------------------
\954\ Sec. 132(j)(4).
---------------------------------------------------------------------------
The value of meals furnished to an employee or the
employee's spouse or dependents by or on behalf of an employer
for the convenience of the employer is excludible from the
employee's gross income, but only if such meals are provided on
the employer's business premises.\955\
---------------------------------------------------------------------------
\955\ Sec. 119(a).
---------------------------------------------------------------------------
Explanation of Provision
In general
The provision eliminates the deduction permitted under
prior law with respect to entertainment, amusement, or
recreation. It also eliminates the deduction permitted to an
employer under prior law for items with respect to qualified
transportation fringes and employer-provided commuting. In
addition, as described below, the provision impacts the
deduction for expenses of an employer associated with providing
food or beverages to employees through an eating facility that
meets requirements for de minimis fringes and for the
convenience of the employer.\956\
---------------------------------------------------------------------------
\956\ The provision generally does not impact the other exceptions
to the 50-percent limitation on deductions for food or beverage
expenses, as described infra under prior law. For example, a restaurant
or catering business may continue to deduct 100 percent of its costs
for food or beverage items, purchased in connection with preparing and
providing meals to its paying customers, which are consumed at the
worksite by employees who work in the employer's restaurant or catering
business.
---------------------------------------------------------------------------
Entertainment, amusement, or recreation expenses
The provision provides that no deduction is allowed with
respect to (1) an activity generally considered to be
entertainment, amusement, or recreation, (2) membership dues
with respect to any club organized for business, pleasure,
recreation, or other social purposes, or (3) a facility or
portion thereof used in connection with any of the above items.
Thus, the provision repeals the prior-law exception to the
deduction disallowance for entertainment, amusement, or
recreation (collectively, ``entertainment'') that is directly
related to (or, in certain cases, associated with) the active
conduct of the taxpayer's trade or business (and the related
rule applying a 50-percent limit to such deductions).\957\
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\957\ As discussed above under prior law, section 274(e)(5)
provides an exception from the deduction disallowance rules for
entertainment expenses directly related to business meetings of a
taxpayer's employees, stockholders, agents, or directors, and section
274(e)(6) provides such an exception for such expenses directly related
and necessary to attendance at business meetings or conventions of
organizations described in section 501(c)(6) and exempt from taxation
under section 501(a). A technical correction may be necessary to
clarify that such exceptions do not apply to expenses of entertainment,
amusement, or recreation (including any facility or portion thereof
used in connection with entertainment, amusement, or recreation) for
which no deduction is allowed under the provision. However, such
exceptions continue to apply to 50 percent of food or beverage expenses
that otherwise satisfy applicable requirements.
---------------------------------------------------------------------------
Notwithstanding these limitations, taxpayers may still
deduct 50 percent of certain business-related food and beverage
expenses. A taxpayer may still generally deduct 50 percent of
the food or beverage expenses associated with operating its
trade or business (e.g., meals consumed by employees on work
travel). A taxpayer may also continue to deduct 50 percent of
the properly substantiated food or beverage expenses associated
with a meal that is considered a business meal with a client,
provided the business meal is not lavish or extravagant.\958\
When a meal is included in an activity or event with a client
that primarily constitutes entertainment, the provision
disallows the deduction for the entire activity or event
including the meal.\959\ For example, food or beverages
consumed during a theatre or sporting event would be
nondeductible under this rule because the activity or event is
primarily entertainment. However, a meal between the taxpayer
(or an employee of the taxpayer) and a client at a restaurant
to primarily discuss business is a business meal that may be
50-percent deductible, provided other applicable requirements
are satisfied, including substantiation.\960\
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\958\ See section 274(k), which was not amended by Pub. L. No. 115-
97.
\959\ An objective test like that under Treas. Reg. sec. 1.274-
2(b)(1)(ii) (which under prior law applies to determine whether an
activity is of a type generally considered to constitute entertainment)
should apply to determine whether an event or activity primarily
constitutes entertainment.
\960\ See sec. 274(d) and (k).
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Qualified transportation fringes and employer-provided commuting
The provision disallows a deduction for items with respect
to providing any qualified transportation fringe to employees
of the taxpayer. Such items include amounts elected by an
employee to be used on a pretax salary basis towards any
qualified transportation fringe benefit. The term ``qualified
transportation fringe'' is defined \961\ to include qualified
parking, and therefore encompasses costs associated with
providing qualified parking, including any parking facility
maintained by the employer or parking on any portion of the
employer's business premises used in connection with qualified
parking. This includes appropriate allocations of depreciation
and other costs with respect to facilities used for parking
(e.g., allocable salaries for security and maintenance
personnel, property taxes, repairs and maintenance, etc.). The
amount of the deduction disallowance is equal to the amount of
direct and other properly allocable costs of the taxpayer to
provide the qualified transportation fringe. Accordingly, the
deduction disallowance is not determined by reference to the
value of the transportation fringe benefit calculated for
purposes of applying section 132(f) and instead, the employer
must take into account the direct and other properly allocable
costs that it incurs to maintain and provide the qualified
parking to its employees.\962\
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\961\ Sec. 132(f).
\962\ The determination of costs associated with providing
qualified transportation fringes that are subject to a deduction
disallowance is consistent with the determination of such costs
required to be included in unrelated business taxable income under
section 512(a)(7) (as added by section 13703 of the Act (Unrelated
Business Taxable Income Increased by Amount of Certain Fringe Benefit
Expenses for which Deduction is Disallowed)). Therefore, this
determination includes pretax salary amounts attributable to any
qualified transportation fringe benefit, costs for parking facilities
used in connection with qualified parking (as defined in section
132(f)(5)(C)), and appropriate allocations of depreciation and other
costs for such facilities. See description of section 13703 of the Act.
A technical correction may be necessary to reflect this intent.
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The provision also disallows a deduction for any expense
incurred for providing any transportation, or any payment or
reimbursement, for commuting between the employee's residence
and place of employment, except as necessary for ensuring the
safety of an employee.
The provision is intended to include qualified
transportation fringe expenses in the exception to the
deduction disallowance for expenses that are treated as
compensation.\963\ Any expenses incurred for providing any form
of transportation which are not qualified transportation
fringes (or any payment or reimbursement) for commuting between
the employee's residence and place of employment, even if
included in compensation, are not eligible for this exception.
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\963\ See section 274(e). A technical correction may be necessary
to reflect this intent. Note that this would apply to qualified bicycle
commuting reimbursements during the suspension period (taxable years
beginning after December 31, 2017, and ending before January 1, 2026)
of the exclusion from gross income for such benefits.
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Meals that are a de minimis fringe or for the convenience of the
employer
For amounts incurred and paid after December 31, 2017, and
before January 1, 2026, the provision reduces the deduction to
50 percent for expenses of the employer associated with
providing food or beverages to employees through an eating
facility that meets the requirements for de minimis fringes and
for the convenience of the employer. Such amounts incurred and
paid after December 31, 2025, are not deductible.
The Treasury Department has issued published guidance
addressing this provision.\964\
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\964\ Notice 2018-76, 2018-42 I.R.B. 599; IRS Publication 15-B,
Employer's Tax Guide to Fringe Benefits (revised Feb. 22, 2018), p. 21.
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Effective Date
The provision generally applies to amounts paid or incurred
after December 31, 2017. However, for expenses of the employer
associated with providing food or beverages to employees
through an eating facility that meets the requirements for de
minimis fringes and for the convenience of the employer,
amounts paid or incurred after December 31, 2025, are not
deductible.
E. Repeal of Deduction for Income Attributable to Domestic Production
Activities (sec. 13305 of the Act and former sec. 199 of the Code)
Prior Law
In general
Section 199 provides a deduction from taxable income (or,
in the case of an individual, adjusted gross income \965\ )
that is equal to nine percent of the lesser of the taxpayer's
qualified production activities income or taxable income
(determined without regard to the section 199 deduction) for
the taxable year.\966\ For corporations subject to the 35-
percent corporate income tax rate, the nine-percent deduction
effectively reduces the corporate income tax rate to slightly
less than 32 percent on qualified production activities
income.\967\ A similar reduction applies to the graduated rates
applicable to individuals with qualifying domestic production
activities income.
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\965\ For this purpose, adjusted gross income is determined after
application of sections 86, 135, 137, 219, 221, 222, and 469, without
regard to the section 199 deduction. Sec. 199(d)(2).
\966\ Sec. 199(a). In the case of oil related qualified production
activities income, the deduction is reduced by three percent of the
least of the taxpayer's oil related qualified production activities
income, qualified production activities income, or taxable income
(determined without regard to the section 199 deduction) for the
taxable year. Sec. 199(d)(9). For this purpose, oil related qualified
production activities income for any taxable year is the portion of
qualified production activities income attributable to the production,
refining, processing, transportation, or distribution of oil, gas, or
any primary product thereof (within the meaning of section 927(a)(2)(C)
as in effect before its repeal) during the taxable year. Sec.
199(d)(9).
\967\ This example assumes the deduction does not exceed the wage
limitation discussed below.
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In general, qualified production activities income is equal
to domestic production gross receipts reduced by the sum of:
(1) the costs of goods sold that are allocable to those
receipts; and (2) other expenses, losses, or deductions which
are properly allocable to those receipts.\968\
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\968\ Sec. 199(c)(1). In computing qualified production activities
income, the domestic production activities deduction itself is not an
allocable deduction. Sec. 199(c)(1)(B)(ii). See Treas. Reg. secs.
1.199-1 through 1.199-9 where the Secretary has prescribed rules for
the proper allocation of items of income, deduction, expense, and loss
for purposes of determining qualified production activities income.
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Domestic production gross receipts generally are gross
receipts of a taxpayer that are derived from: (1) any sale,
exchange, or other disposition, or any lease, rental, or
license, of qualifying production property \969\ that was
manufactured, produced, grown or extracted by the taxpayer in
whole or in significant part within the United States; \970\
(2) any sale, exchange, or other disposition, or any lease,
rental, or license, of qualified film \971\ produced by the
taxpayer; (3) any sale, exchange, or other disposition, or any
lease, rental, or license, of electricity, natural gas, or
potable water produced by the taxpayer in the United States;
(4) construction of real property performed in the United
States by a taxpayer in the ordinary course of a construction
trade or business; or (5) engineering or architectural services
performed in the United States for the construction of real
property located in the United States.\972\
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\969\ Qualifying production property generally includes any
tangible personal property, computer software, and sound recordings.
Sec. 199(c)(5).
\970\ When used in the Code in a geographical sense, the term
``United States'' generally includes only the States and the District
of Columbia. Sec. 7701(a)(9). A special rule for determining domestic
production gross receipts, however, provides that for taxable years
beginning after December 31, 2005, and before January 1, 2017, in the
case of any taxpayer with gross receipts from sources within the
Commonwealth of Puerto Rico, the term ``United States'' includes the
Commonwealth of Puerto Rico, but only if all of the taxpayer's Puerto
Rico-sourced gross receipts are taxable under the Federal income tax
for individuals or corporations for such taxable year. See sections
199(d)(8)(A) and (C). Such special rule was extended to taxable years
beginning before January 1, 2018, by the Bipartisan Budget Act of 2018,
Pub. L. No. 115-123, February 9, 2018. In computing the 50-percent wage
limitation, the taxpayer is permitted to take into account wages paid
to bona fide residents of Puerto Rico for services performed in Puerto
Rico. Sec. 199(d)(8)(B).
\971\ Qualified film includes any motion picture film or videotape
(including live or delayed television programming, but not including
certain sexually explicit productions) if 50 percent or more of the
total compensation relating to the production of the film (including
compensation in the form of residuals and participations) constitutes
compensation for services performed in the United States by actors,
production personnel, directors, and producers. Sec. 199(c)(6).
\972\ Sec. 199(c)(4)(A).
---------------------------------------------------------------------------
The amount of the deduction for a taxable year is limited
to 50 percent of the W-2 wages paid by the taxpayer, and
properly allocable to domestic production gross receipts,
during the calendar year that ends in such taxable year.\973\
---------------------------------------------------------------------------
\973\ Sec. 199(b)(1). For purposes of the provision, ``W-2 wages''
include the sum of the amounts of wages as defined in section 3401(a)
and elective deferrals that the taxpayer properly reports to the Social
Security Administration with respect to the employment of employees of
the taxpayer during the calendar year ending during the taxpayer's
taxable year. Elective deferrals include elective deferrals as defined
in section 402(g)(3), amounts deferred under section 457, and
designated Roth contributions as defined in section 402A. See sec.
199(b)(2)(A). The wage limitation for qualified films includes any
compensation for services performed in the United States by actors,
production personnel, directors, and producers and is not restricted to
W-2 wages. Sec. 199(b)(2)(D).
---------------------------------------------------------------------------
Agricultural and horticultural cooperatives
With regard to member-owned agricultural and horticultural
cooperatives formed under Subchapter T of the Code, section 199
provides the same treatment of qualified production activities
income derived from agricultural or horticultural products that
are manufactured, produced, grown, or extracted by
cooperatives,\974\ or that are marketed through cooperatives,
as it provides for qualified production activities income of
other taxpayers (i.e., the cooperative may claim a deduction
from qualified production activities income).
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\974\ For this purpose, agricultural or horticultural products also
include fertilizer, diesel fuel and other supplies used in agricultural
or horticultural production that are manufactured, produced, grown, or
extracted by the cooperative.
---------------------------------------------------------------------------
In addition, section 199(d)(3)(A) provides that the amount
of any patronage dividends or per-unit retain allocations paid
to a member of an agricultural or horticultural cooperative (to
which Part I of Subchapter T applies), which is allocable to
the portion of qualified production activities income of the
cooperative that is deductible under the provision, is
deductible from the gross income of the member. In order to
qualify, such amount must be designated by the organization as
allocable to the deductible portion of qualified production
activities income in a written notice mailed to its patrons not
later than the payment period described in section 1382(d). In
addition, section 199(d)(3)(B) provides that the cooperative
cannot reduce its income under section 1382 (e.g., cannot claim
a dividends-paid deduction) for such amounts.
Explanation of Provision
The provision repeals the deduction for income attributable
to domestic production activities.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
As the enactment of section 199A is also effective for
taxable years beginning after December 31, 2017,\975\ any item
taken into account in determining the qualified production
activities income of the taxpayer under former section 199
cannot be taken into account in determining the combined
qualified business income amount of the taxpayer under section
199A. For example, assume that an individual holds an interest
in a fiscal-year partnership or S corporation, the taxable year
of which began before January 1, 2018, and ends within or with
the individual's first taxable year beginning after December
31, 2017 (e.g., the individual's 2018 calendar taxable year).
The individual's share of any item from the partnership or S
corporation that constitutes qualified business income,
qualified REIT dividends, qualified cooperative dividends,\976\
and qualified publicly traded partnership income and that is
taken into account in determining taxable income for the
individual's 2018 taxable year is eligible for the section 199A
deduction. However, the individual's share of any item from the
partnership or S corporation that would otherwise be taken into
account in determining qualified production activities income
for the individual's 2018 taxable year is not eligible for the
former section 199 deduction, as former section 199 is repealed
for taxable years beginning after December 31, 2017.
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\975\ For a discussion of the effective date of the enactment of
section 199A, see the description of section 11011 of the Act
(Deduction for Qualified Business Income).
\976\ As originally enacted. Modifications enacted March 23, 2018,
are described in the Appendix.
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F. Denial of Deduction for Certain Fines, Penalties, and Other Amounts
(sec. 13306 of the Act and sec. 162 of the Code)
Prior Law
In general
The Code denies a deduction for fines or penalties paid to
a government for the violation of any law.\977\
---------------------------------------------------------------------------
\977\ Sec. 162(f).
---------------------------------------------------------------------------
Explanation of Provision
The provision denies deductibility for any otherwise
deductible amount paid or incurred (whether by suit, agreement,
or otherwise) to or at the direction of a government or
specified nongovernmental entity in relation to the violation
of any law or the investigation or inquiry by such government
or entity into the potential violation of any law. An exception
applies to payments that the taxpayer establishes are either
restitution (including remediation of property) or amounts
required to come into compliance with any law that was violated
or involved in the investigation or inquiry, that are
identified in the court order or settlement agreement as
restitution, remediation, or required to come into compliance.
In the case of any amount of restitution for failure to pay any
tax and assessed as restitution under the Code, such
restitution is deductible only to the extent it would have been
allowed as a deduction if it had been timely paid. The IRS
remains free to challenge the characterization of an amount so
identified; however, no deduction is allowed unless the
identification is made. Restitution or included remediation of
property does not include reimbursement of government
investigative or litigation costs.
An exception also applies to any amount paid or incurred as
taxes due.\978\
---------------------------------------------------------------------------
\978\ Thus, amounts paid or incurred as taxes due are not affected
by the provision (e.g., State taxes that are otherwise deductible). The
reference to taxes due is also intended to include interest with
respect to such taxes (but not interest, if any, with respect to any
penalties imposed with respect to such taxes).
---------------------------------------------------------------------------
The provision applies only where a government (or other
entity treated in a manner similar to a government under the
provision) is a complainant or investigator with respect to the
violation or potential violation of any law.\979\ The provision
requires government agencies (or entities treated as such
agencies under the provision) to report to the IRS and to the
taxpayer the amount of each settlement agreement or order
entered into where the aggregate amount required to be paid or
incurred to or at the direction of the government is at least
$600 (or such other amount as may be specified by the Secretary
of the Treasury as necessary to ensure the efficient
administration of the internal revenue laws). The report must
separately identify any amounts that are for restitution or
remediation of property, or correction of noncompliance. The
report must be made at the time the agreement is entered into,
as determined by the Secretary of the Treasury.
---------------------------------------------------------------------------
\979\ Thus, for example, the provision does not apply to payments
made by one private party to another in a lawsuit between private
parties, merely because a judge or jury acting in the capacity as a
court directs the payment to be made. The mere fact that a court enters
a judgment or directs a result in a private dispute does not cause the
payment to be made ``at the direction of a government'' for purposes of
the provision.
---------------------------------------------------------------------------
Effective Date
The provision denying the deduction and the reporting
provision are effective for amounts paid or incurred on or
after the date of enactment (i.e., December 22, 2017), except
that they do not apply to amounts paid or incurred under any
binding order or agreement entered into before such date. Such
exception does not apply to an order or agreement requiring
court approval unless the approval was obtained before such
date.
G. Denial of Deduction for Settlements Subject to Nondisclosure
Agreements Paid in Connection with Sexual Harassment or Sexual Abuse
(sec. 13307 of the Act and sec. 162 of the Code)
Prior Law
In general
A taxpayer generally is allowed a deduction for ordinary
and necessary expenses paid or incurred in carrying on any
trade or business.\980\ However, certain exceptions apply. No
deduction is allowed for: (1) any charitable contribution or
gift that exceeds the amount allowable as a deduction under
section 170; (2) any illegal bribe, illegal kickback, or other
illegal payment; (3) certain lobbying and political
expenditures; (4) any fine or similar penalty paid to a
government for the violation of any law; (5) two-thirds of
treble damage payments under the antitrust laws; (6) certain
foreign advertising expenses; (7) certain amounts paid or
incurred by a corporation in connection with the reacquisition
of its stock or of the stock of any related person; or (8)
certain applicable employee remuneration.
---------------------------------------------------------------------------
\980\ Sec. 162(a).
---------------------------------------------------------------------------
Explanation of Provision
Under the provision, no deduction is allowed for any
settlement or payment related to sexual harassment or sexual
abuse if such settlement or payment is subject to a
nondisclosure agreement. In addition, in the case of the
taxpayer for whom a deduction is disallowed, no deduction is
allowed for attorney's fees related to such settlement or
payment. Any attorney's fees incurred by the beneficiary of the
settlement or recipient of the payment are not subject to this
rule.\981\
---------------------------------------------------------------------------
\981\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
Effective Date
The provision is effective for amounts paid or incurred
after the date of enactment (i.e., December 22, 2017).
H. Repeal of Deduction for Local Lobbying Expenses (sec. 13308 of the
Act and sec. 162 of the Code)
Prior Law
In general
A taxpayer generally is allowed a deduction for ordinary
and necessary expenses paid or incurred in carrying on any
trade or business.\982\ However, section 162(e) denies a
deduction for amounts paid or incurred in connection with (1)
influencing legislation,\983\ (2) participation in, or
intervention in, any political campaign on behalf of (or in
opposition to) any candidate for public office, (3) any attempt
to influence the general public, or segments thereof, with
respect to elections, legislative matters, or referendums, or
(4) any direct communication with a covered executive branch
official \984\ in an attempt to influence the official actions
or positions of such official. Expenses paid or incurred in
connection with lobbying and political activities (such as
research for, or preparation, planning, or coordination of, any
previously described activity) also are not deductible.\985\
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\982\ Sec. 162(a).
\983\ The term ``influencing legislation'' means any attempt to
influence any legislation through communication with any member or
employee of a legislative body, or with any government official or
employee who may participate in the formulation of legislation. The
term ``legislation'' includes actions with respect to Acts, bills,
resolutions, or similar items by the Congress, any State legislature,
any local council, or similar governing body, or by the public in a
referendum, initiative, constitutional amendment, or similar procedure.
Secs. 162(e)(4) and 4911(e)(2).
\984\ The term ``covered executive branch official'' means (1) the
President, (2) the Vice President, (3) any officer or employee of the
White House Office of the Executive Office of the President, and the
two most senior level officers of each of the other agencies in such
Executive Office, (4) any individual servicing in a position in level I
of the Executive Schedule under section 5312 of title 5, United States
Code, (5) any other individual designated by the President as having
Cabinet-level status, and (6) any immediate deputy of an individual
described in (4) or (5). Sec. 162(e)(6).
\985\ Sec. 162(e)(5)(C).
---------------------------------------------------------------------------
Exceptions
Local legislation
Notwithstanding the above, a deduction is allowed for
ordinary and necessary expenses incurred in connection with any
legislation of any local council or similar governing body
(``local legislation'').\986\ With respect to local
legislation, the exception permits a deduction for amounts paid
or incurred in carrying on any trade or business (1) in direct
connection with appearances before, submission of statements
to, or sending communications to the committees or individual
members of such council or body with respect to legislation or
proposed legislation of direct interest to the taxpayer, or (2)
in direct connection with communication of information between
the taxpayer and an organization of which the taxpayer is a
member with respect to any such legislation or proposed
legislation which is of direct interest to the taxpayer and
such organization, and (3) that portion of the dues paid or
incurred with respect to any organization of which the taxpayer
is a member which is attributable to the expenses of the
activities described in (1) or (2) carried on by such
organization.\987\
---------------------------------------------------------------------------
\986\ Sec. 162(e)(2)(A).
\987\ Sec. 162(e)(2)(B).
---------------------------------------------------------------------------
For purposes of this exception, legislation of an Indian
tribal government is treated in the same manner as local
legislation.\988\
---------------------------------------------------------------------------
\988\ Sec. 162(e)(7).
---------------------------------------------------------------------------
De minimis
For taxpayers with $2,000 or less of in-house expenditures
related to lobbying and political activities, a de minimis
exception is provided that permits a deduction.\989\
---------------------------------------------------------------------------
\989\ Sec. 162(e)(5)(B).
---------------------------------------------------------------------------
Explanation of Provision
The provision repeals the exception for amounts paid or
incurred related to lobbying local councils or similar
governing bodies, including Indian tribal governments. Thus,
the general disallowance rules applicable to lobbying and
political expenditures will apply to costs incurred related to
such local legislation.
Effective Date
The provision applies to amounts paid or incurred on or
after the date of enactment (i.e., December 22, 2017).
I. Recharacterization of Certain Gains in the Case of Partnership
Profits Interests Held in Connection with Performance of Investment
Services (sec. 13309 of the Act and sec. 1061 of the Code)
Prior Law
Partnership profits interest for services
A profits interest in a partnership is the right to receive
future profits in the partnership but does not generally
include any right to receive money or other property upon the
immediate liquidation of the partnership. The treatment of the
receipt of a profits interest in a partnership (sometimes
referred to as a carried interest) in exchange for the
performance of services has been the subject of controversy.
Though courts have differed, in some instances, a taxpayer
receiving a profits interest for performing services has not
been taxed upon the receipt of the partnership interest.\990\
---------------------------------------------------------------------------
\990\ Only a handful of cases have addressed this issue. Though one
case required the value to be included currently, where value was
easily determined by a sale of the profits interest soon after receipt
(Diamond v. Commissioner, 56 T.C. 530 (1971), aff'd 492 F.2d 286 (7th
Cir. 1974)), a more recent case concluded that partnership profits
interests were not includable on receipt, because the profits interests
were speculative and without fair market value (Campbell v.
Commissioner, 943 F. 2d 815 (8th Cir. 1991)).
---------------------------------------------------------------------------
In 1993, the IRS, referring to the litigation of the tax
treatment of receiving a partnership profits interest and the
results in the cases, issued administrative guidance that the
IRS generally would treat the receipt of a partnership profits
interest for services as not a taxable event for the
partnership or the partner.\991\ Under this guidance, this
treatment does not apply, however, if: (1) the profits interest
relates to a substantially certain and predictable stream of
income from partnership assets, such as income from high-
quality debt securities or a high-quality net lease; (2) within
two years of receipt, the partner disposes of the profits
interest; or (3) the profits interest is a limited partnership
interest in a publicly traded partnership. More recent
administrative guidance \992\ clarifies that this treatment
applies with respect to a substantially unvested profits
interest provided the service partner takes into income his
distributive share of partnership income, and the partnership
does not deduct any amount either on grant or on vesting of the
profits interest.\993\
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\991\ Rev. Proc. 93-27, 1993-2 C.B. 343, citing the Diamond and
Campbell cases, supra.
\992\ Rev. Proc. 2001-43, 2001-2 C.B. 191. This result applies
under the guidance even if the interest is substantially nonvested on
the date of grant.
\993\ A similar result would occur under the ``safe harbor''
election under proposed regulations regarding the application of
section 83 to the compensatory transfer of a partnership interest. REG-
105346-03, 70 Fed. Reg. 29675, May 24, 2005.
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By contrast, a partnership capital interest received for
services is includable in the partner's income under generally
applicable rules relating to the receipt of property for the
performance of services.\994\ A partnership capital interest
for this purpose is an interest that would entitle the
receiving partner to a share of the proceeds if the
partnership's assets were sold at fair market value and the
proceeds were distributed in liquidation.\995\
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\994\ Secs. 61 and 83; Treas. Reg. sec. 1.721-1(b)(1); see U.S. v.
Frazell, 335 F.2d 487 (5th Cir. 1964), cert. denied, 380 U.S. 961
(1965).
\995\ Rev. Proc. 93-27, 1993-2 C.B. 343.
---------------------------------------------------------------------------
Property received for services under section 83
In general
Section 83 governs the amount and timing of income and
deductions attributable to transfers of property in connection
with the performance of services. If property is transferred in
connection with the performance of services, the person
performing the services (the ``service provider'') generally
must recognize income for the taxable year in which the
property is first substantially vested (i.e., transferable or
not subject to a substantial risk of forfeiture).\996\ The
amount includible in the service provider's income is the
excess of the fair market value of the property when it is
substantially vested over the amount (if any) paid for the
property. A deduction generally is allowed to the person for
whom such services are performed (the ``service recipient'')
equal to the amount included in gross income by the service
provider. The deduction generally is allowed for the taxable
year of the service recipient in which or with which ends the
taxable year in which the amount is included in the service
provider's income.\997\
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\996\ The Department of Treasury has issued proposed regulations
regarding the application of section 83 to the compensatory transfer of
a partnership interest. 70 Fed. Reg. 29675, May 24, 2005. The proposed
regulations provide that a partnership interest is ``property'' for
purposes of section 83. Thus, a compensatory transfer of a partnership
interest is includible in the service provider's gross income at the
time that it first becomes substantially vested (or, in the case of a
substantially nonvested partnership interest, at the time of grant if a
section 83(b) election is made). However, because the fair market value
of a compensatory partnership interest is often difficult to determine,
the proposed regulations also permit a partnership and a partner to
elect a safe harbor under which the fair market value of a compensatory
partnership interest is treated as being equal to the liquidation value
of that interest. Therefore, in the case of a true profits interest in
a partnership (one under which the partner would be entitled to nothing
if the partnership were liquidated immediately following the grant),
under the proposed regulations, the grant of a substantially vested
profits interest (or, if a section 83(b) election is made, the grant of
a substantially nonvested profits interest) results in no income
inclusion under section 83 because the fair market value of the
property received by the service provider is zero. The proposed safe
harbor is subject to a number of conditions. For example, the election
cannot be made retroactively and must apply to all compensatory
partnership transfers that occur during the period that the election is
in effect.
\997\ Sec. 83(h).
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Property that is subject to a substantial risk of
forfeiture and that is not transferable is generally referred
to as ``substantially nonvested.'' Property is subject to a
substantial risk of forfeiture if the individual's right to the
property is conditioned on the future performance (or
refraining from performance) of substantial services. In
addition, a substantial risk of forfeiture exists if the right
to the property is subject to a condition other than the
performance of services, provided that the condition relates to
a purpose of the transfer and there is a substantial
possibility that the property will be forfeited if the
condition does not occur.
Section 83(b) election
Under section 83(b), even if the property is substantially
nonvested at the time of transfer, the service provider may
nevertheless elect within 30 days of the transfer to recognize
income for the taxable year of the transfer. Such an election
is referred to as a ``section 83(b) election.'' The service
provider makes an election by filing with the IRS a written
statement that includes the fair market value of the property
at the time of transfer and the amount (if any) paid for the
property. The service provider must also provide a copy of the
statement to the service recipient.
Passthrough tax treatment of partnerships
The character of partnership items passes through to the
partners, as if the items were realized directly by the
partners.\998\ Thus, for example, long-term capital gain of the
partnership is treated as long-term capital gain in the hands
of the partners.
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\998\ Sec. 702.
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A partner holding a partnership interest includes in income
its distributive share (whether or not actually distributed) of
partnership items of income and gain, including capital gain
eligible for the lower tax rates. A partner's basis in the
partnership interest is increased by any amount of gain thus
included and is decreased by losses. These basis adjustments
prevent double taxation of partnership income to the partner,
preserving the partnership's tax status as a passthrough
entity. Money distributed to the partner by the partnership is
taxed to the extent the amount exceeds the partner's basis in
the partnership interest.
Net long-term capital gain
In general, gain is not recognized and loss is not
deductible for income tax purposes until a taxpayer disposes of
an asset. The amount of gain recognized generally is included
in income and the amount of loss sustained in a business or for
profit transaction is generally deductible.
Special rules apply in the case of the sale or exchange of
capital assets. In the case of an individual, estate, or trust,
any adjusted net capital gain that otherwise would be taxed at
the 10- or 15-percent rate is not taxed. Any adjusted net
capital gain that otherwise would be taxed at rates over 15
percent and below 39.6 percent is taxed at a 15-percent rate.
Any adjusted net capital gain that otherwise would be taxed at
a 39.6-percent rate is taxed at a 20-percent rate.\999\
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\999\ Sec. 1. Other rates apply to certain types of gain. The
unrecaptured section 1250 gain is taxed at a maximum rate of 25
percent, and 28-percent rate gain is taxed at a maximum rate of 28
percent. Any amount of unrecaptured section 1250 gain or 28-percent
rate gain otherwise taxed at a 10- or 15-percent rate is taxed at the
otherwise applicable rate. In addition, a tax is imposed on net
investment income in the case of an individual, estate, or trust. In
the case of an individual, the tax is 3.8 percent of the lesser of net
investment income, which includes gains and dividends, or the excess of
modified adjusted gross income over the threshold amount. The threshold
amount is $250,000 in the case of a joint return or surviving spouse,
$125,000 in the case of a married individual filing a separate return,
and $200,000 in the case of any other individual.
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The adjusted net capital gain of an individual is the net
capital gain reduced (but not below zero) by the sum of the 28-
percent rate gain and the unrecaptured section 1250 gain. The
net capital gain is reduced by the amount of gain that the
individual treats as investment income for purposes of
determining the investment interest limitation.\1000\
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\1000\ Sec. 163(d).
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Net capital gain is the excess of the net long-term capital
gain for the taxable year over the net short-term capital loss
for the year.
Net long term capital gain means the excess (if any) of
gain from the sale or exchange of capital assets held more than
one year over the loss from the sale or capital assets held
more than one year (to the extent taken into account in
computing income).
Net short term capital loss means the excess (if any) of
loss from the sale or exchange of capital assets held for not
more than one year over the gain from the sale or capital
assets held for not more than one year (to the extent taken
into account in computing income).
Explanation of Provision
In general
The provision provides for a three-year holding period in
the case of certain net long-term capital gain with respect to
any applicable partnership interest held by the taxpayer.
Interaction with section 83
The provision provides for a three-year holding period in
the case of certain net long-term capital gain with respect to
any applicable partnership interest held by the taxpayer,
notwithstanding the rules of section 83 or any election in
effect under section 83(b). The Congress wishes to clarify the
interaction of section 83 with the provision's three-year
holding requirement, which applies notwithstanding the rules of
section 83 or any election in effect under section 83(b). Under
the provision, the fact that an individual may have included an
amount in income upon acquisition of the applicable partnership
interest, or that an individual may have made a section 83(b)
election with respect to an applicable partnership interest,
does not change the three-year holding period requirement for
long-term capital gain treatment with respect to the applicable
partnership interest. Thus, the provision treats as short-term
capital gain taxed at ordinary income rates the amount of the
taxpayer's net long-term capital gain with respect to an
applicable partnership interest for the taxable year that
exceeds the amount of such gain calculated as if a three-year
(rather than one-year) holding period applies. In making this
calculation, the provision takes account of long-term capital
losses calculated as if a three-year holding period applies.
Short-term capital gain
The provision treats as short-term capital gain taxed at
ordinary income tax rates the amount of the taxpayer's net
long-term capital gain with respect to an applicable
partnership interest for the taxable year that exceeds the
amount of such gain calculated as if a three-year (not one-
year) holding period applies.\1001\ In making this calculation,
the provision takes account of long-term capital losses
calculated as if a three-year holding period applies.
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\1001\ Sec. 1061(a). A net long-term capital gain is defined in
section 1222(7) to mean the excess of long-term capital gains for the
taxable year over the long-term capital losses for such year.
---------------------------------------------------------------------------
A special rule provides that, as provided in regulations or
other guidance issued by the Secretary, this rule does not
apply to income or gain attributable to any asset that is not
held for portfolio investment on behalf of third party
investors. A third party investor means a person (1) who holds
an interest in the partnership that is not property held in
connection with an applicable trade or business (defined below)
with respect to that person, and (2) who is not and has not
been actively engaged in directly or indirectly providing
substantial services for the partnership or any applicable
trade or business (and is (or was) not related to a person so
engaged). A related person for this purpose is a family member
(within the meaning of attribution rules \1002\) or colleague
that is a person who performed a service within the current
calendar year or the preceding three calendar years in any
applicable trade or business in which or for which the taxpayer
performed a service.
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\1002\ Sec. 318(a)(1).
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Applicable partnership interest
An applicable partnership interest is any interest in a
partnership that, directly or indirectly, is transferred to (or
held by) the taxpayer in connection with performance of
services in any applicable trade or business. The services may
be performed by the taxpayer or by any other related person or
persons \1003\ in any applicable trade or business. It is
intended that partnership interests shall not fail to be
treated as transferred or held in connection with the
performance of services merely because the taxpayer also made
contributions to the partnership, and the Treasury Department
is directed to provide guidance implementing this intent. An
applicable partnership interest does not include an interest
held by a person who is employed by another entity that is
conducting a trade or business (which is not an applicable
trade or business) and who provides services only to the other
entity.
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\1003\ Although the provision does not supply a definition of a
related person for purposes of the rule defining an applicable
partnership interest in section 1061(c)(1), it is intended that for
this purpose a related person means a related person within the meaning
of section 267(b) or 707(b). A technical correction may be needed to
carry out this intent.
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An applicable partnership interest does not include an
interest in a partnership directly or indirectly held by a
corporation. For example, if two corporations form a
partnership to conduct a joint venture for developing and
marketing a pharmaceutical product, the partnership interests
held by the two corporations are not applicable partnership
interests. The term ``corporation'' for purposes of section
1061(c)(4)(A) does not include an S corporation, so a
partnership interest held by an S corporation is not excluded
from the term ``applicable partnership interest.''
An applicable partnership interest does not include any
capital interest in a partnership giving the taxpayer a right
to share in partnership capital commensurate with the amount of
capital contributed (as of the time the partnership interest
was received), or commensurate with the value of the
partnership interest that is taxed under section 83 on receipt
or vesting of the partnership interest. For example, in the
case of a partner who holds a capital interest in the
partnership with respect to capital he or she contributed to
the partnership, if the partnership agreement provides that the
partner's share of partnership capital is commensurate with the
amount of capital he or she contributed (as of the time the
partnership interest was received) compared to total
partnership capital, the partnership interest is not an
applicable partnership interest to that extent.
Applicable trade or business
An applicable trade or business means any activity
(regardless of whether the activity is conducted in one or more
entities) that consists in whole or in part of the following:
(1) raising or returning capital, and either (2) investing in
(or disposing of) specified assets (or identifying specified
assets for investing or disposition), or (3) developing
specified assets.
Developing specified assets takes place, for example, if it
is represented to investors, lenders, regulators, or others
that the value, price, or yield of a portfolio business may be
enhanced or increased in connection with choices or actions of
a service provider or of others acting in concert with or at
the direction of a service provider. Services performed as an
employee of an applicable trade or business are treated as
performed in an applicable trade or business for purposes of
this rule. Merely voting shares owned or exercising the right
to vote with respect to shares owned does not amount to
development; for example, a mutual fund that merely votes
proxies received with respect to shares of stock it holds is
not engaged in development.
Specified assets
Under the provision, specified assets means securities
(generally as defined under rules for mark-to-market accounting
for securities dealers), commodities (as defined under rules
for mark-to-market accounting for commodities dealers), real
estate held for rental or investment, cash or cash equivalents,
options or derivative contracts with respect to such
securities, commodities, real estate, cash or cash equivalents,
as well as an interest in a partnership to the extent of the
partnership's proportionate interest in the foregoing. A
security for this purpose means any (1) share of corporate
stock, (2) partnership interest or beneficial ownership
interest in a widely held or publicly traded partnership or
trust, (3) note, bond, debenture, or other evidence of
indebtedness, (4) interest rate, currency, or equity notional
principal contract, (5) interest in, or derivative financial
instrument in, any such security or any currency (regardless of
whether section 1256 applies to the contract), and (6) position
that is not such a security and is a hedge with respect to such
a security and is clearly identified. A commodity for this
purpose means any (1) commodity that is actively traded, (2)
notional principal contract with respect to such a commodity,
(3) interest in, or derivative financial instrument in, such a
commodity or notional principal contract, or (4) position that
is not such a commodity and is a hedge with respect to such a
commodity and is clearly identified. For purposes of the
provision, real estate held for rental or investment does not
include, for example, real estate on which the holder operates
an active farm.
A partnership interest, for purposes of determining the
proportionate interest of a partnership in any specified asset,
includes any partnership interest that is not otherwise treated
as a security for purposes of the provision (for example, an
interest in a partnership that is not widely held or publicly
traded). For example, assume that a hedge fund acquires an
interest in a partnership that is neither publicly traded nor
widely held and whose assets consist of stocks, bonds,
positions that are clearly identified hedges with respect to
securities, and commodities; the partnership interest is a
specified asset for purposes of the provision.
Transfer of applicable partnership interest to related person
If a taxpayer transfers any applicable partnership
interest, directly or indirectly, to a person related to the
taxpayer, then the taxpayer includes in gross income as short-
term capital gain so much of the taxpayer's net long-term
capital gain attributable to the sale or exchange of an asset
held for not more than three years as is allowable to the
interest. The amount included as short-term capital gain on the
transfer is reduced by the amount treated as short-term capital
gain on the transfer for the taxable year under the general
rule of the provision (that is, amounts are not double-
counted). A related person for this purpose is a family member
(within the meaning of attribution rules \1004\) or colleague,
that is a person who performed a service within the current
calendar year or the preceding three calendar years in any
applicable trade or business in which or for which the taxpayer
performed a service.
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\1004\ Sec. 318(a)(1).
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Reporting requirement
The Secretary is directed to require reporting (at the time
in the manner determined by the Secretary) necessary to carry
out the purposes of the provision. The penalties otherwise
applicable to a failure to report to partners under section
6031(b) apply to failure to report under this requirement.
Regulatory authority
The Treasury Department is directed to issue regulations or
other guidance necessary to carry out the purposes of the
provision. Such guidance is to address prevention of the abuse
of the purposes of the provision, including through the
allocation of income to tax-indifferent parties. Guidance is
also to provide for the application of the provision in the
case of tiered structures of entities.
The Treasury Department and IRS have issued published
guidance addressing this provision.\1005\
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\1005\ Notice 2018-18, 2018-12 I.R.B. 443, March 19, 2018.
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
J. Prohibition on Cash, Gift Cards, and Other Nontangible Personal
Property as Employee Achievement Awards (sec. 13310 of the Act and
secs. 74(c) and 274(j) of the Code)
Prior Law
An employer's deduction for the cost of an employee
achievement award is limited to a certain amount.\1006\
Employee achievement awards that are deductible by an employer
(or would be deductible but for the fact that the employer is a
tax-exempt organization) are excludible from an employee's
gross income.\1007\ Amounts attributable to employee
achievement awards that are excludible from gross income under
section 74(c) for income tax purposes are also excluded from
wages for employment tax purposes.
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\1006\ Secs. 274(j)(1) and (2).
\1007\ Sec. 74(c).
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Generally, an employee achievement award is an item of
tangible personal property given to an employee in recognition
of either length of service or safety achievement and presented
as part of a meaningful presentation.\1008\
---------------------------------------------------------------------------
\1008\ Sec. 274(j)(3).
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Explanation of Provision
The provision adds a definition of ``tangible personal
property'' that may be considered a deductible employee
achievement award. It provides that tangible personal property
shall not include cash, cash equivalents, gift cards, gift
coupons or gift certificates (other than arrangements
conferring only the right to select and receive tangible
personal property from a limited array of such items
preselected or preapproved by the employer), or vacations,
meals, lodging, tickets to theater or sporting events, stocks,
bonds, other securities, and other similar items. No inference
is intended that this is a change from prior law and guidance.
Effective Date
The provision applies to amounts paid or incurred after
December 31, 2017.
K. Elimination of Deduction for Living Expenses Incurred by Members of
Congress (sec. 13311 of the Act and sec. 162 of the Code)
Prior Law
Section 162 generally permits a deduction for ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business. Such expenses include
certain traveling expenses while temporarily (within a one-year
period) away from home in the pursuit of a trade or business.
For this purpose, the place of residence of a Member of
Congress within the State, congressional district, or
possession that he or she represents is considered the Member's
home, but amounts expended for living expenses in excess of
$3,000 within a taxable year are not deductible.
Explanation of Provision
The provision repeals the deduction for living expenses of
Members of Congress.
Effective Date
The provision is effective for taxable years beginning
after the date of enactment of the Act (i.e., December 22,
2017).
L. Certain Contributions by Governmental Entities Not Treated as
Contributions to Capital (sec. 13312 of the Act and sec. 118 of the
Code)
Prior Law
The gross income of a corporation does not include any
contribution to its capital.\1009\ For purposes of this rule, a
contribution to the capital of a corporation does not include
any contribution in aid of construction or any other
contribution from a customer or potential customer.\1010\ A
special rule allows certain contributions in aid of
construction received by a regulated public utility that
provides water or sewerage disposal services to be treated as a
tax-free contribution to the capital of the utility.\1011\ No
deduction or credit is allowed for, or by reason of, any
expenditure that constitutes a contribution that is treated as
a tax-free contribution to the capital of the utility.\1012\
Section 118 applies only to corporations.
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\1009\ Sec. 118(a).
\1010\ Sec. 118(b).
\1011\ Sec. 118(c)(1).
\1012\ Sec. 118(c)(4).
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If property is acquired by a corporation as a contribution
to capital and is not contributed by a shareholder as such, the
adjusted basis of the property is zero.\1013\ If the
contribution consists of money, the corporation must first
reduce the basis of any property acquired with the contributed
money within the following 12-month period, and then reduce the
basis of other property held by the corporation.\1014\
Similarly, the adjusted basis of any property acquired by a
utility with a contribution in aid of construction is
zero.\1015\
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\1013\ Sec. 362(c)(1).
\1014\ Sec. 362(c)(2). See also Treas. Reg. sec. 1.362-2.
\1015\ Sec. 118(c)(4).
---------------------------------------------------------------------------
Explanation of Provision
The provision provides that the term ``contribution to the
capital of the taxpayer'' does not include (1) any contribution
in aid of construction (without exception) \1016\ or any other
contribution as a customer or potential customer, and (2) any
contribution by any governmental entity or civic group (other
than a contribution made by a shareholder as such). Thus, for
example, a municipal tax abatement for locating a business in a
particular municipality is not considered a contribution to
capital of the corporation. The provision instructs the
Secretary to issue such regulations or other guidance as may be
necessary or appropriate to carry out this section, including
regulations or other guidance for determining whether any
contribution constitutes a contribution in aid of construction.
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\1016\ The special rules for water and sewerage disposal utilities
are repealed.
---------------------------------------------------------------------------
Effective Date
In general, the provision applies to contributions made
after the date of enactment (i.e., December 22, 2017). The
provision does not apply to any contribution made after
December 22, 2017, by a governmental entity which is made
pursuant to a master development plan that has been approved
prior to such date by a governmental entity.
M. Repeal of Rollover of Publicly Traded Securities Gain into
Specialized Small Business Investment Companies (sec. 13313 of the Act
and former sec. 1044 of the Code)
Prior Law
A corporation or individual may elect to roll over tax-free
any capital gain realized on the sale of publicly-traded
securities to the extent of the taxpayer's cost of purchasing
common stock or a partnership interest in a specialized small
business investment company within 60 days of the sale.\1017\
The amount of gain that an individual may elect to roll over
for a taxable year is limited to (1) $50,000 or (2) $500,000
reduced by the gain previously excluded.\1018\ For
corporations, these limits are $250,000 and $1 million,
respectively.\1019\
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\1017\ Sec. 1044(a).
\1018\ Sec. 1044(b)(1).
\1019\ Sec. 1044(b)(2).
---------------------------------------------------------------------------
Explanation of Provision
The provision repeals the election to roll over tax-free
capital gain realized on the sale of publicly-traded
securities.
Effective Date
The provision applies to sales after December 31, 2017.
N. Certain Self-Created Property Not Treated as a Capital Asset (sec.
13314 of the Act and sec. 1221(a)(3) of the Code)
Prior Law
In general, property held by a taxpayer (whether or not
connected with his trade or business) is considered a capital
asset.\1020\ Certain assets, however, are specifically excluded
from the definition of capital asset. Such excluded assets are:
inventory property, property of a character subject to
depreciation (including real property),\1021\ certain self-
created intangibles, accounts or notes receivable acquired in
the ordinary course of business (e.g., for providing services
or selling property), publications of the U.S. Government
received by a taxpayer other than by purchase at the price
offered to the public, commodities derivative financial
instruments held by a commodities derivatives dealer unless
established to the satisfaction of the Secretary that any such
instrument has no connection to the activities of such dealer
as a dealer and clearly identified as such before the close of
the day on which it was acquired, originated, or entered into,
hedging transactions clearly identified as such, and supplies
regularly used or consumed by the taxpayer in the ordinary
course of a trade or business of the taxpayer.\1022\
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\1020\ Sec. 1221(a).
\1021\ The net gain from the sale, exchange, or involuntary
conversion of certain property used in the taxpayer's trade or business
(in excess of depreciation recapture) is treated as long-term capital
gain. Sec. 1231. However, net gain from such property is treated as
ordinary income to the extent that losses from such property in the
previous five years were treated as ordinary losses. Sec. 1231(c).
\1022\ Sec. 1221(a)(1)-(8).
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Self-created intangibles subject to the exception are
copyrights, literary, musical, or artistic compositions,
letters or memoranda, or similar property which is held either
by the taxpayer whose personal efforts created the property, or
(in the case of a letter, memorandum, or similar property) a
taxpayer for whom the property was produced.\1023\ For the
purpose of determining gain, a taxpayer with a transferred
basis from the taxpayer whose personal efforts created the
property, or for whom the property was created, also is subject
to the exception.\1024\ However, a taxpayer may elect to treat
musical compositions and copyrights in musical works as capital
assets.\1025\
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\1023\ Sec. 1221(a)(3)(A) and (B).
\1024\ Sec. 1221(a)(3)(C).
\1025\ Sec. 1221(b)(3). Thus, if a taxpayer who owns musical
compositions or copyrights in musical works that the taxpayer created
(or if a taxpayer to which the musical compositions or copyrights have
been transferred by the works' creator in a substituted basis
transaction) elects the application of this provision, gain from a sale
of the compositions or copyrights is treated as capital gain, not
ordinary income.
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Since the intent of Congress is that profits and losses
arising from everyday business operations be characterized as
ordinary income and loss, the general definition of capital
asset is narrowly applied and the categories of exclusions are
broadly interpreted.\1026\
---------------------------------------------------------------------------
\1026\ Corn Products Refining Co. v. Commissioner, 350 U.S. 46, 52
(1955).
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Explanation of Provision
This provision amends section 1221(a)(3), resulting in the
exclusion of a patent, invention, model or design (whether or
not patented), and a secret formula or process which is held
either by the taxpayer who created the property or a taxpayer
with a substituted or transferred basis from the taxpayer who
created the property (or for whom the property was created)
from the definition of a ``capital asset.'' Thus, gains or
losses from the sale or exchange of a patent, invention, model
or design (whether or not patented), or a secret formula or
process which is held either by the taxpayer who created the
property or a taxpayer with a substituted or transferred basis
from the taxpayer who created the property (or for whom the
property was created) will not receive capital gain treatment
under section 1221.\1027\
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\1027\ However, consistent with prior law, the transfer (other than
by gift, inheritance, or devise) of a patent by an individual that
created the patent, or any other individual who acquired an interest in
the patent in an exchange for consideration in money (i.e., an exchange
that did not result in a substituted or transferred basis in the
patent) prior to the actual reduction to practice of the invention
covered by the patent (where such other individual is not the employer
of the creator or related to the creator), is treated as a sale or
exchange of a capital asset held for more than one year. See section
1235.
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Effective Date
The provision applies to dispositions after December 31,
2017.
PART V--BUSINESS CREDITS
A. Modification of Orphan Drug Credit (sec. 13401 of the Act and secs.
45C and 280C of the Code)
Prior Law
Section 45C provides a 50-percent business tax credit for
qualified clinical testing expenses incurred in testing of
certain drugs for rare diseases or conditions, generally
referred to as ``orphan drugs.'' Qualified clinical testing
expenses are costs incurred to test an orphan drug after the
drug has been approved for human testing by the Food and Drug
Administration (``FDA'') but before the drug has been approved
for sale by the FDA.\1028\ A rare disease or condition is
defined as one that (1) affects fewer than 200,000 persons in
the United States, or (2) affects more than 200,000 persons,
but for which there is no reasonable expectation that
businesses could recoup the costs of developing a drug for such
disease or condition from sales in the United States of the
drug.\1029\
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\1028\ Sec. 45C(b).
\1029\ Sec. 45C(d).
---------------------------------------------------------------------------
Amounts included in computing the credit under this section
are excluded from the computation of the research credit under
section 41.\1030\
---------------------------------------------------------------------------
\1030\ Sec. 45C(c).
---------------------------------------------------------------------------
No deduction is allowed for the portion of otherwise
allowable qualified clinical testing expenses equal to the
amount of the orphan drug credit allowed for the taxable
year.\1031\
---------------------------------------------------------------------------
\1031\ Sec. 280C(b).
---------------------------------------------------------------------------
Explanation of Provision
The provision reduces the credit rate to 25 percent of
qualified clinical testing expenses. The provision also allows
taxpayers to elect a reduced orphan drug credit rather than
having their otherwise allowable deduction for qualified
clinical testing expenses reduced by that amount. If an
election is made, the orphan drug credit is reduced by an
amount equal to that credit multiplied by the highest corporate
tax rate.
Effective Date
The provision applies to amounts paid or incurred in
taxable years beginning after December 31, 2017.
B. Rehabilitation Credit Limited to Certified Historic Structures (sec.
13402 of the Act and sec. 47 of the Code)
Prior Law
Section 47 provides a two-tier tax credit for
rehabilitation expenditures.
A 20-percent credit is provided for qualified
rehabilitation expenditures with respect to a certified
historic structure. For this purpose, a certified historic
structure means any building that is listed in the National
Register, or that is located in a registered historic district
and is certified by the Secretary of the Interior to the
Secretary of the Treasury as being of historic significance to
the district.
A 10-percent credit is provided for qualified
rehabilitation expenditures with respect to a qualified
rehabilitated building, which generally means a building that
was first placed in service before 1936. A pre-1936 building
must meet requirements with respect to retention of existing
external walls and internal structural framework of the
building in order for expenditures with respect to it to
qualify for the 10-percent credit. A building is treated as
having met the substantial rehabilitation requirement under the
10-percent credit only if the rehabilitation expenditures
during the 24-month period selected by the taxpayer and ending
within the taxable year exceed the greater of (1) the adjusted
basis of the building (and its structural components), or (2)
$5,000.
The provision requires the use of straight-line
depreciation or the alternative depreciation system in order
for rehabilitation expenditures to be treated as qualified
under the provision.
Explanation of Provision
The provision repeals the 10-percent credit for pre-1936
buildings.
The provision retains the 20-percent credit for qualified
rehabilitation expenditures with respect to a certified
historic structure, with a modification. Under the provision,
the credit allowable for a taxable year during the five-year
period beginning in the taxable year in which the qualified
rehabilitated building is placed in service is an amount equal
to the ratable share. The ratable share for a taxable year
during the five-year period is amount equal to 20 percent of
the qualified rehabilitation expenditures for the building, as
allocated ratably to each taxable year during the five-year
period. Congress intended that the sum of the ratable shares
for the taxable years during the five-year period does not
exceed 100 percent of the credit for qualified rehabilitation
expenditures for the qualified rehabilitated building.
Effective Date
The provision applies to amounts paid or incurred after
December 31, 2017.
A transition rule provides that in the case of qualified
rehabilitation expenditures (for either a certified historic
structure or a pre-1936 building), with respect to any building
owned or leased (as provided under prior law) by the taxpayer
at all times on and after January 1, 2018, the 24-month period
selected by the taxpayer (section 47(c)(1)(C)(i)), or the 60-
month period selected by the taxpayer under the rule for phased
rehabilitation (section 47(c)(1)(C)(ii)), is to begin not later
than the end of the 180-day period beginning on the date of the
enactment of the Act, and the amendments made by the provision
apply to such expenditures paid or incurred after the end of
the taxable year in which such 24-month or 60-month period
ends.
C. Employer Credit for Paid Family and Medical Leave (sec. 13403 of the
Act and new sec. 45S of the Code)
Prior Law
The Family and Medical Leave Act of 1993, as amended (the
``FMLA''), generally requires employers to provide employees
with up to 26 weeks of leave under certain circumstances.\1032\
The FMLA does not require that the employer continue to pay
employees during such leave, although employers may choose to
pay for all or a portion of such leave. State and local
governments may provide, or State and local laws may require
employers to provide, employees with up to a certain amount of
paid leave for types of leave that may or may not fall under
the FMLA.
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\1032\ Pub. L. No. 103-3 (Feb. 5, 1993); 29 U.S.C. sec. 2601, et
seq.
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Compensation paid to employees during FMLA leave is
generally deductible as an ordinary and necessary business
expense. Such compensation constitutes wages taxable to the
employee for income and employment tax purposes. Although the
wages may be taken into account in the computation of the
general business credit \1033\ as part of the computation of
those credits that are computed with respect to qualified wages
paid,\1034\ prior law does not otherwise provide a credit to
employers for compensation paid to employees while on leave.
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\1033\ Under section 38 and applicable rules.
\1034\ See, e.g., sec. 45A (Indian employment credit) and sec. 51
(work opportunity tax credit).
---------------------------------------------------------------------------
Explanation of Provision
The provision temporarily allows ``eligible employers'' to
claim a general business credit equal to 12.5 percent of the
amount of eligible wages (based on the normal hourly wage rate)
\1035\ paid to ``qualifying employees'' during any period in
which such employees are on ``family and medical leave'' if the
rate of payment under the program is 50 percent of the wages
normally paid to an employee for actual services performed for
the employer. The credit is increased by 0.25 percentage points
(but not above 25 percent) for each percentage point by which
the rate of payment exceeds 50 percent. The maximum amount of
family and medical leave that may be taken into account with
respect to any qualifying employee for any taxable year is 12
weeks.
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\1035\ Wages for this purpose are Federal Unemployment Tax Act
wages defined in section 3306(b), without regard to the dollar
limitation, but do not include amounts taken into account for purposes
of determining any other credit under subpart D of the Code. A
technical correction may be necessary to reflect that the wages with
respect to the credit are limited to the employee's normal hourly wage
rate and do not include additional amounts, such as a bonus, that could
be paid during the leave period.
---------------------------------------------------------------------------
An ``eligible employer'' is one which has in place a
written policy that allows all qualifying full-time employees
not less than two weeks of annual paid family and medical
leave, and which allows all less-than-full-time qualifying
employees a commensurate amount of leave (on a pro rata basis)
compared to the leave provided to full-time employees. The
policy must also provide that the rate of payment under the
program is not less than 50 percent of the wages normally paid
to any such employee for services performed for the employer.
In addition, in order to be an eligible employer, the
employer is prohibited from certain practices or acts which are
also prohibited under the FMLA, regardless of whether the
employer is subject to the FMLA. Specifically, the employer
must provide paid family and medical leave in compliance with a
written policy that ensures that the employer will not
interfere with, restrain, or deny the exercise of or the
attempt to exercise, any right provided under the policy and
will not discharge or in any other manner discriminate against
any individual for opposing any practice prohibited by the
policy.
The provision treats all members of an aggregated group
\1036\ as a single employer, other than for purposes of the
requirement for an employer to have in place a written policy
with certain terms.\1037\ In other words, the aggregation rule
does not prevent an employer within an aggregated group from
qualifying for the credit notwithstanding that other employers
within the same aggregated group do not have the required
written policy. However, the terms (the offer, the actual
benefit, etc.) of the employer's paid leave cannot be
discriminatory based on taking into account all employees of
all employers otherwise treated as a single employer under the
provision. For example, if employees who earn below a certain
threshold (such as $20,000 annually) are employed by one or
more employers within the aggregated group that do not have the
required written policy in place, while employees earning above
$20,000 are employed by another employer in the group having
the required written policy (Employer A), Employer A is not an
eligible employer. Similarly, if employees are separately
employed by category or position (such as part-time employees,
or administrative employees) on a discriminatory basis for
purposes of providing paid family and medical leave, this
results in failure to be an eligible employer.
---------------------------------------------------------------------------
\1036\ Under subsections (a) and (b) of section 52.
\1037\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
A ``qualifying employee'' means any individual who is an
employee under tax rules and principles and is defined in
section 3(e) of the Fair Labor Standards Act of 1938,\1038\ as
amended, who has been employed by the employer for one year or
more, and who for the preceding year, had compensation not in
excess of 60 percent of the compensation threshold for highly
compensated employees.\1039\ For 2018, this 60 percent amount
is $72,000.
---------------------------------------------------------------------------
\1038\ Pub. L. No. 75-718 (June 25, 1938); 29 U.S.C. sec. 201, et
seq.
\1039\ Sec. 414(q)(1)(B) ($120,000 for 2018).
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``Family and medical leave'' for purposes of new section
45S is generally defined as leave described under sections
102(a)(1)(A)-(E) or 102(a)(3) of the FMLA.\1040\ If an employer
provides paid leave as vacation leave, personal leave, or other
medical or sick leave \1041\ (unless the medical or sick leave
is specifically for one or more of the ``family and medical
leave'' purposes defined above), such paid leave would not be
considered to be family and medical leave. In addition, leave
paid for by a State or local government or required by State or
local law (including such leave required to be paid by the
employer) is not taken into account in determining the amount
of paid family and medical leave provided by the employer that
is eligible for the credit.
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\1040\ FMLA section 102(a)(1) provides leave for FMLA purposes due
to (A) the birth of a son or daughter of the employee and in order to
care for such son or daughter; (B) the placement of a son or daughter
with the employee for adoption or foster care; (C) caring for the
spouse, or a son, daughter, or parent, of the employee, if such spouse,
son, daughter, or parent has a serious health condition; (D) a serious
health condition that makes the employee unable to perform the
functions of the employee's position; (E) any qualifying exigency (as
the Secretary of Labor shall, by regulation, determine) arising out of
the fact that the spouse, or a son, daughter, or parent of the employee
is on covered active duty (or has been notified of an impending call or
order to covered active duty) in the Armed Forces. In addition, FMLA
section 102(a)(3) provides leave for FMLA purposes due to the need of
an employee who is a spouse, son, daughter, parent, or next-of-kin of
an eligible service member to care for such service member.
\1041\ These terms mean these types of leave within the meaning of
FMLA section 102(d)(2).
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The Secretary will make determinations as to whether an
employer or an employee satisfies the applicable requirements
for an eligible employer or qualifying employee, based on
information provided by the employer that the Secretary
determines to be necessary or appropriate.
The following examples illustrate the operation of the
interaction between State or local government mandated paid
leave and the credit. Assume that in each of the examples 1
through 3 below, a State mandates that an employer provide two
weeks of family and medical leave at a rate of 50 percent of
its employees' normal hourly wage rate. For purposes of the
examples, assume that all other applicable requirements of
section 45S are met (including that employees are qualifying
employees) unless otherwise indicated:
Example 1.--Assume that the employer provides its employees
with four weeks of paid leave, at 50 percent of the employees'
normal hourly wage rate. Under this fact pattern, the employer
would be eligible for a credit of 12.5 percent of the eligible
wages paid with respect to weeks three and four of paid leave,
as those payments constitute two weeks of non-mandated paid
leave at 50 percent of the employees' normal hourly wage rate.
Example 2.--Assume that the employer provides its employees
with three weeks of paid leave, at 50 percent of the employees'
normal hourly wage rate. Under this fact pattern, the employer
would not be eligible for the credit under section 45S.
Although the employer pays its employees a total of three
weeks' compensation at 50 percent of the employees' normal
hourly wage rate, because the compensation for two of those
weeks are mandated by State law, under 45S(c)(4), that
compensation is disregarded for purposes of the credit. Thus,
the employer provides only one week of non-mandated paid leave
at 50 percent of its employees' normal hourly wage rate, and
fails to qualify as an eligible employer under 45S(c)(1)(A).
Example 3.--Assume that the employer provides its employees
with two weeks of paid leave, at 100 percent of the employees'
normal hourly wage rate. Under this fact pattern, the employer
would be eligible for a credit of 12.5 percent of the eligible
wages paid with respect to the two weeks of paid leave. The
employer has provided non-mandated paid leave at 50 percent of
the employees' normal hourly wage rate for two weeks, and thus
qualifies for the credit under section 45S. The employer may
not receive a credit at a rate in excess of 12.5 percent,
notwithstanding that the total compensation paid to its
employees on family and medical leave was 100 percent of the
normal hourly wage rate, because 50 percent of the paid leave
provided by the employer was mandated by State law.\1042\
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\1042\ If this example instead assumed that the State required an
employer to provide paid leave at a rate of only 40 percent of its
employees' normal hourly wage rate, then the employer would be eligible
for a credit based on 15 percent of the employees' wages (as the
employer would have paid non-State mandated compensation of 60 percent
of the employees' normal hourly wage rate under this fact pattern).
Alternatively, if the example instead assumed that the State required
an employer to pay 60 percent of its employees' normal hourly wage
rate, the employer could not qualify for the section 45S credit if the
employer paid its employees 100 percent of their normal hourly wage
rate (because the amount of non-State mandated paid leave from the
employer does not equal or exceed 50 percent of the employee's normal
hourly wage rate).
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Example 4.--Assume instead that the State requires only
that an employer offer four weeks of unpaid family and medical
leave. If the employer were to provide its employees with two
weeks of paid leave at 50 percent of its employees' normal
hourly wage rate, the employer would be eligible for a credit
of 12.5 percent of the wages paid with respect to those two
weeks of paid leave, as those payments constitute two weeks of
non-mandated paid leave at 50 percent of the employees' normal
hourly wage rate.
The Treasury Department has issued published guidance
addressing this provision.\1043\
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\1043\ Notice 2018-71, 2018-41 I.R.B.548.
---------------------------------------------------------------------------
Effective Date
The provision is generally effective for wages paid in
taxable years beginning after December 31, 2017, and before
January 1, 2020.
D. Repeal of Tax Credit Bonds (sec. 13404 of the Act and former secs.
54A, 54B, 54C, 54D, 54E, 54F and 6431 of the Code)
Prior Law
In general
Tax-credit bonds provide tax credits to investors to
replace a prescribed portion of the interest cost. The
borrowing subsidy generally is measured by reference to the
credit rate set by the Treasury Department. Current tax-credit
bonds include qualified tax credit bonds, which have certain
common general requirements, and include new clean renewable
energy bonds, qualified energy conservation bonds, qualified
zone academy bonds, and qualified school construction
bonds.\1044\
---------------------------------------------------------------------------
\1044\ The authority to issue two other types of tax-credit bonds,
recovery zone economic development bonds and Build America Bonds,
expired on January 1, 2011.
---------------------------------------------------------------------------
Qualified tax-credit bonds
General rules applicable to qualified tax-credit bonds
\1045\
---------------------------------------------------------------------------
\1045\ Certain other rules apply to qualified tax credit bonds,
such as maturity limitations, reporting requirements, spending rules,
and rules relating to arbitrage. Separate rules apply in the case of
tax-credit bonds which are not qualified tax-credit bonds (i.e.,
``recovery zone economic development bonds,'' and ``Build America
Bonds'').
---------------------------------------------------------------------------
Unlike tax-exempt bonds, qualified tax-credit bonds
generally are not interest-bearing obligations. Rather, the
taxpayer holding a qualified tax-credit bond on a credit
allowance date is entitled to a tax credit. The amount of the
credit is determined by multiplying the bond's credit rate by
the face amount on the holder's bond. The credit rate for an
issue of qualified tax credit bonds is determined by the
Secretary and is estimated to be a rate that permits issuance
of the qualified tax-credit bonds without discount and interest
cost to the qualified issuer.\1046\ The credit accrues
quarterly and is includible in gross income (as if it were an
interest payment on the bond), and can be claimed against
regular income tax liability and alternative minimum tax
liability. Unused credits may be carried forward to succeeding
taxable years. In addition, credits may be separated from the
ownership of the underlying bond similar to how interest
coupons can be stripped for interest-bearing bonds.
---------------------------------------------------------------------------
\1046\ However, for new clean renewable energy bonds and qualified
energy conservation bonds, the applicable credit rate is 70 percent of
the otherwise applicable rate.
---------------------------------------------------------------------------
New clean renewable energy bonds
New clean renewable energy bonds (``New CREBs''') may be
issued by qualified issuers to finance qualified renewable
energy facilities.\1047\ Qualified renewable energy facilities
are facilities that: (1) qualify for the tax credit under
section 45 (other than Indian coal and refined coal production
facilities), without regard to the placed-in-service date
requirements of that section; and (2) are owned by a public
power provider, governmental body, or cooperative electric
company.
---------------------------------------------------------------------------
\1047\ Sec. 54C.
---------------------------------------------------------------------------
The term ``qualified issuers'' includes: (1) public power
providers; (2) a governmental body; (3) cooperative electric
companies; (4) a not-for-profit electric utility that has
received a loan or guarantee under the Rural Electrification
Act; and (5) clean renewable energy bond lenders. There was
originally a national limitation for New CREBs of $800 million.
The national limitation was then increased by an additional
$1.6 billion in 2009. As with other tax credit bonds, a
taxpayer holding New CREBs on a credit allowance date is
entitled to a tax credit. However, the credit rate on New CREBs
is set by the Secretary at a rate that is 70 percent of the
rate that would permit issuance of such bonds without discount
and interest cost to the issuer.\1048\
---------------------------------------------------------------------------
\1048\ Given the differences in credit quality and other
characteristics of individual issuers, the Secretary cannot set credit
rates in a manner that will allow each issuer to issue tax credit bonds
at par.
---------------------------------------------------------------------------
Qualified energy conservation bonds
Qualified energy conservation bonds may be used to finance
qualified conservation purposes.
The term ``qualified conservation purpose'' means:
Capital expenditures incurred for purposes
of: (a) reducing energy consumption in publicly owned
buildings by at least 20 percent; (b) implementing
green community programs; \1049\ (c) rural development
involving the production of electricity from renewable
energy resources; or (d) any facility eligible for the
production tax credit under section 45 (other than
Indian coal and refined coal production facilities);
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\1049\ Capital expenditures to implement green community programs
include grants, loans, and other repayment mechanisms to implement such
programs. For example, States may issue these tax credit bonds to
finance retrofits of existing private buildings through loans and/or
grants to individual homeowners or businesses, or through other
repayment mechanisms. Other repayment mechanisms can include periodic
fees assessed on a government bill or utility bill that approximates
the energy savings of energy efficiency or conservation retrofits.
Retrofits can include heating, cooling, lighting, water-saving, storm
water-reducing, or other efficiency measures.
---------------------------------------------------------------------------
Expenditures with respect to facilities or
grants that support research in: (a) development of
cellulosic ethanol or other nonfossil fuels; (b)
technologies for the capture and sequestration of
carbon dioxide produced through the use of fossil
fuels; (c) increasing the efficiency of existing
technologies for producing nonfossil fuels; (d)
automobile battery technologies and other technologies
to reduce fossil fuel consumption in transportation;
and (e) technologies to reduce energy use in buildings;
Mass commuting facilities and related
facilities that reduce the consumption of energy,
including expenditures to reduce pollution from
vehicles used for mass commuting;
Demonstration projects designed to promote
the commercialization of: (a) green building
technology; (b) conversion of agricultural waste for
use in the production of fuel or otherwise; (c)
advanced battery manufacturing technologies; (d)
technologies to reduce peak-use of electricity; and (e)
technologies for the capture and sequestration of
carbon dioxide emitted from combusting fossil fuels in
order to produce electricity; and
Public education campaigns to promote energy
efficiency (other than movies, concerts, and other
events held primarily for entertainment purposes).
There was originally a national limitation on qualified
energy conservation bonds of $800 million. The national
limitation was then increased by an additional $2.4 billion in
2009. As with other qualified tax credit bonds, the taxpayer
holding qualified energy conservation bonds on a credit
allowance date is entitled to a tax credit. The credit rate on
the bonds is set by the Secretary at a rate that is 70 percent
of the rate that would permit issuance of such bonds without
discount and interest cost to the issuer.\1050\
---------------------------------------------------------------------------
\1050\ Given the differences in credit quality and other
characteristics of individual issuers, the Secretary cannot set credit
rates in a manner that will allow each issuer to issue tax credit bonds
at par.
---------------------------------------------------------------------------
Qualified zone academy bonds
A qualified zone academy bond (``QZABs'') is defined as any
bond issued by a State or local government, provided that (1)
at least 95 percent of the proceeds are used for the purpose of
renovating, providing equipment to, developing course materials
for use at, or training teachers and other school personnel in
a ``qualified zone academy,'' and (2) private entities have
promised to contribute to the qualified zone academy certain
equipment, technical assistance or training, employee services,
or other property or services with a value equal to at least 10
percent of the bond proceeds.
A total of $400 million of QZABs has been authorized to be
issued annually in calendar years 1998 through 2008. The
authorization was increased to $1.4 billion for calendar year
2009, and also for calendar year 2010. For each of the calendar
years 2011 through 2016, the authorization was set at $400
million.
Qualified school construction bonds
Qualified school construction bonds must meet three
requirements: (1) 100 percent of the available project proceeds
of the bond issue is used for the construction, rehabilitation,
or repair of a public school facility or for the acquisition of
land on which such a bond-financed facility is to be
constructed; (2) the bonds are issued by a State or local
government within which such school is located; and (3) the
issuer designates such bonds as qualified school construction
bonds.
There is a national limitation on qualified school
construction bonds of $11 billion for calendar years 2009 and
2010, and zero after 2010. If an amount allocated is unused for
a calendar year, it may be carried forward to the following and
subsequent calendar years. Under a separate special rule, the
Secretary of the Interior may allocate $200 million of school
construction bond authority for Indian schools.
Direct-pay bonds and expired tax-credit bond provisions
The Code provides that an issuer may elect to issue certain
tax-credit bonds as ``direct-pay bonds.'' Instead of a credit
to the holder, with a ``direct-pay bond'' the Federal
government pays the issuer a percentage of the interest on the
bonds. The following tax-credit bonds may be issued as direct-
pay bonds: new clean renewable energy bonds, qualified energy
conservation bonds, and qualified school construction bonds.
Qualified zone academy bonds may not be issued as direct-pay
using any national zone academy bond allocation for calendar
years after 2011 or any carryforward of such allocations. The
ability to issue Build America Bonds and Recovery Zone bonds,
which have direct-pay features, expired January 1, 2011.
Explanation of Provision
The provision prospectively repeals authority to issue tax-
credit bonds and direct-pay bonds.
Effective Date
The provision applies to bonds issued after December 31,
2017.
PART VI--PROVISIONS RELATED TO SPECIFIC ENTITES AND INDUSTRIES
SUBPART A--PARTNERSHIPS PROVISIONS
A. Treatment of Gain or Loss of Foreign Persons from Sale or Exchange
of Interests in Partnerships Engaged in Trade or Business Within the
United States (sec. 13501 of the Act and secs. 864(c) and 1446 of the
Code)
Prior Law
In general
A partnership generally is not treated as a taxable entity,
but rather, income of the partnership is taken into account on
the tax returns of the partners. The character (as capital or
ordinary) of partnership items passes through to the partners
as if the items were realized directly by the partners.\1051\ A
partner holding a partnership interest includes in income its
distributive share (whether or not actually distributed) of
partnership items of income and gain, including capital gain
eligible for the lower tax rates, and deducts its distributive
share of partnership items of deduction and loss. A partner's
basis in the partnership interest is increased by any amount of
gain and decreased by any amount of losses thus included. These
basis adjustments prevent double taxation of partnership income
to the partner. Money distributed to the partner by the
partnership is taxed to the extent the amount exceeds the
partner's basis in the partnership interest.
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\1051\ Sec. 702.
---------------------------------------------------------------------------
Gain or loss from the sale or exchange of a partnership
interest generally is treated as gain or loss from the sale or
exchange of a capital asset.\1052\ However, the amount of money
and the fair market value of property received in the exchange
that represent the partner's share of certain ordinary income-
producing assets of the partnership give rise to ordinary
income rather than capital gain.\1053\ In general, a
partnership does not adjust the basis of partnership property
following the transfer of a partnership interest unless either
the partnership has made a one-time election to do so,\1054\ or
the partnership has a substantial built-in loss immediately
after the transfer.\1055\ If an election is in effect or the
partnership has a substantial built-in loss immediately after
the transfer, adjustments are made with respect to the
transferee partner. These adjustments are to account for the
difference between the transferee partner's proportionate share
of the adjusted basis of the partnership property and the
transferee partner's basis in its partnership interest.\1056\
The effect of the adjustments on the basis of partnership
property is to approximate the result of a direct purchase of
the property by the transferee partner.
---------------------------------------------------------------------------
\1052\ Sec. 741; Pollack v. Commissioner, 69 T.C. 142 (1977).
\1053\ Sec. 751(a). These ordinary income-producing assets are
unrealized receivables of the partnership or inventory items of the
partnership (``751 assets'').
\1054\ Sec. 754.
\1055\ Sec. 743(a).
\1056\ Sec. 743(b).
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Source of gain or loss on transfer of a partnership interest
A foreign person that is engaged in a trade or business in
the United States is taxed on income that is effectively
connected with the conduct of that trade or business
(``effectively connected gain or loss'').\1057\ Partners in a
partnership are treated as engaged in the conduct of a trade or
business within the United States if the partnership is so
engaged.\1058\ Any gross income derived by the foreign person
that is not effectively connected with the person's U.S.
business is not taken into account in determining the rates of
U.S. tax applicable to the person's income from the
business.\1059\
---------------------------------------------------------------------------
\1057\ Secs. 871(b), 864(c), and 882.
\1058\ Sec. 875.
\1059\ Secs. 871(b)(2) and 882(a)(2). Non-business income received
by foreign persons from U.S. sources is generally subject to tax on a
gross basis at a rate of 30 percent, and is collected by withholding at
the source of the payment. The income of non-resident aliens or foreign
corporations that is subject to tax at a rate of 30 percent is fixed or
determinable annual or periodical income that is not effectively
connected with the conduct of a U.S. trade or business.
---------------------------------------------------------------------------
Among the factors taken into account in determining whether
income, gain, or loss is effectively connected gain or loss are
the extent to which the income, gain, or loss is derived from
assets used in or held for use in the conduct of the U.S. trade
or business and whether the activities of the trade or business
were a material factor in the realization of the income, gain,
or loss (the ``asset-use'' and ``business-activities''
tests).\1060\ In determining whether the asset-use or business-
activities tests are met, due regard is given to whether such
assets or such income, gain, or loss were accounted for through
such trade or business. Thus, notwithstanding the general rule
that source of gain or loss from the sale or exchange of
personal property is generally determined by the residence of
the seller,\1061\ a foreign partner may have effectively
connected income by reason of the asset use or business
activities of the partnership in which he is an investor.
---------------------------------------------------------------------------
\1060\ Sec. 864(c)(2).
\1061\ Sec. 865(a).
---------------------------------------------------------------------------
Special rules apply to treat gain or loss from disposition
of U.S. real property interests as effectively connected with
the conduct of a U.S. trade or business.\1062\ To the extent
that consideration received by the nonresident alien or foreign
corporation for all or part of its interest in a partnership is
attributable to a U.S. real property interest, that
consideration is considered to be received from the sale or
exchange in the United States of such property.\1063\ In
certain circumstances, gain attributable to sales of U.S. real
property interests may be subject to withholding tax of ten
percent of the amount realized on the transfer.\1064\
---------------------------------------------------------------------------
\1062\ Sec. 897(a) and (g).
\1063\ Sec. 897(g).
\1064\ Sec. 1445(e)(5). Temp. Treas. Reg. sec. 1.1445-11T(b) and
(d).
---------------------------------------------------------------------------
Under a 1991 revenue ruling, the IRS ruled that the asset-
use test and business-activities test should be applied to
partnership assets to determine the extent to which income
derived from the sale or exchange of a partnership interest is
effectively connected with the partnership's U.S.
business.\1065\ Under the ruling, unrealized gain or loss in
partnership assets that would be treated as effectively
connected with the conduct of a U.S. trade or business if those
assets were sold by the partnership is treated as effectively
connected with the conduct of a U.S. trade or business. The
ruling thus takes an aggregate approach to taxation of the sale
of a partnership interest, treating such sale as a sale of the
separate assets of the partnership rather than as a sale of an
interest in the entity as a whole.
---------------------------------------------------------------------------
\1065\ Rev. Rul. 91-32, 1991-1 C.B. 107.
---------------------------------------------------------------------------
However, a 2017 Tax Court case, Grecian Magnesite Mining v.
Commissioner, rejected the aggregate approach adopted by the
ruling and instead held that the rules of subchapter K required
that sale of a partnership interest be treated as sale of an
interest in the entity as a whole rather than the sale or
exchange of the underlying partnership property. Having reached
that conclusion, the court then concluded that the gain from
the taxpayer's sale of its partnership interest was income from
sources outside the United States, did not satisfy any
exception to the general rule that foreign-source income is not
ECI, and thus was not effectively connected with the conduct of
the partnership's trade or business in the United States.\1066\
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\1066\ See Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3
(July 13, 2017). The IRS filed a notice of appeal with the U.S. Circuit
Court of Appeals for the District of Columbia on December 18, 2017.
Grecian Magnesite Mining v. Commissioner, No. 17-1269 (D.C. Cir. Filed
Dec. 18, 2017). The IRS filed its opening brief in that appeal on June
8, 2018, Grecian Magnesite filed its brief on July 3, 2018, and the IRS
filed a reply brief on August 6, 2018. Oral argument in the appeal was
held on October 9, 2018.
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Explanation of Provision
The provision overturns the result in Grecian Magnesite by
treating gain or loss from the sale or exchange of a
partnership interest as effectively connected with a U.S. trade
or business to the extent that the transferor would have had
effectively connected gain or loss had the partnership sold all
of its assets at fair market value as of the date of the sale
or exchange.\1067\ The provision requires that any gain or loss
from the hypothetical asset sale by the partnership be
allocated to interests in the partnership in the same manner as
non-separately stated income and loss.\1068\
---------------------------------------------------------------------------
\1067\ Sec. 864(c)(8)(B).
\1068\ Ibid.
---------------------------------------------------------------------------
The provision also requires the transferee of a partnership
interest to withhold 10 percent of the amount realized on the
sale or exchange of a partnership interest unless the
transferor certifies that the transferor is not a nonresident
alien individual or foreign corporation.\1069\ Congress intends
that, under regulatory authority provided to carry out
withholding requirements of the provision, the Secretary may
provide guidance permitting a broker, as agent of the
transferee, to deduct and withhold the tax equal to 10 percent
of the amount realized on the disposition of a partnership
interest to which the provision applies. If the transferee
fails to withhold the correct amount, the partnership is
required to deduct and withhold from distributions to the
transferee partner an amount equal to the amount the transferee
failed to withhold.\1070\
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\1069\ Sec. 1446(f)(1).
\1070\ Sec. 1446(f)(4).
---------------------------------------------------------------------------
The provision provides the Secretary of the Treasury with
specific regulatory authority to issue such regulations as the
Secretary determines appropriate for the application of the
provision.\1071\ Such guidance may identify other exchanges to
which tax-free exchange treatment may otherwise apply, such as
those described in sections 332, 351, 354, 355, 356, or 361,
under comparable provisions of subchapter K, or under such
other provisions that the Secretary determines
appropriate.\1072\
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\1071\ Secs. 864(c)(8)(E) and 1446(f)(6).
\1072\ Sec. 864(c)(8)(E).
The Treasury Department and IRS have issued published
guidance addressing this provision.\1073\
---------------------------------------------------------------------------
\1073\ Notice 2018-8, 2018-7 I.R.B. 352 (Jan. 2, 2018); Notice
2018-29, 2018-16 I.R.B. 495 (Apr. 2, 2018).
---------------------------------------------------------------------------
Effective Date
The portion of the provision treating gain or loss on sale
of a partnership interest as effectively connected income is
effective for sales and exchanges on or after November 27,
2017. The portion of the provision requiring withholding on
sales or exchanges of partnership interests is effective for
sales and exchanges after December 31, 2017.
B. Modify Definition of Substantial Built-in Loss in the Case of
Transfer of Partnership Interest (sec. 13502 of the Act and sec. 743(d)
of the Code)
Prior Law
In general, a partnership does not adjust the basis of
partnership property following the transfer of a partnership
interest unless either the partnership has made a one-time
election under section 754 to make basis adjustments, or the
partnership has a substantial built-in loss immediately after
the transfer.\1074\
---------------------------------------------------------------------------
\1074\ Sec. 743(a).
---------------------------------------------------------------------------
If an election is in effect, or if the partnership has a
substantial built-in loss immediately after the transfer,
adjustments are made with respect to the transferee partner.
These adjustments are to account for the difference between the
transferee partner's proportionate share of the adjusted basis
of the partnership property and the transferee's basis in its
partnership interest.\1075\ The adjustments are intended to
adjust the basis of partnership property to approximate the
result of a direct purchase of the property by the transferee
partner.
---------------------------------------------------------------------------
\1075\ Sec. 743(b).
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A substantial built-in loss exists if the partnership's
adjusted basis in its property exceeds by more than $250,000
the fair market value of the partnership property.\1076\
Certain securitization partnerships and electing investment
partnerships are not treated as having a substantial built-in
loss in certain instances, and thus are not required to make
basis adjustments to partnership property.\1077\ For electing
investment partnerships, in lieu of the partnership basis
adjustments, a partner-level loss limitation rule
applies.\1078\
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\1076\ Sec. 743(d).
\1077\ See sec. 743(e) (alternative rules for electing investment
partnerships) and sec. 743(f) (exception for securitization
partnerships).
\1078\ Unlike in the case of an electing investment partnership,
the partner-level loss limitation rule does not apply for a
securitization partnership.
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Explanation of Provision
The provision modifies the definition of a substantial
built-in loss for purposes of section 743(d), affecting
transfers of partnership interests. Under the provision, in
addition to the prior- and present-law definition, a
substantial built-in loss also exists if the transferee would
be allocated a net loss in excess of $250,000 upon a
hypothetical disposition by the partnership of all
partnership's assets in a fully taxable transaction for cash
equal to the assets' fair market value, immediately after the
transfer of the partnership interest.
For example, a partnership of three taxable partners
(partners A, B, and C) has not made an election pursuant to
section 754. The partnership has two assets, one of which,
Asset X, has a built-in gain of $1 million, while the other
asset, Asset Y, has a built-in loss of $900,000. Pursuant to
the partnership agreement, any gain on sale or exchange of
Asset X is specially allocated to partner A. The three partners
share equally in all other partnership items, including in the
built-in loss in Asset Y. In this case, each of partner B and
partner C has a net built-in loss of $300,000 (one third of the
loss attributable to asset Y) allocable to his partnership
interest. Nevertheless, the partnership does not have an
overall built-in loss, but a net built-in gain of $100,000 ($1
million minus $900,000). Partner C sells his partnership
interest to another person, D, for $33,333. Under the
provision, the test for a substantial built-in loss applies
both at the partnership level and at the transferee partner
level. If the partnership were to sell all its assets for cash
at their fair market value immediately after the transfer to D,
D would be allocated a loss of $300,000 (one third of the
built-in loss of $900,000 in Asset Y). A substantial built-in
loss exists under the partner-level test added by the
provision, and the partnership adjusts the basis of its assets
accordingly with respect to D.
Effective Date
The provision applies to transfers of partnership interests
after December 31, 2017.
C. Charitable Contributions and Foreign Taxes Taken into Account in
Determining Limitation on Allowance of Partner's Share of Loss (sec.
13503 of the Act and sec. 704 of the Code)
Prior Law
A partner's distributive share of partnership loss
(including capital loss) is allowed only to the extent of the
adjusted basis (before reduction by current year's losses) of
the partner's interest in the partnership at the end of the
partnership taxable year in which the loss occurred. Any
disallowed loss is allowable as a deduction at the end of the
first succeeding partnership taxable year, and subsequent
taxable years, to the extent that the partner's adjusted basis
for its partnership interest at the end of any such year
exceeds zero (before reduction by the loss for the year).\1079\
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\1079\ Sec. 704(d) and Treas. Reg. sec. 1.704-1(d)(1).
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A partner's basis in its partnership interest is increased
by its distributive share of income (including tax exempt
income). A partner's basis in its partnership interest is
decreased (but not below zero) by distributions by the
partnership and its distributive share of partnership losses
and expenditures of the partnership not deductible in computing
partnership taxable income and not properly chargeable to
capital account.\1080\ In the case of a charitable
contribution, a partner's basis is reduced by the partner's
distributive share of the adjusted basis of the contributed
property.\1081\
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\1080\ Sec. 705(a).
\1081\ Rev. Rul. 96-11, 1996-1 C. B. 140.
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A partnership computes its taxable income in the same
manner as an individual with certain exceptions. The exceptions
provide, in part, that the deductions for foreign taxes and
charitable contributions are not allowed to the
partnership.\1082\ Instead, a partner takes into account its
distributive share of the foreign taxes paid by the partnership
and the charitable contributions made by the partnership for
the taxable year.\1083\
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\1082\ Sec. 703(a)(2)(B) and (C). In addition, section 703(a)(2)
provides that other deductions are not allowed to the partnership,
notwithstanding that the partnership's taxable income is computed in
the same manner as an individual's taxable income, specifically:
personal exemptions, net operating loss deductions, certain itemized
deductions for individuals, or depletion.
\1083\ Sec. 702.
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However, in applying the basis limitation on partner
losses, Treasury regulations do not take into account the
partner's share of partnership charitable contributions and
foreign taxes paid or accrued.\1084\ The IRS has taken the
position in a private letter ruling that the basis limitation
on partner losses does not apply to limit the partner's
deduction for its share of the partnership's charitable
contributions.\1085\ While the regulations relating to the loss
limitation do not mention the foreign tax credit, a taxpayer
may choose the foreign tax credit in lieu of deducting foreign
taxes.\1086\
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\1084\ The regulation provides that ``[i]f the partner's
distributive share of the aggregate of items of loss specified in
section 702(a)(1), (2), (3), (8) [now (7)], and (9) [now (8)] exceeds
the basis of the partner's interest computed under the preceding
sentence, the limitation on losses under section 704(d) must be
allocated to his distributive share of each such loss.'' The regulation
does not refer to section 702(a)(4) (charitable contributions) and (6)
(foreign taxes paid or accrued). Treas. Reg. sec. 1.704-1(d)(2).
\1085\ Priv. Ltr. Rul. 8405084. See also William S. McKee, William
F. Nelson and Robert L. Whitmire, Federal Taxation of Partnerships and
Partners, WG&L, 4th Edition (2011), paragraph 11.05[1][b], p. 11-214
(noting that the ``failure to include charitable contributions in the
section 704(d) limitation is an apparent technical flaw in the statute.
Because of it, a zero-basis partner may reap the benefits of a
partnership charitable contribution without an offsetting decrease in
the basis of his interest, whereas a fellow partner who happens to have
a positive basis may do so only at the cost of a basis decrease'').
\1086\ Sec. 901.
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By contrast, under S corporation rules limiting the losses
and deductions which may be taken into account by a shareholder
of an S corporation to the shareholder's basis in stock and
debt of the corporation, the shareholder's pro rata share of
charitable contributions and foreign taxes are taken into
account.\1087\ In the case of charitable contributions, a
special rule is provided prorating the amount of appreciation
not subject to the limitation in the case of charitable
contributions of appreciated property by the S
corporation.\1088\
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\1087\ Sec. 1366(d) and (a)(1). Under a related rule, the
shareholder's basis in his interest is decreased by the basis (rather
than the fair market value) of appreciated property by reason of a
charitable contribution of the property by the S corporation (sec.
1367(a)(2)).
\1088\ Sec. 1366(d)(4).
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Explanation of Provision
The provision modifies the basis limitation on partner
losses to provide that the limitation takes into account a
partner's distributive share of partnership charitable
contributions (as defined in section 170(c)) and taxes
(described in section 901) paid or accrued to foreign countries
and to possessions of the United States. Thus, the amount of
the basis limitation on partner losses is decreased to reflect
these items. In the case of a charitable contribution by the
partnership, the amount of the basis limitation on partner
losses is decreased by the partner's distributive share of the
adjusted basis of the contributed property. In the case of a
charitable contribution by the partnership of property whose
fair market value exceeds its adjusted basis, a special rule
provides that the basis limitation on partner losses does not
apply to the extent of the partner's distributive share of the
excess.
Effective Date
The provision applies to partnership taxable years
beginning after December 31, 2017.
D. Repeal of Technical Termination of Partnerships (sec. 13504 of the
Act and sec. 708(b) of the Code)
Prior Law
A partnership is considered as terminated under specified
circumstances.\1089\ Special rules apply in the case of the
merger, consolidation, or division of a partnership.\1090\
---------------------------------------------------------------------------
\1089\ Sec. 708(b)(1).
\1090\ Sec. 708(b)(2). Mergers, consolidations, and divisions of
partnerships take either an assets-over form or an assets-up form
pursuant to Treas. Reg. sec. 1.708-1(c).
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A partnership is treated as terminated if no part of any
business, financial operation, or venture of the partnership
continues to be carried on by any of its partners in a
partnership.\1091\
---------------------------------------------------------------------------
\1091\ Sec. 708(b)(1)(A).
---------------------------------------------------------------------------
A partnership is also treated as terminated if within any
12-month period, there is a sale or exchange of 50 percent or
more of the total interest in partnership capital and
profits.\1092\ This is sometimes referred to as a technical
termination. Under regulations, the technical termination gives
rise to a deemed contribution of all the partnership's assets
and liabilities to a new partnership in exchange for an
interest in the new partnership, followed by a deemed
distribution of interests in the new partnership to the
purchasing partners and the other remaining partners.\1093\
---------------------------------------------------------------------------
\1092\ Sec. 708(b)(1)(B).
\1093\ Treas. Reg. sec. 1.708-1(b)(4).
---------------------------------------------------------------------------
The effect of a technical termination is not necessarily
the end of the partnership's existence, but rather the
termination of some tax attributes. Upon a technical
termination, the partnership's taxable year closes, potentially
resulting in short taxable years.\1094\ Partnership-level
elections generally cease to apply following a technical
termination.\1095\ A technical termination generally results in
the restart of partnership depreciation recovery periods.
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\1094\ Sec. 706(c)(1); Treas. Reg. sec. 1.708-1(b)(3).
\1095\ Partnership level elections include, for example, the
section 754 election to adjust basis on a transfer or distribution, as
well as other elections that determine the partnership's tax treatment
of partnership items. A list of elections can be found at William S.
McKee, William F. Nelson, and Robert L. Whitmire, Federal Taxation of
Partnerships and Partners, 4th edition, para. 9.01[7], pp. 9-42-9-44.
---------------------------------------------------------------------------
Explanation of Provision
The provision repeals the section 708(b)(1)(B) rule
providing for technical terminations of partnerships. The
provision does not change the prior- and present-law rule of
section 708(b)(1)(A) that a partnership is considered as
terminated if no part of any business, financial operation, or
venture of the partnership continues to be carried on by any of
its partners in a partnership.
Effective Date
The provision applies to partnership taxable years
beginning after December 31, 2017.
SUBPART B--INSURANCE REFORMS
A. Net Operating Losses of Life Insurance Companies (sec. 13511 of the
Act and sec. 805 of the Code)
Prior Law
A net operating loss (``NOL'') generally means the amount
by which a taxpayer's business deductions exceed its gross
income. In general, an NOL may be carried back two years and
carried over 20 years to offset taxable income in such years.
NOLs offset taxable income in the order of the taxable years to
which the NOL may be carried.\1096\
---------------------------------------------------------------------------
\1096\ Sec. 172(b)(2).
---------------------------------------------------------------------------
For purposes of computing the alternative minimum tax
(``AMT''), a taxpayer's NOL deduction cannot reduce the
taxpayer's alternative minimum taxable income (``AMTI'') by
more than 90 percent of the AMTI.\1097\
---------------------------------------------------------------------------
\1097\ Sec. 56(d).
---------------------------------------------------------------------------
In the case of a life insurance company, a deduction is
allowed in the taxable year for operations loss carryovers and
carrybacks, in lieu of the deduction for net operating losses
allowed to other corporations.\1098\ A life insurance company
is permitted to treat a loss from operations (as defined under
section 810(c)) for any taxable year as an operations loss
carryback to each of the three taxable years preceding the loss
year and an operations loss carryover to each of the 15 taxable
years following the loss year.\1099\
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\1098\ Secs. 810, 805(a)(5).
\1099\ Sec. 810(b)(1). Special rules apply with respect to a new
company as defined in section 810(e).
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Explanation of Provision
The provision repeals the operations loss deduction for
life insurance companies and allows the NOL deduction under
section 172, effective for losses arising in taxable years
beginning after December 31, 2017. Thus, an NOL of a life
insurance company arising in a taxable year beginning after
December 31, 2017, is carried over (and not carried back) and
is subject to a limitation on deductibility based on 80 percent
of taxable income (determined without regard to certain
deductions) under the NOL rules.\1100\ Because the provision
applies to losses arising in taxable years beginning after
December 31, 2017, operations loss carryovers from taxable
years beginning on or before December 31, 2017, are allowed as
deductions in taxable years beginning after December 31, 2017,
in accordance with section 810 as in effect before its repeal
by the Act. For example, in the case of an operations loss of a
life insurance company arising in a taxable year beginning in
2017, the 15-year carryforward limitation under the law in
effect for the year in which the loss arose continues to apply
to the loss. Such losses may expire if not used within the 15-
year carryforward period.
---------------------------------------------------------------------------
\1100\ See sec. 172. For a discussion of the changes made by the
Act to section 172, see the description of section 13302 of the Act
(Modification of Net Operating Loss Deduction).
---------------------------------------------------------------------------
Effective Date
The provision applies to losses arising in taxable years
beginning after December 31, 2017.
B. Repeal of Small Life Insurance Company Deduction (sec. 13512 of the
Act and former sec. 806 of the Code)
Prior Law
The small life insurance company deduction for any taxable
year is 60 percent of so much of the tentative life insurance
company taxable income (``LICTI'') for such taxable year as
does not exceed $3 million, reduced (but not below zero) by 15
percent of the excess of tentative LICTI over $3 million. The
maximum deduction that can be claimed by a small company is
$1.8 million, and a company with a tentative LICTI of $15
million or more is not entitled to any small company deduction.
A small life insurance company for this purpose is one with
less than $500 million of assets.
Explanation of Provision
The provision repeals the small life insurance company
deduction.
The provision makes a conforming amendment, moving to
section 453B(e)(3) (relating to installment sales) the prior-
and present-law rule regarding the treatment of a real estate
activity that constitutes the active conduct of a trade or
business and of performance of administrative services in
connection with certain plans.
The repeal of section 806(b)(3)(C) as part of the repeal of
section 806 does not alter the applicability of limitations
under section 1503(c) relating to the use of certain losses
against income of life insurance companies. Thus, limitations
under section 1503(c) continue to apply.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
C. Adjustment for Change in Computing Reserves (sec. 13513 of the Act
and sec. 807(f) of the Code)
Prior Law
Change in method of accounting
In general, a taxpayer may change its method of accounting
under section 446 with the consent of the Secretary (or may be
required to change its method of accounting by the Secretary).
In such instances, a taxpayer generally is required to make an
adjustment (a ``section 481(a) adjustment'') to prevent amounts
from being duplicated in, or omitted from, the calculation of
the taxpayer's income. Pursuant to IRS procedures, negative
section 481(a) adjustments generally are deducted from income
in the year of the change whereas positive section 481(a)
adjustments generally are required to be included in income
ratably over four taxable years.\1101\
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\1101\ See, e.g., Rev. Proc. 2015-13, 2015-5 I.R.B. 419, and Rev.
Proc. 2017-30, 2017-18 I.R.B. 1131.
---------------------------------------------------------------------------
However, section 807(f) explicitly provides that changes in
the basis for determining life insurance company reserves are
to be taken into account ratably over 10 years.
10-year spread for change in computing life insurance company reserves
For Federal income tax purposes, a life insurance company
includes in gross income any net decrease in reserves, and
deducts a net increase in reserves.\1102\ Methods for
determining reserves for tax purposes generally are based on
reserves prescribed by the National Association of Insurance
Commissioners for purposes of financial reporting under State
regulatory rules.
---------------------------------------------------------------------------
\1102\ Sec. 807.
---------------------------------------------------------------------------
Income or loss resulting from a change in the method of
computing reserves is taken into account ratably over a 10-year
period.\1103\ The rule for a change in basis in computing
reserves applies only if there is a change in basis in
computing the Federally prescribed reserve (as distinguished
from the net surrender value). Although life insurance tax
reserves require the use of a Federally prescribed method,
interest rate, and mortality or morbidity table, changes in
other assumptions for computing statutory reserves (e.g., when
premiums are collected and claims are paid) may cause increases
or decreases in a company's life insurance reserves that must
be spread over a 10-year period. Changes in the net surrender
value of a contract are not subject to the 10-year spread
because, apart from its use as a minimum in determining the
amount of life insurance tax reserves, the net surrender value
is not a reserve but a current liability.
---------------------------------------------------------------------------
\1103\ Sec. 807(f).
---------------------------------------------------------------------------
If for any taxable year the taxpayer is not a life
insurance company, the balance of any adjustments to reserves
is taken into account for the preceding taxable year.
Explanation of Provision
A change in the basis for computing life insurance reserves
or any other item referred to in section 807(c) in a taxable
year is taken into account under section 481 as an adjustment
attributable to a change in method of accounting initiated by
the taxpayer and made with the consent of the Secretary. The
prior-law 10-year spread rule to account for such a change is
repealed. Thus, income or loss resulting from a change in
method of computing life insurance company reserves is taken
into account consistent with IRS procedures, generally ratably
over a four-year period, instead of over a 10-year period.
Consistent with IRS procedures, a company that makes a
change in method of computing life insurance company reserves
is required to comply with procedures for automatic method
changes \1104\ and is required to report and file such
statements and other information as the Secretary requires
\1105\ under those procedures.
---------------------------------------------------------------------------
\1104\ Because the change is treated as initiated by the taxpayer
and made with the consent of the Secretary, the procedures for
automatic method changes apply. Procedures for automatic method changes
are set forth in Rev. Proc. 2018-31, 2018-22 I.R.B. 637.
\1105\ Thus, the company is required to file Form 3115, for
example.
---------------------------------------------------------------------------
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
D. Repeal of Special Rule for Distributions to Shareholders from Pre-
1984 Policyholders Surplus Account (sec. 13514 of the Act and former
sec. 815 of the Code)
Prior Law
Under the Federal tax law in effect from 1959 through 1983,
a life insurance company was subject to a three-phase taxable
income computation. A company was taxed on the lesser of its
gain from operations or its taxable investment income (Phase I)
and, if its gain from operations exceeded its taxable
investment income, 50 percent of such excess (Phase II). For
stock insurance companies, Federal income tax on the other 50
percent of the gain from operations was deferred, and was
accounted for as part of a policyholder's surplus account and,
subject to certain limitations, taxed only when distributed to
stockholders or upon corporate dissolution (Phase III). To
determine whether amounts had been distributed, a company
maintained a shareholders surplus account, which generally
included the company's previously taxed income that would be
available for distribution to shareholders. Distributions to
shareholders were treated as being first out of the
shareholders surplus account, then out of the policyholders
surplus account, and finally out of other accounts.\1106\
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\1106\ Former sec. 815. The policyholders surplus account was also
reduced by the amount of tax paid on distributions from the account.
The additional reduction in the account was subject to tax. A
distribution from a policyholders surplus account was subject to tax
regardless of whether life insurance company taxable income was
positive or negative, so that the taxable amount was not offset by a
current operations loss. Former sec. 815(d) and (f).
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The Deficit Reduction Act of 1984 \1107\ included
provisions that, for 1984 and later years, eliminated further
deferral of tax on amounts (described above) that previously
would have been deferred under the three-phase system. Although
for taxable years after 1983, life insurance companies may not
enlarge their policyholders surplus account, the companies are
not taxed on previously deferred amounts unless the amounts are
treated as distributed to shareholders or subtracted from the
policyholders surplus account.\1108\
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\1107\ Pub. L. No. 98-369.
\1108\ Sec. 815.
---------------------------------------------------------------------------
Any direct or indirect distribution to shareholders from an
existing policyholders surplus account of a stock life
insurance company is subject to tax at the corporate rate in
the taxable year of the distribution. Prior law for 1984 and
later years (like pre-1984 law) provides that any distribution
to shareholders is treated as made (1) first out of the
shareholders surplus account, to the extent thereof, (2) then
out of the policyholders surplus account, to the extent
thereof, and (3) finally, out of other accounts.
For taxable years beginning after December 31, 2004, and
before January 1, 2007, the application of the rules imposing
income tax on distributions to shareholders from the
policyholders surplus account of a life insurance company were
suspended.\1109\ Distributions in those years were treated as
first made out of the policyholders surplus account, to the
extent thereof, and then out of the shareholders surplus
account, and lastly out of other accounts.
---------------------------------------------------------------------------
\1109\ Former sec. 815(g).
---------------------------------------------------------------------------
Explanation of Provision
The provision repeals section 815, the rules imposing
income tax on distributions to shareholders from the
policyholders surplus account of a stock life insurance
company.
In the case of any stock life insurance company with an
existing policyholders surplus account (as defined in section
815 before its repeal), tax is imposed on the balance of the
account as of the close of the company's last taxable year
beginning before January 1, 2018. A life insurance company is
required to pay tax on the balance of the account ratably over
the first eight taxable years beginning after December 31,
2017. Specifically, the tax imposed on a life insurance company
is the tax on the sum of life insurance company taxable income
for the taxable year (but not less than zero) plus 1/8 of the
balance of the existing policyholders surplus account as of
December 31, 2017. Thus, life insurance company losses are not
allowed to offset the amount of the policyholders surplus
account balance subject to tax.
For example, assume a company has a policyholders surplus
account balance of $64 as of December 31, 2017 (the end of its
taxable year). For its 2018 taxable year, the company has a
loss of $4. Under the provision, the company has an income
inclusion for 2018 of $8 (that is, 1/8 of its $64 balance) and
a $4 net operating loss carryforward to its next taxable year.
For its 2019 taxable year, the company has a loss of $2 (after
taking into account the loss carryforward under the rules of
section 172) and also has a tax credit of $1. Under the
provision, the company has an income inclusion for 2019 of $8
(that is, 1/8 of $64), a $2 net operating loss carryforward to
its next taxable year, and a $1 general business credit
carryforward.\1110\
---------------------------------------------------------------------------
\1110\ A technical correction may be needed to clarify that the
income inclusion under the provision may not be offset by a credit.
---------------------------------------------------------------------------
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
E. Modification of Proration Rules for Property and Casualty Insurance
Companies (sec. 13515 of the Act and sec. 832(b) of the Code)
Prior Law
The taxable income of a property and casualty insurance
company is determined as the sum of its gross income from
underwriting income and investment income (as well as gains and
other income items), reduced by allowable deductions.\1111\
Underwriting income means the premiums earned on insurance
contracts during the taxable year reduced by losses incurred
and expenses incurred. The amount of losses incurred takes into
account the change during the taxable year in unpaid losses on
life insurance contracts (if any) plus discounted unpaid losses
of the property and casualty insurance company.
---------------------------------------------------------------------------
\1111\ Sec. 832.
---------------------------------------------------------------------------
A proration rule applies to property and casualty insurance
companies. A property and casualty insurance company must
reduce the amount of its deduction for losses incurred by 15
percent of (1) the insurer's tax-exempt interest, (2) the
deductible portion of dividends received (with special rules
for dividends from affiliates), and (3) the increase for the
taxable year in the cash value of life insurance, endowment, or
annuity contracts the company owns.\1112\ This proration rule
reflects the fact that reserves are generally funded in part
from tax-exempt interest, from deductible dividends, and from
other untaxed amounts.\1113\
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\1112\ Sec. 832(b)(5).
\1113\ See H.R. Rep. 99-426, Tax Reform Act of 1985, Report of the
Committee on Ways and Means, House of Representatives, on H.R. 3838,
December 7, 1985, page 670 (Reasons for Change). The Conference
Agreement adopted the House bill provision with modifications. See H.R.
Rep. 99-841, Tax Reform Act of 1986, Conference Report to Accompany
H.R. 3838, September 18, 1986, pp. 356-7.
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Explanation of Provision
The provision replaces the 15-percent reduction under prior
law \1114\ with a reduction equal to 5.25 percent divided by
the top corporate tax rate. The top corporate tax rate is 21
percent for 2018 and thereafter,\1115\ so the percentage
reduction is 25 percent under the proration rule for property
and casualty insurance companies. The proration percentage will
be automatically adjusted in the future if the highest
corporate tax rate is changed, so that the product of the
proration percentage and the highest corporate tax rate always
equals 5.25 percent.
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\1114\ The product of the prior-law 15-percent proration percentage
and the prior-law highest corporate tax rate of 35 percent equals 5.25
percent.
\1115\ See the description of section 13001 of the Act (21-Percent
Corporate Tax Rate).
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
F. Repeal of Special Estimated Tax Payments (sec. 13516 of the Act and
former sec. 847 of the Code)
Prior Law
Allowance of additional deduction and establishment of special loss
discount account
Prior law allows an insurance company required to discount
its unpaid loss reserves an additional deduction that is not to
exceed the excess of (1) the amount of the undiscounted unpaid
losses over (2) the amount of the related discounted unpaid
losses, to the extent the amount was not deducted in a
preceding taxable year.\1116\ The provision imposes the
requirement that a special loss discount account be established
and maintained, and that special estimated tax payments be
made. Unused amounts of special estimated tax payments are
treated as a section 6655 estimated tax payment for the 16th
year after the year for which the special estimated tax payment
was made.
---------------------------------------------------------------------------
\1116\ Sec. 847.
---------------------------------------------------------------------------
The total payments by a taxpayer, including section 6655
estimated tax payments and other tax payments, together with
special estimated tax payments made under this provision, are
generally the same as the total tax payments that the taxpayer
would make if the taxpayer did not elect to have this provision
apply, except to the extent amounts can be refunded under the
provision in the 16th year.
Calculation of special estimated tax payments based on tax benefit
attributable to deduction
More specifically, prior law imposes a requirement that the
taxpayer make special estimated tax payments in an amount equal
to the tax benefit attributable to the additional deduction
allowed under the provision. If amounts are included in gross
income as a result of a reduction in the taxpayer's special
loss discount account or the liquidation or termination of the
taxpayer's insurance business, and an additional tax is due for
any year as a result of the inclusion, then an amount of the
special estimated tax payments equal to such additional tax is
applied against such additional tax. If there is an adjustment
reducing the amount of additional tax against which the special
estimated tax payment was applied, then in lieu of any credit
or refund for the reduction, a special estimated tax payment is
treated as made in an amount equal to the amount that would
otherwise be allowable as a credit or refund.
The amount of the tax benefit attributable to the deduction
is to be determined (under Treasury regulations (which have not
been promulgated)) by taking into account tax benefits that
would arise from the carryback of any net operating loss for
the year as well as current year benefits. In addition, tax
benefits for the current and carryback years are to take into
account the benefit of filing a consolidated return with
another insurance company without regard to the consolidation
limitations imposed by section 1503(c).
The taxpayer's estimated tax payments under section 6655
are to be determined without regard to the additional deduction
allowed under this provision and the special estimated tax
payments. Legislative history \1117\ indicates that it is
intended that the taxpayer may apply the amount of an
overpayment of any section 6655 estimated tax payments for the
taxable year against the amount of the special estimated tax
payment required under this provision. The special estimated
tax payments under this provision are not treated as estimated
tax payments for purposes of section 6655 (e.g., for purposes
of calculating penalties or interest on underpayments of
estimated tax) when such special estimated tax payments are
made.
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\1117\ See H.R. Rep. No. 100-1104, Conference Report to accompany
H.R. 4333, the Technical and Miscellaneous Revenue Act of 1988, October
21, 1988, p. 174.
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Refundable amount
To the extent that a special estimated tax payment is not
used to offset additional tax due for any of the first 15
taxable years beginning after the year for which the payment
was made, such special estimated tax payment is treated as an
estimated tax payment made under section 6655 for the
16th year after the year for which the special
estimated tax payment was made. If the amount of such deemed
section 6655 payment, together with the taxpayer's other
payments credited against tax liability for such
16th year, exceeds the tax liability for such year,
then the excess (up to the amount of the deemed section 6655
payment) may be refunded to the taxpayer to the same extent
provided under prior law with respect to overpayments of tax.
Regulatory authority
In addition to the regulatory authority to adjust the
amount of special estimated tax payments in the event of a
change in the corporate tax rate, authority is provided to
Treasury to prescribe regulations necessary or appropriate to
carry out the purposes of the provision.
Regulations have not been promulgated under section 847.
Explanation of Provision
The provision repeals section 847. Thus, the election to
apply section 847, the additional deduction, special loss
discount account, special estimated tax payment, and refundable
amount rules of prior law are eliminated.
The entire balance of an existing account is included in
income of the taxpayer for the first taxable year beginning
after 2017, and the entire amount of existing special estimated
tax payments are applied against the amount of additional tax
attributable to this inclusion. Any special estimated tax
payments in excess of this amount are treated as estimated tax
payments under section 6655.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
G. Computation of Life Insurance Tax Reserves (sec. 13517 of the Act
and sec. 807 of the Code)
Prior Law and Background
In general
In determining life insurance company taxable income, a
life insurance company includes in gross income any net
decrease in reserves, and deducts a net increase in
reserves.\1118\ Methods for determining reserves for tax
purposes generally are based on reserves prescribed by the
National Association of Insurance Commissioners (``NAIC'') for
purposes of financial reporting under State laws and State
insurance regulatory rules (known as annual statements).
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\1118\ Sec. 807.
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For Federal income tax purposes, in computing the net
increase or net decrease in reserves, six items are taken into
account. These are: (1) life insurance reserves; (2) unearned
premiums and unpaid losses included in total reserves; (3)
amounts that are discounted at interest to satisfy obligations
under insurance and annuity contracts that do not involve life,
accident, or health contingencies when the computation is made;
(4) dividend accumulations and other amounts held at interest
in connection with insurance and annuity contracts; (5)
premiums received in advance and liabilities for premium
deposit funds; and (6) reasonable special contingency reserves
under contracts of group term life insurance or group accident
and health insurance that are held for retired lives, premium
stabilization, or a combination of both. No deduction for asset
adequacy reserves or deficiency reserves is allowed.
Life insurance reserves are amounts set aside to mature or
liquidate future unaccrued claims arising from life insurance,
annuity, and noncancellable accident and health insurance
contracts involving, at the time with respect to which the
reserve is computed, life, accident, or health
contingencies.\1119\ Additional requirements also apply to life
insurance reserves.\1120\
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\1119\ Sec. 816(b)(1)(B).
\1120\ See secs. 816(b)(1)(A), 816(b)(2), and 816(h).
---------------------------------------------------------------------------
The amount of life insurance reserves for any contract is
the greater of the net surrender value of the contract or the
reserves determined under Federally prescribed rules, but may
not exceed the statutory reserve with respect to the contract
(for regulatory reporting). In computing the Federally
prescribed reserve for any type of contract, the taxpayer must
use the tax reserve method applicable to the contract, an
interest rate for discounting of reserves to take account of
the time value of money, and the prevailing commissioners'
standard tables for mortality or morbidity.
Interest rate
The assumed interest rate to be used in computing the
Federally prescribed reserve is the greater of the applicable
Federal interest rate or the prevailing State assumed interest
rate. The applicable Federal interest rate is the annual rate
determined by the Secretary under the discounting rules for
property and casualty reserves for the calendar year in which
the contract is issued. The prevailing State assumed interest
rate is generally the highest assumed interest rate permitted
to be used in at least 26 States in computing life insurance
reserves for insurance or annuity contracts of that type as of
the beginning the calendar year in which the contract is
issued. In determining the highest assumed rates permitted in
at least 26 States, each State is treated as permitting the use
of every rate below its highest rate.
A one-time election is permitted (revocable only with the
consent of the Secretary) to apply an updated applicable
Federal interest rate every five years in calculating life
insurance reserves. The election is provided to take account of
the fluctuations in market rates of return that companies
experience with respect to life insurance contracts of long
duration. The use of the updated applicable Federal interest
rate under the election does not cause the recalculation of
life insurance reserves for any prior year. Under the election
no change is made to the interest rate used in determining life
insurance reserves if the updated applicable Federal interest
rate is less than one-half of one percentage point different
from the rate used by the company in calculating life insurance
reserves during the preceding five years.
Development of principle-based reserving for insurance regulatory
purposes
In 2012, the NAIC established a task force to develop State
regulatory insurance reserving methodology that takes into
account a wide range of future economic conditions (a
stochastic approach referred to as principle-based reserving or
``PBR''). The PBR approach would supplement or replace static
formulas and assumptions for determining reserves as prescribed
by then-existing State laws (a deterministic or a formulaic
approach). Starting in 2017, a Valuation Manual that includes
PBR requirements became operative.\1121\ By October, 2017,
legislatures of 47 States had enacted legislation relating to
PBR insurance reserves for State regulatory purposes. The NAIC
has adopted revised insurance company accreditation standards
to become effective Jan. 1, 2020; until then, generally, PBR
methodology for State insurance regulatory purposes is optional
for many types of insurance contracts issued by life
insurers.\1122\
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\1121\ The Valuation Manual sets forth requirements for insurance
regulatory reserves. National Association of Insurance Commissioners,
Valuation Manual, January 1, 2018 Edition, VM-20, Requirements for
Principle-Based Reserves for Life Products, and VM-21, Requirements for
Principle-Based Reserves for Variable Annuities, https://www.naic.org/
documents/prod_serv_2018_valuation_manual.pdf.
\1122\ National Association of Insurance Commissioners Center for
Insurance Policy and Research, The National System of State Regulation
and Principle-Based Reserving, July 12, 2018, https://www.naic.org/
cipr_topics/principle_based_reserving_pbr.htm.
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Explanation of Provision
For purposes of determining the deduction for increases in
certain reserves of a life insurance company, the amount of the
life insurance reserves for any contract (other than certain
variable contracts) is the greater of (1) the net surrender
value of the contract (if any), or (2) 92.81 percent of the
amount determined using the tax reserve method applicable to
the contract as of the date the reserve is determined.\1123\
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\1123\ Sec. 807(d)(1)(A).
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In the case of a variable contract, the amount of life
insurance reserves for the contract is the sum of (1) the
greater of (a) the net surrender value of the contract, or (b)
the separate-account reserve amount under section 817 for the
contract, plus (2) 92.81 percent of the excess (if any) of the
amount determined using the tax reserve method applicable to
the contract as of the date the reserve is determined over the
amount determined in (1).\1124\
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\1124\ Sec. 807(d)(1)(B).
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In no event shall the amount of life insurance reserve
exceed the amount of the annual statement reserve.\1125\ As
under prior law, no deduction for asset adequacy reserves or
deficiency reserves is allowed.\1126\
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\1125\ Sec. 807(d)(1)(C).
\1126\ See sec. 816(h). As under prior law, life insurance reserves
are amounts set aside to mature or liquidate future unaccrued claims
arising from life insurance, annuity, and noncancellable accident and
health insurance contracts involving, at the time with respect to which
the reserve is computed, life, accident, or health contingencies. Sec.
816(b)(1)(B).
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Consistent with the purpose of the provision to accommodate
the NAIC-prescribed principle-based reserve methodology and to
provide for a tax reserve amount that is simpler, more
transparent, and easier to compute than under prior law, the
provision provides for a percentage reduction to address the
inconsistency of insurance regulatory accounting with accurate
measurement of income for Federal income tax purposes. Under
NAIC-prescribed principle-based reserve methodology in effect
at the time of the enactment of the provision, principle-base
reserves for any contract do not include any asset adequacy
reserve component.\1127\ Therefore, no asset adequacy reserve-
related reduction to the NAIC-prescribed PBR reserves as then
in effect is necessary or required before applying the
percentage reduction in computing tax reserves.
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\1127\ National Association of Insurance Commissioners Statutory
Issue Paper No. 154, Implementation of Principle-Based Reserving,
finalized December 10, 2016, https://www.naic.org/sap_app_updates/
documents/154_a.pdf (IP No. 154). IP No. 154 states at page IP154-4,
``Asset adequacy testing is an existing requirement which functions as
an additional check of reserve adequacy by reviewing to ensure that
assets will be sufficient and available to meet reserving obligations
as claims become due. No changes were recommended . . . because asset
adequacy testing under the Actuarial Opinion and Memorandum Regulation
(Model #822) have [sic] not changed.'' The Actuarial Opinion and
Memorandum Regulation (Model #822) indicates or implies that asset
adequacy reserves are to be separately stated and held as an additional
reserve for insurance regulatory reporting purposes, stating at page
822-3 (section 5.E.2), ``If the appointed actuary determines as the
result of asset adequacy analysis that a reserve should be held in
addition to the aggregate reserve held by the company and calculated in
accordance with methods set forth in the Standard Valuation Law, the
company shall establish the additional reserve.''
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For example, an insurance company issues life insurance
contracts in 2018. The annual statement reserve for the
contracts can be determined under an NAIC-prescribed PBR method
in effect in 2018.\1128\ Because the principle-based reserve
for the contracts includes no asset adequacy reserve component,
no asset adequacy reserve-related reduction is necessary before
applying 92.81 percent to determine the tax reserve for the
contracts. However, as under prior law, asset adequacy reserves
or deficiency reserves remain nondeductible for Federal income
tax purposes. If a tax reserve method currently or in the
future (whether prescribed by the NAIC,\1129\ or consistent
with the section 807 tax reserve method \1130\) includes an
amount, such as an asset adequacy reserve, deficiency reserve,
or other reserve or amount that is not deductible for Federal
income tax purposes, the reserve amount is reduced by the
nondeductible amount before applying the percentage reduction
under section 807.
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\1128\ Use of the PBR methodology is optional in some cases until
2020.
\1129\ Sec. 807(d)(3)(A)(iv)(I).
\1130\ Sec. 807(d)(3)(A)(iv)(II).
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A no-double-counting rule provides that no amount or item
is taken into account more than once in determining any reserve
under subchapter L of the Code.\1131\ For example, an amount
taken into account in determining a loss reserve under section
807 may not be taken into account again in determining a loss
reserve under section 832. Similarly, a loss reserve determined
under the tax reserve method (whether the Commissioners Reserve
Valuation Method, the Commissioner's Annuity Reserve Valuation
Method, a principle-based reserve method, or another method
developed in the future, that is prescribed for a type of
contract by the National Association of Insurance
Commissioners) may not again be taken into account in
determining the portion of the reserve that is separately
accounted for under section 817 or be included also in
determining the net surrender value of a contract. The
provision provides reserve rules for supplemental benefits and
retains prior-law rules regarding certain contracts issued by
foreign branches of domestic life insurance companies.
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\1131\ Sec. 807(d)(1)(D).
---------------------------------------------------------------------------
The provision requires the Secretary to provide for
reporting (at such time and in such manner as the Secretary
shall prescribe) with respect to the opening balance and
closing balance or reserves and with respect to the method of
computing reserves for purposes of determining income.\1132\
For this purpose, the Secretary may require that a life
insurance company (including an affiliated group filing a
consolidated return that includes a life insurance company) is
required to report each of the line item elements of each
separate account by combining them with each such item from all
other separate accounts and the general account, and to report
the combined amounts on a line-by-line basis on the taxpayer's
return. Similarly, the Secretary may in such guidance provide
that reporting on a separate account by separate account basis
is generally not permitted. Under existing regulatory
authority, if the Secretary determines it is necessary in order
to carry out and enforce this provision, the Secretary may
require e-filing or comparable filing of the return on magnetic
media or other machine readable form, and may require that the
taxpayer provide its annual statement via a link, electronic
copy, or other similar means.
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\1132\ Sec. 807(e)(6).
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017. For the first taxable year beginning after
December 31, 2017, the difference in the amount of the reserve
with respect to any contract at the end of the preceding
taxable year and the amount of such reserve determined as if
the proposal had applied for that year is taken into account in
determining income for each of the eight taxable years
following that preceding year, one-eighth per year.
H. Modification of Rules for Life Insurance Proration for Purposes of
Determining the Dividends Received Deduction (sec. 13518 of the Act and
sec. 812 of the Code)
Prior Law
Reduction of reserve deduction and dividends received deduction to
reflect untaxed income
A life insurance company is subject to proration rules in
calculating life insurance company taxable income.
The proration rules reduce the company's deductions,
including reserve deductions and dividends received deductions,
if the life insurance company has tax-exempt income, deductible
dividends received, or other similar untaxed income items,
because deductible reserve increases can be viewed as being
funded proportionately out of taxable and tax-exempt income.
Under the proration rules, the net increase and net
decrease in reserves (for purposes of computing life insurance
company taxable income) are adjusted by reducing the ending
balance of the reserve items by the policyholders' share of
tax-exempt interest and by the policyholders' share of the
increase for the taxable year in policy cash values of life
insurance policies and annuity and endowment contracts.\1133\
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\1133\ Secs. 807(a)(2)(B) and (b)(1)(B).
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Similarly, under the proration rules, a life insurance
company is allowed a dividends-received deduction for
intercorporate dividends from nonaffiliates only in proportion
to the company's share of such dividends,\1134\ but not for the
policyholders' share. Fully deductible dividends from
affiliates are excluded from the application of this proration
formula, if such dividends are not themselves distributions
from tax-exempt interest or from dividend income that would not
be fully deductible if received directly by the taxpayer.
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\1134\ Secs. 805(a)(4) and 812. Under pre-1984 law, described in
Joint Committee on Taxation, General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, JCS-41-84, December
31, 1984, p. 572-573, ``a life insurance company was taxed on the
lesser of its table investment income or its gain from operations. If a
company's gain from operations exceeded its taxable investment income,
the company was taxed on 50 percent of such excess. . . . The
computation of gain from operations began with the company's total
income, including the company's share of investment yield, net capital
gain, premiums, and other considerations, decreases in insurance
reserves and all other amounts.'' Thus, under the law prior to 1984, a
life insurance company preferred to have a low company's share for
purposes of determining its taxable income, and a high company's share
for purposes of the proration rules. After 1983, no such tension
remained.
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Company's share and policyholder's share
The life insurance company proration rules provide that the
company's share, for this purpose, means the percentage
obtained by dividing the company's share of the net investment
income for the taxable year by the net investment income for
the taxable year.\1135\ Net investment income means 95 percent
of gross investment income, in the case of assets held in
segregated asset accounts under variable contracts, and 90
percent of gross investment income in other cases.\1136\
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\1135\ Sec. 812(a).
\1136\ Sec. 812(c).
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Gross investment income includes specified items.\1137\ The
specified items include interest (including tax-exempt
interest), dividends, rents, royalties and other related
specified items, the amount by which net short-term capital
gain exceeds net long-term capital loss, and trade or business
income. Gross investment income generally does not include gain
(other than the amount by which net short-term capital gain
exceeds net long-term capital loss) that is, or is considered
as, from the sale or exchange of a capital asset. Gross
investment income also does not include the appreciation in the
value of assets that is taken into account in computing the
company's tax reserve deduction under section 817.
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\1137\ Sec. 812(d).
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The company's share of net investment income, for purposes
of this calculation, is the net investment income for the
taxable year, reduced by the sum of (a) the policy interest for
the taxable year and (b) a portion of policyholder
dividends.\1138\ Policy interest is defined to include required
interest at the greater of the prevailing State assumed rate or
the applicable Federal rate (plus some other interest items).
In any case where neither the prevailing State assumed interest
rate nor the applicable Federal rate is used, ``another
appropriate rate'' is used for this calculation. No statutory
definition of ``another appropriate rate'' is provided; the law
is unclear as to what rate or rates are appropriate for this
purpose.\1139\
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\1138\ Sec. 812(b)(1). This portion is defined as gross investment
income's share of policyholder dividends.
\1139\ Legislative history of section 812 mentions that the general
concept that items of investment yield should be allocated between
policyholders and the company was retained from prior law. H. Rep. 98-
861, Conference Report to accompany H.R. 4170, the Deficit Reduction
Act of 1984, 98th Cong., 2d Sess., 1065 (June 23, 1984). This concept
is referred to in Joint Committee on Taxation, General Explanation of
the Revenue Provisions of the Deficit Reduction Act of 1984, JCS-41-84,
December 31, 1984, p. 622, stating, ``[u]nder the Act, the formula used
for purposes of determining the policyholders' share is based generally
on the proration formula used under prior law in computing gain or loss
from operations (i.e., by reference to `required interest').'' This may
imply that a reference to pre-1984-law regulations may be appropriate.
See Rev. Rul. 2003-120, 2003-2 C.B. 1154, and Technical Advice
Memoranda 20038008 and 200339049.
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In 2007, the IRS issued Rev. Rul. 2007-54,\1140\
interpreting required interest under section 812(b) to be
calculated by multiplying the mean of a contract's beginning-
of-year and end-of-year reserves by the greater of the
applicable Federal interest rate or the prevailing State
assumed interest rate, for purposes of determining separate
account reserves for variable contracts. However, Rev. Rul.
2007-54 was suspended by Rev. Rul. 2007-61, in which the IRS
and the Treasury Department stated that the issues would more
appropriately be addressed by regulation.\1141\ No regulations
have been issued to date.
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\1140\ 2007-38 I.R.B. 604.
\1141\ 2007-42 I.R.B. 799.
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General account and separate accounts
A variable contract is generally a life insurance (or
annuity) contract whose death benefit (or annuity payout)
depends explicitly on the investment return and market value of
underlying assets.\1142\ The investment risk is generally that
of the policyholder, not the insurer. The assets underlying
variable contracts are maintained in separate accounts held by
life insurers. These separate accounts are distinct from the
insurer's general account in which it maintains assets
supporting products other than variable contracts.
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\1142\ Section 817(d) provides a more detailed definition of a
variable contract.
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Reserves
For Federal income tax purposes, a life insurance company
includes in gross income any net decrease in reserves, and
deducts a net increase in reserves.\1143\ Methods for
determining reserves for tax purposes generally are based on
reserves prescribed by the National Association of Insurance
Commissioners for purposes of financial reporting under State
regulatory rules.
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\1143\ Sec. 807.
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In the case of variable contracts, however, a special rule
eliminates the effect of gains and losses for purposes of
determining the inclusion or deduction relating to a change in
the amount of the tax reserves.\1144\ Under this rule, realized
and unrealized gains are subtracted from, and realized and
unrealized losses are added to, the amount of tax reserves
taken into account for variable contracts, whether or not the
assets have been disposed of. The basis of assets in the
separate account is increased to reflect appreciation, and
reduced to reflect depreciation in value, so as to take account
of the subtracted or added amounts.
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\1144\ Sec. 817. The rule also applies in the case of certain other
deductions for benefits paid and assumption reinsurance costs incurred
with respect to variable contracts (sec. 817(a) flush language).
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Dividends received deduction
A corporate taxpayer may partially or fully deduct
dividends received.\1145\ The percentage of the allowable
dividends received deduction depends on the percentage of the
stock of the distributing corporation that the recipient
corporation owns.
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\1145\ Sec. 243 et seq. Conceptually, dividends received by a
corporation are retained in corporate solution; these amounts are taxed
when distributed to noncorporate shareholders.
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Limitation on dividends received deduction under section
246(c)(4)
The dividends received deduction is not allowed with
respect to stock either (1) held for 45 days or less during a
91-day period beginning 45 days before the ex-dividend date, or
(2) to the extent the taxpayer is under an obligation to make
related payments with respect to positions in substantially
similar or related property.\1146\ The taxpayer's holding
period is reduced for periods during which its risk of loss is
reduced.\1147\
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\1146\ Sec. 246(c).
\1147\ Sec. 246(c)(4). For this purpose, the holding period is
reduced for periods in which (1) the taxpayer has an obligation to sell
or has shorted substantially similar stock; (2) the taxpayer has
granted an option to buy substantially similar stock; or (3) under
Treasury regulations, the taxpayer has diminished its risk of loss by
holding other positions with respect to substantially similar or
related property.
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Explanation of Provision
The provision modifies and simplifies the life insurance
company proration rules \1148\ for reducing dividends received
deductions \1149\ and reserve deductions \1150\ with respect to
untaxed income. For purposes of these life insurance proration
rules, the company's share is 70 percent. The policyholder's
share is 30 percent.
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\1148\ Sec. 812.
\1149\ Sec. 804(a)(4).
\1150\ Secs. 807(a) and (b).
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
I. Capitalization of Certain Policy Acquisition Expenses (sec. 13519 of
the Act and sec. 848 of the Code)
Prior Law
In the case of an insurance company, specified policy
acquisition expenses for any taxable year are required to be
capitalized, and generally are amortized over the 120-month
period beginning with the first month in the second half of the
taxable year.\1151\
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\1151\ Sec. 848.
---------------------------------------------------------------------------
A special rule provides for 60-month amortization of the
first $5 million of specified policy acquisition expenses with
a phase-out. The phase-out reduces the amount amortized over 60
months by the excess of the insurance company's specified
policy acquisition expenses for the taxable year over $10
million.
Specified policy acquisition expenses are determined as
that portion of the insurance company's general deductions for
the taxable year that does not exceed a specific percentage of
the net premiums for the taxable year on each of three
categories of insurance contracts. For annuity contracts, the
percentage is 1.75 percent; for group life insurance contracts,
the percentage is 2.05 percent; and for all other specified
insurance contracts, the percentage is 7.7 percent.
With certain exceptions, a specified insurance contract is
any life insurance, annuity, or noncancellable accident and
health insurance contract or combination thereof. A group life
insurance contract is any life insurance contract that covers a
group of individuals defined by reference to employment
relationship, membership in an organization, or similar factor,
the premiums for which are determined on a group basis, and the
proceeds of which are payable to (or for the benefit of)
persons other than the employer of the insured, an organization
to which the insured belongs, or other similar person.
Explanation of Provision
The provision extends the amortization period for specified
policy acquisition expenses from a 120-month period to a 180-
month period beginning with the first month in the second half
of the taxable year. The provision does not change the special
rule providing for 60-month amortization of the first $5
million of specified policy acquisition expenses (with
phaseout). The provision specifies that for annuity contracts,
the percentage is 2.09 percent; for group life insurance
contracts, the percentage is 2.45 percent; and for all other
specified insurance contracts, the percentage is 9.20
percent.\1152\
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\1152\ A technical correction may be needed to correct statutory
references so that the provision achieves this result.
---------------------------------------------------------------------------
Effective Date
The provision applies to taxable years beginning after
December 31, 2017. A transition rule permits specified policy
acquisition expenses first required to be capitalized in a
taxable year beginning before January 1, 2018, to continue to
be allowed as a deduction ratably over the 120-month period
beginning with the first month in the second half of the
taxable year. It is intended that the 60-month amortization
rule continue to apply to such amounts eligible for the 60-
month amortization rule and first required to be capitalized in
a taxable year beginning before January 1, 2018.
J. Tax Reporting for Life Settlement Transactions and Clarification of
Tax Basis of Life Insurance Transactions, and Exception to Transfer for
Valuable Consideration Rules (secs. 13520-13522 of the Act and secs.
101 and 1016(a) and new sec. 6050Y of the Code)
Prior Law
An exclusion from Federal income tax is provided for
amounts received under a life insurance contract paid by reason
of the death of the insured.\1153\
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\1153\ Sec. 101(a)(1). In the case of certain accelerated death
benefits and viatical settlements, special rules treat certain amounts
as amounts paid by reason of the death of an insured (that is,
generally, excludable from income). Sec. 101(g). The rules relating to
accelerated death benefits provide that amounts treated as paid by
reason of the death of the insured include any amount received under a
life insurance contract on the life of an insured who is a terminally
ill individual, or who is a chronically ill individual (provided
certain requirements are met). For this purpose, a terminally ill
individual is one who has been certified by a physician as having an
illness or physical condition which can reasonably be expected to
result in death in 24 months or less after the date of the
certification. A chronically ill individual is one who has been
certified by a licensed health care practitioner within the preceding
12-month period as meeting certain ability-related requirements. In the
case of a viatical settlement, if any portion of the death benefit
under a life insurance contract on the life of an insured who is
terminally ill or chronically ill is sold to a viatical settlement
provider, the amount paid for the sale or assignment of that portion is
treated as an amount paid under the life insurance contract by reason
of the death of the insured (that is, generally, excludable from
income). For this purpose, a viatical settlement provider is a person
regularly engaged in the trade or business of purchasing, or taking
assignments of, life insurance contracts on the lives of terminally ill
or chronically ill individuals (provided certain requirements are met).
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Under rules known as the transfer for value rules, if a
life insurance contract is sold or otherwise transferred for
valuable consideration, the amount paid by reason of the death
of the insured that is excludable generally is limited.\1154\
Under the limitation, the excludable amount may not exceed the
sum of (1) the actual value of the consideration, and (2) the
premiums or other amounts subsequently paid by the transferee
of the contract. Thus, for example, if a person buys a life
insurance contract, and the consideration he pays combined with
his subsequent premium payments on the contract are less than
the amount of the death benefit he later receives under the
contract, then the difference is includable in the buyer's
income.
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\1154\ Sec. 101(a)(2).
---------------------------------------------------------------------------
Exceptions are provided to the limitation on the excludable
amount. The limitation on the excludable amount does not apply
if (1) the transferee's basis in the contract is determined in
whole or in part by reference to the transferor's basis in the
contract,\1155\ or (2) the transfer is to the insured, to a
partner of the insured, to a partnership in which the insured
is a partner, or to a corporation in which the insured is a
shareholder or officer.\1156\
---------------------------------------------------------------------------
\1155\ Sec. 101(a)(2)(A).
\1156\ Sec. 101(a)(2)(B).
---------------------------------------------------------------------------
IRS guidance sets forth more details of the tax treatment
of a life insurance policyholder who sells or surrenders the
life insurance contract and the tax treatment of other sellers
and of buyers of life insurance contracts. The guidance relates
to the character of taxable amounts (ordinary or capital) and
to the taxpayer's basis in the life insurance contract.
In Revenue Ruling 2009-13,\1157\ the IRS ruled that income
recognized under section 72(e) on surrender to the life
insurance company of a life insurance contract with cash value
is ordinary income. In the case of a sale of a cash value life
insurance contract, the IRS ruled that the insured's (seller's)
basis is reduced by the cost of insurance, and the gain on sale
of the contract is ordinary income to the extent of the amount
that would be recognized as ordinary income if the contract
were surrendered (the ``inside buildup''), and any excess is
long-term capital gain. Gain on the sale of a term life
insurance contract (without cash surrender value) is long-term
capital gain under the ruling.
---------------------------------------------------------------------------
\1157\ 2009-21 I.R.B. 1029.
---------------------------------------------------------------------------
In Revenue Ruling 2009-14,\1158\ the IRS ruled that under
the transfer for value rules, a portion of the death benefit
received by a buyer of a life insurance contract on the death
of the insured is includable as ordinary income. The portion is
the excess of the death benefit over the consideration and
other amounts (e.g., premiums) paid for the contract. Upon sale
of the contract by the purchaser of the contract, the gain is
long-term capital gain, and in determining the gain, the basis
of the contract is not reduced by the cost of insurance.
---------------------------------------------------------------------------
\1158\ 2009-21 I.R.B. 1031.
---------------------------------------------------------------------------
Explanation of Provision
In general
The provision imposes reporting requirements in the case of
the purchase of an existing life insurance contract in a
reportable policy sale and imposes reporting requirements on
the payor in the case of the payment of reportable death
benefits. The provision sets forth rules for determining the
basis of a life insurance or annuity contract. Lastly, the
provision modifies the transfer for value rules in a transfer
of an interest in a life insurance contract in a reportable
policy sale.
Reporting requirements for acquisitions of life insurance contracts
Reporting upon acquisition of life insurance contract
The reporting requirement applies to every person who
acquires a life insurance contract, or any interest in a life
insurance contract, in a reportable policy sale during the
taxable year.\1159\
---------------------------------------------------------------------------
\1159\ Sec. 6050Y.
---------------------------------------------------------------------------
Reportable policy sale
A reportable policy sale means the acquisition of an
interest in a life insurance contract, directly or indirectly,
if the acquirer has no substantial family, business, or
financial relationship with the insured (apart from the
acquirer's interest in the life insurance contract).\1160\ An
indirect acquisition includes the acquisition of an interest in
a partnership, trust, or other entity that holds an interest in
the life insurance contract.
---------------------------------------------------------------------------
\1160\ Sec. 101(a)(3)(B). A substantial family, business or
financial relationship with the insured apart from the interest in the
life insurance contract is not further defined in the statute. The
Treasury Department is directed to provide guidance as to the
definition. Transactions to which new section 101(a)(3)(A) does not
apply by reason of guidance regarding this definition under new section
101(a)(3)(B) may be subject to reporting under new section 6050Y as
provided in such guidance as needed to carry out the purposes of the
provision.
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Buyer reporting
Under the reporting requirement, the buyer reports
information about the purchase to the IRS, to the insurance
company that issued the contract, and to the seller.\1161\ The
information reported by the buyer about the purchase is (1) the
buyer's name, address, and taxpayer identification number
(``TIN''), (2) the name, address, and TIN of each recipient of
payment in the reportable policy sale, (3) the date of the
sale, (4) the name of the issuer, and (5) the amount of each
payment. The statement the buyer provides to any issuer of a
life insurance contract is not required to include the amount
of the payment or payments for the purchase of the contract.
---------------------------------------------------------------------------
\1161\ Sec. 6050Y(a).
---------------------------------------------------------------------------
Reporting of seller's basis in the life insurance contract
On receipt of a report described above, or on any notice of
the transfer of a life insurance contract to a foreign person,
the issuer is required to report to the IRS and to the seller
(1) the name, address, and TIN of the seller or the transferor
to a foreign person, (2) the basis of the contract (i.e., the
investment in the contract within the meaning of section
72(e)(6)), and (3) the policy number of the contract.\1162\
Notice of the transfer of a life insurance contract to a
foreign person is intended to include any sort of notice,
including information provided for nontax purposes such as
change of address notices for purposes of sending statements or
for other purposes, or information relating to loans, premiums,
or death benefits with respect to the contract.
---------------------------------------------------------------------------
\1162\ Sec. 6050Y(b).
---------------------------------------------------------------------------
Reporting with respect to reportable death benefits
When a reportable death benefit is paid under a life
insurance contract, the payor insurance company is required to
report information about the payment to the IRS and to the
payee.\1163\ Under this reporting requirement, the payor
reports (1) the name, address and TIN of the person making the
payment, (2) the name, address, and TIN of each recipient of a
payment, (3) the date of each such payment, (4) the gross
amount of the payment (5) the payor's estimate of the buyer's
basis in the contract.
---------------------------------------------------------------------------
\1163\ Sec. 6050Y(c).
---------------------------------------------------------------------------
A reportable death benefit means an amount paid by reason
of the death of the insured under a life insurance contract
that has been transferred in a reportable policy sale.
For purposes of these reporting requirements, a payment
means the amount of cash and the fair market value of any
consideration transferred in a reportable policy sale.
Determination of basis
In determining the basis of a life insurance or annuity
contract, no adjustment is made for mortality, expense, or
other reasonable charges incurred under the contract (known as
``cost of insurance'').\1164\ This reverses the position of the
IRS in Revenue Ruling 2009-13 that on sale of a life insurance
contract, the insured's (seller's) basis is reduced by the cost
of insurance.
---------------------------------------------------------------------------
\1164\ Sec. 1016(a)(1)(B).
---------------------------------------------------------------------------
Scope of transfer for value rules
The provision provides that the exceptions to the transfer
for value rules do not apply in the case of a transfer of a
life insurance contract, or any interest in a life insurance
contract, in a reportable policy sale.\1165\ Thus, some portion
of the death benefit ultimately payable under such a contract
may be includable in income.
---------------------------------------------------------------------------
\1165\ Sec. 101(a)(3)(A).
---------------------------------------------------------------------------
Effective Date
Under the provision, the reporting requirement is effective
for reportable policy sales occurring after December 31, 2017,
and reportable death benefits paid after December 31, 2017. The
clarification of the basis rules for life insurance and annuity
contracts is effective for transactions entered into after
August 25, 2009. The modification of the exceptions to the
transfer for value rules is effective for transfers occurring
after December 31, 2017.
K. Modification of Discounting Rules for Property and Casualty
Insurance Companies (sec. 13523 of the Act and sec. 846(c) of the Code)
Prior Law
A property and casualty insurance company generally is
subject to tax on its taxable income.\1166\ The taxable income
of a property and casualty insurance company is determined as
the sum of its underwriting income and investment income (as
well as gains and other income items), reduced by allowable
deductions.\1167\ Among the items that are deductible in
calculating underwriting income are additions to reserves for
losses incurred and expenses incurred.
---------------------------------------------------------------------------
\1166\ Sec. 831(a).
\1167\ Sec. 832.
---------------------------------------------------------------------------
To take account of the time value of money, discounting of
unpaid losses is required. All property and casualty loss
reserves (unpaid losses and unpaid loss adjustment expenses)
for each line of business (as shown on the annual statement)
are required to be discounted for Federal income tax purposes.
The discounted reserves are calculated using a prescribed
interest rate which is based on the applicable Federal mid-term
rate (``mid-term AFR''). The discount rate is the average of
the mid-term AFRs effective at the beginning of each month over
the 60-month period preceding the calendar year for which the
determination is made.
To determine the period over which the reserves are
discounted, a prescribed loss payment pattern applies. The
prescribed length of time is either the accident year and the
following three calendar years, or the accident year and the
following 10 calendar years, depending on the line of business.
In the case of certain ``long-tail'' lines of business, the 10-
year period is extended, but not by more than five additional
years. Thus, prior law limits the maximum duration of any loss
payment pattern to the accident year and the following 15
years. The Treasury Department is directed to determine a loss
payment pattern for each line of business by reference to the
historical loss payment pattern for that line of business using
aggregate experience reported on the annual statements of
insurance companies, and is required to make this determination
every five years, starting with 1987.
Under the discounting rules, an election is provided
permitting a taxpayer to use its own (rather than an industry-
wide) historical loss payment pattern with respect to all lines
of business, provided that applicable requirements are met.
Treasury publishes discount factors for each line of
business to be applied by taxpayers for discounting
reserves.\1168\ The discount factors are published annually,
based on (1) the interest rate applicable to the calendar year,
and (2) the loss payment pattern for each line of business as
determined every five years.
---------------------------------------------------------------------------
\1168\ The most recent property and casualty reserve discount
factors published by Treasury are in Rev. Proc. 2016-58, 2016-51 I.R.B.
839, and see Rev. Proc. 2012-44, 2012-49 I.R.B. 645.
---------------------------------------------------------------------------
Explanation of Provision
The provision modifies the reserve discounting rules
applicable to property and casualty insurance companies. In
general, the provision modifies the prescribed interest rate,
extends the periods applicable under the loss payment pattern,
and repeals the election to use a taxpayer's historical loss
payment pattern.
Interest rate
The provision provides that the interest rate is an annual
rate for any calendar year to be determined by Treasury based
on the corporate bond yield curve (rather than the mid-term AFR
as under prior law). For this purpose, the corporate bond yield
curve means, with respect to any month, a yield curve that
reflects the average, for the preceding 60-month period (not
24-month period), of monthly yields on investment grade
corporate bonds with varying maturities and that are in the top
three quality levels available.\1169\ It is expected that
Treasury will determine a 60-month average corporate bond yield
curve for the 60 months preceding the first month of the
calendar year for which the determination is made.
---------------------------------------------------------------------------
\1169\ This rule adopts the definition found in section
430(h)(2)(D)(i) of the term ``corporate bond yield curve.'' The
definition provides for a rate based on the average of monthly yields
on investment grade corporate bonds with varying maturities, so that
under the property and casualty reserve discounting rules, with respect
to a payment pattern of any duration, a rate may be determined based on
corporate bonds of a similar duration. However, section 430, which
relates to minimum funding standards for single-employer defined
benefit pension plans, includes other rules not relevant to this
provision, including rules for determining an ``effective interest
rate,'' such as segment rate rules. The term ``effective interest
rate'' along with these other rules, including the segment rate rules,
do not apply for purposes of property and casualty insurance reserve
discounting.
---------------------------------------------------------------------------
Loss payment patterns
The provision extends the periods applicable for
determining loss payment patterns. Under the provision, the
maximum duration of the loss payment pattern generally is
determined by the amount of losses remaining unpaid using
aggregate industry experience for each line of business.
Like prior law, the provision provides that Treasury
determines a loss payment pattern for each line of business by
reference to the historical loss payment pattern for that line
of business using aggregate experience reported on the annual
statements of insurance companies, and is required to make this
determination every five years.
The prior-law three-year period for discounting certain
lines of business other than long-tail lines of business is not
modified by the provision.
Under the provision, the prior-law 10-year period following
the accident year is extended up to a maximum of 14 more years
for the lines of business to which each period applies. To the
extent these unpaid losses have not been treated as paid before
the 24th year after the accident year, they are
treated as paid in that 24th year. The lines of
business to which the 10-year period, with any extensions,
applies are the auto liability, other liability, medical
malpractice, workers' compensation, nonproportional
reinsurance, international, and multiple peril lines.\1170\
---------------------------------------------------------------------------
\1170\ A technical correction may be needed to clarify that the 10-
year period, with any extensions, applies to the reinsurance and
international lines of business.
---------------------------------------------------------------------------
The provision repeals the prior-law rule providing that in
the case of certain long-tail lines of business, the 10-year
period is extended, but not by more than five additional years.
Election to use own historical loss payment pattern
The provision repeals the prior-law election permitting a
taxpayer to use its own (rather than an aggregate industry-
experience-based) historical loss payment pattern with respect
to all lines of business.
The Treasury Department and IRS have issued published
guidance addressing this provision.\1171\
---------------------------------------------------------------------------
\1171\ Reg-103163-18. 83 Fed. Reg. 55646, November 7, 2018, and
Rev. Proc. 2018-13, 2018-7 I.R.B. 356, February 12, 2018.
---------------------------------------------------------------------------
Effective Date
The provision generally applies to taxable years beginning
after December 31, 2017. Under a transitional rule for the
first taxable year beginning in 2018, the amount of unpaid
losses and expenses unpaid (under section 832(b)(5)(B) and (6))
and the unpaid losses (under sections 807(c)(2) and 805(a)(1))
at the end of the preceding taxable year are determined as if
the provision had applied to these items in such preceding
taxable year, using the interest rate and loss payment patterns
for accident years ending with calendar year 2018. Any
adjustment is spread over eight taxable years, i.e., is
included in the taxpayer's gross income ratably in the first
taxable year beginning in 2018 and the seven succeeding taxable
years. For taxable years subsequent to the first taxable year
beginning in 2018, the provision applies to such unpaid losses
and expenses unpaid (i.e., unpaid losses and expenses unpaid at
the end of the taxable year preceding the first taxable year
beginning in 2018) by using the interest rate and loss payment
patterns applicable to accident years ending with calendar year
2018.
SUBPART C--BANKS AND FINANCIAL INSTRUMENTS
A. Limitation on Deduction for FDIC Premiums (sec. 13531 of the Act and
sec. 162 of the Code)
Prior Law
Corporations organized under the laws of any of the 50
States (and the District of Columbia) generally are subject to
the U.S. corporate income tax on their worldwide taxable
income. The taxable income of a C corporation \1172\ generally
comprises gross income less allowable deductions. A taxpayer
generally is allowed a deduction for ordinary and necessary
expenses paid or incurred in carrying on any trade or
business.\1173\
---------------------------------------------------------------------------
\1172\ Corporations subject to tax are commonly referred to as C
corporations after subchapter C of the Code, which sets forth corporate
tax rules. Certain specialized entities that invest primarily in real
estate related assets (real estate investment trusts) or in stock and
securities (regulated investment companies) and that meet other
requirements, generally including annual distribution of 90 percent of
their income, are allowed to deduct their distributions to
shareholders, thus generally paying little or no corporate-level tax
despite otherwise being subject to subchapter C.
\1173\ Sec. 162(a). However, certain exceptions apply. No deduction
is allowed for: (1) any charitable contribution or gift that would be
allowable as a deduction under section 170 were it not for the
percentage limitations, the dollar limitations, or the requirements as
to the time of payment, set forth in such section; (2) any illegal
bribe, illegal kickback, or other illegal payment; (3) certain lobbying
and political expenditures; (4) any fine or similar penalty paid to a
government for the violation of any law; (5) two-thirds of treble
damage payments under the antitrust laws; (6) certain foreign
advertising expenses; (7) certain amounts paid or incurred by a
corporation in connection with the reacquisition of its stock or of the
stock of any related person; or (8) certain applicable employee
remuneration.
---------------------------------------------------------------------------
Corporations that make a valid election pursuant to section
1362 of subchapter S of the Code, referred to as S
corporations, generally are not subject to corporate-level
income tax on their income. Instead, an S corporation passes
through to shareholders its items of income and loss. The
shareholders separately take into account their shares of these
items on their individual income tax returns.
Banks, thrifts, and credit unions
In general
Financial institutions are subject to the same Federal
income tax rules and rates as are applied to other corporations
or entities, with specified exceptions.
C corporation banks and thrifts
A bank is generally taxed for Federal income tax purposes
as a C corporation. For this purpose a bank generally means a
corporation, a substantial portion of whose business is
receiving deposits and making loans and discounts, or
exercising certain fiduciary powers.\1174\ A bank for this
purpose generally includes domestic building and loan
associations, mutual stock or savings banks, and certain
cooperative banks that are commonly referred to as
thrifts.\1175\
---------------------------------------------------------------------------
\1174\ Sec. 581. See also Treas. Reg. sec. 1.581-1(a).
\1175\ While the general principles for determining the taxable
income of a corporation are applicable to a mutual savings bank, a
building and loan association, and a cooperative bank, there are
certain exceptions and special rules for such institutions. Treas. Reg.
sec. 1.581-2(a).
---------------------------------------------------------------------------
S corporation banks
A bank is generally eligible to elect S corporation status
under section 1362, provided it meets the other requirements
for making this election and it does not use the reserve method
of accounting for bad debts as described in section 585.\1176\
---------------------------------------------------------------------------
\1176\ Sec. 1361(b)(2)(A).
---------------------------------------------------------------------------
Special bad debt loss rules for small banks Section 166
provides a deduction for any debt that becomes worthless
(wholly or partially) within a taxable year. The reserve method
of accounting for bad debts, repealed in 1986 \1177\ for most
taxpayers, is allowed under section 585 for any bank (as
defined in section 581) other than a large bank. For this
purpose, a bank is a large bank if, for the taxable year (or
for any preceding taxable year after 1986), the average
adjusted basis of all its assets (or the assets of the
controlled group of which it is a member) exceeds $500 million.
Deductions for reserves are taken in lieu of a worthless debt
deduction under section 166. Accordingly, a small bank is able
to take deductions for additions to a bad debt reserve.
Additions to the reserve are determined under an experience
method that generally looks to the ratio of (1) the total bad
debts sustained during the taxable year and the five preceding
taxable years to (2) the sum of the loans outstanding at the
close of such taxable years.\1178\
---------------------------------------------------------------------------
\1177\ Tax Reform Act of 1986, Pub. L. No. 99-514.
\1178\ Sec. 585(b)(2).
---------------------------------------------------------------------------
Credit unions
Credit unions are exempt from Federal income
taxation.\1179\ The exemption is based on their status as not-
for-profit mutual or cooperative organizations (without capital
stock) operated for the benefit of their members, who generally
must share a common bond. The definition of common bond has
been expanded to permit greater use of credit unions.\1180\
While significant differences between the rules under which
credit unions and banks operate have existed in the past, most
of those differences have disappeared over time.\1181\
---------------------------------------------------------------------------
\1179\ Sec. 501(c)(14)(A). For a discussion of the history of and
reasons for Federal tax exemption, see United States Department of the
Treasury, Comparing Credit Unions with Other Depository Institutions,
Report 3070, January 15, 2001, available at https://www.treasury.gov/
press-center/press-releases/Documents/report30702.doc.
\1180\ The Credit Union Membership Access Act, Pub. L. No. 105-219,
allows multiple common bond credit unions. The legislation in part
responds to National Credit Union Administration v. First National Bank
& Trust Co., 522 U.S. 479 (1998), which interpreted the permissible
membership of tax-exempt credit unions narrowly.
\1181\ The Treasury Department has concluded that any remaining
regulatory differences do not raise competitive equity concerns between
credit unions and banks. United States Department of the Treasury,
Comparing Credit Unions with Other Depository Institutions, Report
3070, January 15, 2001, p. 2, available at https://www.treasury.gov/
press-center/press-releases/Documents/report30702.doc.
---------------------------------------------------------------------------
FDIC premiums
The Federal Deposit Insurance Corporation (``FDIC'')
provides deposit insurance for banks and savings institutions.
To maintain its status as an insured depository institution, a
bank must pay semiannual assessments into the deposit insurance
fund. Assessments for deposit insurance are treated as ordinary
and necessary business expenses. These assessments, also known
as premiums, are deductible once the all events test for the
premium is satisfied.\1182\
---------------------------------------------------------------------------
\1182\ Technical Advice Memorandum 199924060, March 5, 1999, and
Rev. Rul. 80-230, 1980-2 C.B. 169, 1980.
---------------------------------------------------------------------------
Explanation of Provision
No deduction is allowed for the applicable percentage of
any FDIC premium paid or incurred by the taxpayer. For
taxpayers with total consolidated assets of $50 billion or
more, the applicable percentage is 100 percent. Otherwise, the
applicable percentage is the ratio of the excess of total
consolidated assets over $10 billion to $40 billion. For
example, for a taxpayer with total consolidated assets of $20
billion, no deduction is allowed for 25 percent of FDIC
premiums. The provision does not apply to taxpayers with total
consolidated assets (as of the close of the taxable year) that
do not exceed $10 billion.
FDIC premium means any assessment imposed under section
7(b) of the Federal Deposit Insurance Act.\1183\ The term total
consolidated assets has the meaning given such term under
section 165 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.\1184\
---------------------------------------------------------------------------
\1183\ 12 U.S.C. sec. 1817(b).
\1184\ Pub. L. No. 111-203.
---------------------------------------------------------------------------
For purposes of determining a taxpayer's total consolidated
assets, members of an expanded affiliated group are treated as
a single taxpayer. An expanded affiliated group means an
affiliated group as defined in section 1504(a), determined by
substituting ``more than 50 percent'' for ``at least 80
percent'' each place it appears and without regard to the
exceptions from the definition of includible corporation for
insurance companies and foreign corporations. A partnership or
any other entity other than a corporation is treated as a
member of an expanded affiliated group if such entity is
controlled by members of such group.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
B. Repeal of Advance Refunding Bonds (sec. 13532 of the Act and sec.
149 of the Code)
Prior Law
Section 103 generally provides that gross income does not
include interest received on State or local bonds. State and
local bonds are classified generally as either governmental
bonds or private activity bonds. Governmental bonds are bonds
the proceeds of which are primarily used to finance
governmental facilities or the debt is repaid with governmental
funds. Private activity bonds are bonds in which the State or
local government serves as a conduit providing financing to
nongovernmental persons (e.g., private businesses or
individuals).\1185\ Bonds issued to finance the activities of
charitable organizations described in section 501(c)(3)
(``qualified 501(c)(3) bonds'') are one type of private
activity bond. The exclusion from income for interest on State
and local bonds only applies if certain Code requirements are
met.
---------------------------------------------------------------------------
\1185\ Sec. 141.
---------------------------------------------------------------------------
The exclusion for income for interest on State and local
bonds applies to refunding bonds but there are limits on
advance refunding bonds. A refunding bond is defined as any
bond used to pay principal, interest, or redemption price on a
prior bond issue (the refunded bond). Different rules apply to
current as opposed to advance refunding bonds. A current
refunding occurs when the refunded bond is redeemed within 90
days of issuance of the refunding bonds. Conversely, a bond is
classified as an advance refunding if it is issued more than 90
days before the redemption of the refunded bond.\1186\ Proceeds
of advance refunding bonds are generally invested in an escrow
account and held until a future date when the refunded bond may
be redeemed.
---------------------------------------------------------------------------
\1186\ Sec. 149(d)(5).
---------------------------------------------------------------------------
Although there is no statutory limitation on the number of
times that tax-exempt bonds may be currently refunded, the Code
limits advance refundings. The primary Federal tax policy
concern with advance refundings is that they result in two
issues of tax-exempt bonds that remain outstanding
simultaneously for more than 90 days to finance the same
project or activity and that thereby results in increased
Federal revenue cost for multiple Federal subsidies.\1187\
Generally, governmental bonds and qualified 501(c)(3) bonds may
be advance refunded one time.\1188\ Private activity bonds,
other than qualified 501(c)(3) bonds, may not be advance
refunded at all.\1189\ Furthermore, in the case of an advance
refunding bond that results in interest savings (e.g., a high
interest rate to low interest rate refunding), the refunded
bond must be redeemed on the first call date 90 days after the
issuance of the refunding bond that results in debt service
savings.\1190\
---------------------------------------------------------------------------
\1187\ See S. Rep. No. 99-313 at 828 (1986).
\1188\ Sec. 149(d)(3). Bonds issued before 1986 and pursuant to
certain transition rules contained in the Tax Reform Act of 1986 may be
advance refunded more than one time in certain cases.
\1189\ Sec. 149(d)(2).
\1190\ Sec. 149(d)(3)(A)(iii) and (B); Treas. Reg. sec. 1.149(d)-
1(f)(3). A ``call'' provision provides the issuer of a bond with the
right to redeem the bond prior to the stated maturity.
---------------------------------------------------------------------------
Explanation of Provision
The provision repeals the exclusion from gross income for
interest on a bond issued to advance refund another tax-exempt
bond.
Effective Date
The provision applies to advance refunding bonds issued
after December 31, 2017.
SUBPART D--S CORPORATIONS
A. Expansion of Qualifying Beneficiaries of an Electing Small Business
Trust (sec. 13541 of the Act and sec. 1361(c) of the Code)
Prior Law
An electing small business trust (``ESBT'') may be a
shareholder of an S corporation.\1191\ Generally, the eligible
beneficiaries of an ESBT include individuals, estates, and
certain charitable organizations eligible to hold S corporation
stock directly. A nonresident alien individual may not be a
shareholder of an S corporation and may not be a potential
current beneficiary of an ESBT.\1192\
---------------------------------------------------------------------------
\1191\ Sec. 1361(c)(2)(A)(v).
\1192\ Secs. 1361(b)(1)(C) and (c)(2)(B)(v).
---------------------------------------------------------------------------
The portion of an ESBT which consists of the stock of an S
corporation is treated as a separate trust and generally is
taxed on its share of the S corporation's income at the highest
rate of tax imposed on individual taxpayers. This income
(whether or not distributed by the ESBT) is not taxed to the
beneficiaries of the ESBT.
Explanation of Provision
The provision allows a nonresident alien individual to be a
potential current beneficiary of an ESBT.
Effective Date
The provision takes effect on January 1, 2018.
B. Charitable Contribution Deduction for Electing Small Business Trusts
(sec. 13542 of the Act and sec. 641(c) of the Code)
Prior Law
An electing small business trust (``ESBT'') may be a
shareholder of an S corporation.\1193\ The portion of an ESBT
that consists of the stock of an S corporation is treated as a
separate trust and generally is taxed on its share of the S
corporation's income at the highest rate of tax imposed on
individual taxpayers. This income (whether or not distributed
by the ESBT) is not taxed to the beneficiaries of the ESBT. In
addition to nonseparately computed income or loss, an S
corporation reports to its shareholders their pro rata share of
certain separately stated items of income, loss, deduction, and
credit.\1194\ For this purpose, charitable contributions (as
defined in section 170(c)) of an S corporation are separately
stated and taken by the shareholder.
---------------------------------------------------------------------------
\1193\ Sec. 1361(c)(2)(A)(v).
\1194\ Sec. 1366(a)(1).
---------------------------------------------------------------------------
The treatment of a charitable contribution passed through
by an S corporation depends on the shareholder. Because an ESBT
is a trust, the deduction for charitable contributions
applicable to trusts,\1195\ rather than the deduction
applicable to individuals,\1196\ applies to the trust.
Generally, a trust is allowed a charitable contribution
deduction for amounts of gross income, without limitation,
which pursuant to the terms of the governing instrument are
paid for a charitable purpose. No carryover of excess
contributions is allowed. An individual is allowed a charitable
contribution deduction limited to certain percentages of
adjusted gross income generally with a five-year carryforward
of amounts in excess of this limitation.
---------------------------------------------------------------------------
\1195\ Sec. 642(c).
\1196\ Sec. 170.
---------------------------------------------------------------------------
Explanation of Provision
The provision provides that the charitable contribution
deduction of an ESBT is not determined by the rules generally
applicable to trusts but rather by the rules applicable to
individuals. Thus, the percentage limitations and carryforward
provisions applicable to individuals apply to charitable
contributions taken into account by the portion of an ESBT
holding S corporation stock.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
C. Modification of Treatment of S Corporation Conversions to C
Corporations (sec. 13543 of the Act and secs. 481 and 1371 of the Code)
Prior Law
Changes in accounting method
Cash and accrual methods in general
Taxpayers using the cash method generally recognize items
of income when actually or constructively received and items of
expense when paid. The cash method is administratively easy and
provides the taxpayer flexibility in the timing of income
recognition. It is the method generally used by most individual
taxpayers, including farm and nonfarm sole proprietorships.
Taxpayers using an accrual method generally accrue items of
income when all the events have occurred that fix the right to
receive the income and the amount of the income can be
determined with reasonable accuracy.\1197\ Taxpayers using an
accrual method of accounting generally may not deduct items of
expense prior to when all the events have occurred that fix the
obligation to pay the liability, the amount of the liability
can be determined with reasonable accuracy, and economic
performance has occurred.\1198\ Accrual methods of accounting
generally result in a more accurate measure of economic income
than does the cash method. The accrual method is often used by
businesses for financial accounting purposes.
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\1197\ See, e.g., sec. 451. For a discussion of changes made to
section 451 by the Act, see the discussion of section 13221 of the Act
(Certain Special Rules for Taxable Year of Inclusion).
\1198\ See, e.g., sec. 461.
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A C corporation, a partnership that has a C corporation as
a partner, or a tax-exempt trust or corporation with unrelated
business income generally may not use the cash method.
Exceptions are made for the aforementioned entities to the
extent their average annual gross receipts do not exceed $5
million for all prior years (including prior taxable years of
any predecessor of the entity) (the ``gross receipts
test''),\1199\ as well as for farming businesses,\1200\ and
qualified personal service corporations.\1201\ The cash method
may not be used by any tax shelter.\1202\ In addition, the cash
method generally may not be used if the purchase, production,
or sale of merchandise is an income producing factor to the
taxpayer.\1203\ Such taxpayers generally are required to keep
inventories and use an accrual method with respect to inventory
items.\1204\
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\1199\ The Act modifies the gross receipts to apply to taxpayers
with average annual gross receipts that do not exceed $25 million for
the three prior taxable years. See section 13102 of the Act (Small
Business Accounting Method Reform and Simplification).
\1200\ A farming business is defined as a trade or business of
farming, including operating a nursery or sod farm, or the raising or
harvesting of trees bearing fruit, nuts, or other crops, timber, or
ornamental trees (other than evergreen trees that are more than six
years old at the time they are severed from their roots). Secs.
448(d)(1) and 263A(e)(4). See also Treas. Reg. sec. 1.263A-4(a)(4).
\1201\ A qualified personal service corporation is a corporation
(1) substantially all of whose activities involve the performance of
services in the fields of health, law, engineering, architecture,
accounting, actuarial science, performing arts, or consulting, and (2)
substantially all of the stock of which (by value) is owned by current
or former employees performing such services, their estates, or heirs.
Sec. 448(d)(2).
\1202\ Secs. 448(a)(3) and (d)(3) and 461(i)(3) and (4). For this
purpose, a tax shelter includes: (1) any enterprise (other than a C
corporation) if at any time interests in such enterprise have been
offered for sale in any offering required to be registered with any
Federal or State agency having the authority to regulate the offering
of securities for sale; (2) any syndicate (within the meaning of
section 1256(e)(3)(B)); or (3) any tax shelter as defined in section
6662(d)(2)(C)(ii). In the case of a farming trade or business, a tax
shelter includes any tax shelter as defined in section
6662(d)(2)(C)(ii) or any partnership or any other enterprise other than
a corporation which is not an S corporation engaged in the trade or
business of farming, (1) if at any time interests in such partnership
or enterprise have been offered for sale in any offering required to be
registered with any Federal or State agency having authority to
regulate the offering of securities for sale or (2) if more than 35
percent of the losses during any period are allocable to limited
partners or limited entrepreneurs. For this purpose, certain holdings
held directly by individuals that are attributable to active farm
management activities are not treated as being held by a limited
partner or a limited entrepreneur. See the second section 461(j)
(relating to farming syndicate defined), as in effect prior to the
enactment of the Consolidated Appropriations Act, 2018, Pub. L. No.
115-141, section 401(a)(117), March 23, 2018, which, as part of
repealing general deadwood-related provisions, redesignated the second
``subsection (j)'' (relating to farming syndicate defined) as
``subsection (k)''.
\1203\ Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
\1204\ Sec. 471 and Treas. Reg. secs. 1.446-1(c)(2) and 1.471-1.
However, section 13102 of the Act (Small Business Accounting Method
Reform and Simplification) provides an exemption from the requirement
to use inventories for taxpayers that meet the $25 million gross
receipts test provided in such section. Accordingly, under the Act,
such taxpayers are also eligible to use the cash method.
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Procedures for changing a method of accounting
A taxpayer filing its first return may adopt any
permissible method of accounting in computing taxable income
for the year.\1205\ Except as otherwise provided, section
446(e) requires taxpayers to secure the consent of the
Secretary before changing a method of accounting. The
regulations under section 446 provide rules for determining (1)
what a method of accounting is, (2) how an adoption of a method
is adopted,\1206\ and (3) how a change in method of accounting
is effectuated.\1207\
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\1205\ Treas. Reg. sec. 1.446-1(e)(1).
\1206\ See also, Rev. Rul. 90-38, 1990-1 C.B. 57 (holding that a
taxpayer adopts a method of accounting (1) when it uses a permissible
method of accounting on a single tax return, or (2) when it uses the
same impermissible method of accounting on two or more consecutive tax
returns).
\1207\ Treas. Reg. sec. 1.446-1(e).
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Section 481 prescribes the rules to be followed in
computing taxable income in cases where the taxable income of
the taxpayer is computed under a different method of accounting
than the prior taxable year (e.g., when changing from the cash
method to an accrual method). In computing taxable income for
the year of change, the taxpayer must take into account those
adjustments which are determined to be necessary solely by
reason of such change in order to prevent items of income or
expense from being duplicated or omitted (i.e., ``section
481(a) adjustments'').\1208\ The year of change is the taxable
year for which the taxable income of the taxpayer is computed
under a different method than the prior taxable year.\1209\
Congress has provided the Secretary with the authority to
prescribe the timing and manner in which such adjustments are
taken into account in computing taxable income.\1210\ Net
section 481(a) adjustments that decrease taxable income
generally are taken into account entirely in the taxable year
of change, and net section 481(a) adjustments that increase
taxable income generally are taken into account ratably during
the four-taxable-year period beginning with the taxable year of
change.\1211\
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\1208\ Sec. 481(a)(2) and Treas. Reg. sec. 1.481-1(a)(1).
\1209\ Treas. Reg. sec. 1.481-1(a)(1).
\1210\ Sec. 481(c). While Treasury regulations generally provide
that the entire adjustments required by section 481(a) are taken into
account entirely in the taxable year of change, the Secretary has
provided the Commissioner with the authority to provide additional
guidance regarding the taxable year or years in which section 481(a)
adjustments are taken into account. See Treas. Reg. secs. 1.446-
1(e)(3), 1.481-1(c)(2), and 1.481-4.
\1211\ See section 7.03 of Rev. Proc. 2015-13, 2015-5 I.R.B 419.
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Post-termination distributions
Termination of a subchapter S election results in the
conversion of the S corporation to a C corporation, whether the
termination is by shareholder revocation of the election or
because the corporation no longer satisfies the definition of a
small business corporation.\1212\ Distributions of cash by the
C corporation to its shareholders during the post-termination
transition period are tax-free to the shareholders (to the
extent of the amount that was in the S corporation's
accumulated adjustment account at the time of conversion) and
reduce the shareholders' adjusted basis in the stock.\1213\ The
post-termination transition period is generally the one-year
period after the S corporation election terminates.\1214\ A
corporation, with the consent of its shareholders, may elect to
have this provision not apply.\1215\
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\1212\ Secs. 1361(b)(1) (definition of small business corporation)
and 1361(d) (termination).
\1213\ Sec. 1371(e)(1).
\1214\ Sec. 1377(b).
\1215\ Sec. 1371(e)(2).
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Explanation of Provision
Under the provision, any section 481(a) adjustment of an
eligible terminated S corporation attributable to the
revocation of its S corporation election (i.e., a change from
the cash method to an accrual method) is taken into account
ratably during the six-taxable-year period beginning with the
year of change.\1216\ An eligible terminated S corporation is
any C corporation that (1) is an S corporation on December 21,
2017 (i.e., the day before enactment of the Act),\1217\ (2)
revokes its S corporation election under section 1362(a) during
the two-year period beginning December 22, 2017 (i.e., the date
of such enactment), and (3) has all of same owners (and in
identical proportions) on the date the S corporation election
is revoked as on December 22, 2017.
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\1216\ Note that section 13102 of the Act (Small Business
Accounting Method Reform and Simplification) expands the universe of
partnerships and C corporations eligible to use the cash method to
include partnerships or C corporations with average annual gross
receipts that do not exceed $25 million for the three prior taxable
years. Accordingly, an eligible terminated S corporation with average
annual gross receipts that do not exceed $25 million that used the cash
method prior to revoking its S corporation election may be eligible to
remain on the cash method as a C corporation.
\1217\ A clerical correction to the Act may be necessary to clarify
that the phrase ``date of enactment of the Tax Cuts and Jobs Act''
referenced in section 481(d) means the date of enactment of Pub. L. No.
115-97.
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Under the provision, in the case of any distribution of
money by an eligible terminated S corporation after the post-
termination transition period, the eligible terminated S
corporation may elect \1218\ to allocate the accumulated
adjustments account (``AAA'') to such distribution, and treat
the distribution as chargeable to accumulated earnings and
profits (``E&P''), in the same ratio as the AAA bears to the
accumulated E&P. The Secretary may prescribe rules for
allocation of the AAA and E&P in the case of a distribution of
money by an eligible terminated S corporation that has both
accumulated E&P and current E&P.
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\1218\ A technical correction may be necessary to reflect this
intent.
The Treasury Department has issued published guidance
addressing this provision.\1219\
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\1219\ See Rev. Proc. 2018-44, 2018-37 I.R.B. 426 (Aug. 22, 2018).
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Effective Date
The provision is effective as of December 22, 2017 (i.e.,
upon enactment).
PART VII--EMPLOYMENT
SUBPART A--COMPENSATION
A. Modification of Limitation on Excessive Employee Remuneration (sec.
13601 of the Act and sec. 162(m) of the Code)
Prior Law
In general
An employer generally may deduct reasonable compensation
for personal services as an ordinary and necessary business
expense. Section 162(m) provides an explicit limitation on the
deductibility of compensation expenses in the case of publicly
traded corporate employers. The otherwise allowable deduction
for compensation with respect to a covered employee of a
publicly held corporation is limited to no more than $1 million
per year.\1220\ The deduction limitation applies when the
deduction attributable to the compensation would otherwise be
taken.
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\1220\ Sec. 162(m). This deduction limitation applies for purposes
of the regular income tax and the alternative minimum tax.
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Covered employees
Section 162(m) defines a covered employee as (1) the chief
executive officer of the corporation (or an individual acting
in such capacity) as of the close of the taxable year and (2)
any employee whose total compensation is required to be
reported to shareholders under the Securities Exchange Act of
1934 \1221\ (``Exchange Act'') by reason of being among the
corporation's four most highly compensated officers for the
taxable year (other than the chief executive officer).\1222\
Treasury regulations under section 162(m) provide that whether
an employee is the chief executive officer or among the four
most highly compensated officers should be determined pursuant
to the executive compensation disclosure rules promulgated
under the Exchange Act.\1223\
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\1221\ Pub. L. No. 73-291; 15 U.S.C. sec. 78a, et seq.
\1222\ Sec. 162(m)(3).
\1223\ Treas. Reg. sec. 1.162-27(c)(2)(ii).
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In 2006, the Securities and Exchange Commission amended
certain rules relating to executive compensation, including
which officers' compensation must be disclosed under the
Exchange Act. Under the new rules, such officers are (1) the
principal executive officer (or an individual acting in such
capacity), (2) the principal financial officer (or an
individual acting in such capacity), and (3) the three most
highly compensated officers, other than the principal executive
officer or principal financial officer.
In response to the Securities and Exchange Commission's new
disclosure rules, the Internal Revenue Service issued updated
guidance on identifying which employees are covered by section
162(m).\1224\ The updated guidance provides that the term
``covered employee'' means any employee who is (1) as of the
close of the taxable year, the principal executive officer (or
an individual acting in such capacity) defined in reference to
the Exchange Act, or (2) among the three most highly
compensated officers \1225\ for the taxable year (other than
the principal executive officer or principal financial
officer), again defined by reference to the Exchange Act. Thus,
under current guidance, only four employees are covered under
section 162(m) for any taxable year. Under Treasury
regulations, the requirement that the individual meet the
criteria as of the last day of the taxable year applies to both
the principal executive officer and the three highest
compensated officers.\1226\
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\1224\ Notice 2007-49, 2007-25 I.R.B. 1429.
\1225\ By reason of being among the officers whose total
compensation is required to be reported to shareholders under the
Securities Exchange Act of 1934.
\1226\ Treas. Reg. sec. 1.162-27(c)(2)(i).
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Definition of publicly held corporation
For purposes of the deduction disallowance of section
162(m), a publicly held corporation means any corporation
issuing any class of common equity securities required to be
registered under section 12 of the Exchange Act.\1227\ All U.S.
publicly traded companies are subject to this registration
requirement, including their foreign affiliates. A foreign
company publicly traded through American depository receipts
(``ADRs''') is also subject to this registration requirement if
more than 50 percent of the issuer's outstanding voting
securities are held, directly or indirectly, by residents of
the United States and either (i) the majority of the executive
officers or directors are United States citizens or residents,
(ii) more than 50 percent of the assets of the issuer are
located in the United States, or (iii) the business of the
issuer is administered principally in the United States. Other
foreign companies are not subject to the registration
requirement even if their stock is publicly traded through
ADRs.
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\1227\ Sec. 162(m)(2).
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Remuneration subject to the deduction limitation
In general
Unless specifically excluded, the deduction limitation
applies to all remuneration for services, including cash and
the cash value of all remuneration (including benefits) paid in
a medium other than cash. If an individual is a covered
employee for a taxable year, the deduction limitation applies
to all compensation not explicitly excluded from the deduction
limitation, regardless of whether the compensation is for
services as a covered employee and regardless of when the
compensation was earned. The $1 million cap is reduced by
excess parachute payments (as defined in section 280G) that are
not deductible by the corporation.\1228\
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\1228\ Sec. 162(m)(4)(F).
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Certain types of compensation are not subject to the
deduction limit and are not taken into account in determining
whether other compensation exceeds $1 million. The following
types of compensation are not taken into account: (1)
remuneration payable on a commission basis; \1229\ (2)
remuneration payable solely on account of the attainment of one
or more performance goals if certain outside director and
shareholder approval requirements are met (``performance-based
compensation''); \1230\ (3) payments to a tax-favored
retirement plan (including salary reduction contributions);
\1231\ (4) amounts that are excludable from the executive's
gross income (such as employer-provided health benefits and
miscellaneous fringe benefits \1232\); \1233\ and (5) any
remuneration payable under a written binding contract which was
in effect on February 17, 1993.\1234\ In addition, remuneration
does not include compensation for which a deduction is
allowable after a covered employee ceases to be a covered
employee. Thus, the deduction limitation often does not apply
to deferred compensation that is otherwise subject to the
deduction limitation (e.g., is not performance-based
compensation) because the payment of the compensation is
deferred until after termination of employment.
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\1229\ Sec. 162(m)(4)(B).
\1230\ Sec. 162(m)(4)(C).
\1231\ Treas. Reg. secs. 1.162-27(c)(3)(ii)(A) and (B).
\1232\ Secs. 105, 106, and 132.
\1233\ Treas. Reg. sec. 1.162-27(c)(3)(ii)(B).
\1234\ Treas. Reg. sec. 1.162-27(h).
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Performance-based compensation
Compensation qualifies for the exception for performance-
based compensation only if (1) it is paid solely on account of
the attainment of one or more performance goals, (2) the
performance goals are established by a compensation committee
consisting solely of two or more outside directors, (3) the
material terms under which the compensation is to be paid,
including the performance goals, are disclosed to and approved
by the shareholders in a separate majority-approved vote prior
to payment, and (4) prior to payment, the compensation
committee certifies that the performance goals and any other
material terms were in fact satisfied.\1235\
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\1235\ Sec. 162(m)(4)(C); Treas. Reg. sec. 162-27(e). A director is
considered an outside director if he or she is not a current employee
of the corporation (or related entities), is not a former employee of
the corporation (or related entities) who is receiving compensation for
prior services (other than benefits under a qualified retirement plan),
was not an officer of the corporation (or related entities) at any
time, and is not currently receiving compensation for personal services
in any capacity (e.g., for services as a consultant) other than as a
director. Treas. Reg. sec. 1.162-27(e)(3).
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Compensation (other than a stock option or other stock
appreciation right (``SAR'') that meets certain requirements)
is not treated as paid solely on account of the attainment of
one or more performance goals unless the compensation is paid
to the particular executive pursuant to a pre-established
objective performance formula or standard that precludes
discretion. A stock option or SAR with an exercise price not
less than the fair market value, on the date the option or SAR
is granted, of the stock subject to the option or SAR,
generally is treated as meeting the exception for performance-
based compensation, provided that the requirements for outside
director and shareholder approval are met (without the need for
certification that the performance standards have been met).
This is the case because the amount of compensation
attributable to such an option or SAR received by the executive
is based solely on an increase in the corporation's stock
price. Stock-based compensation is not treated as performance-
based if it depends on factors other than corporate
performance, unless all of the general requirements for
performance-based compensation are met.\1236\
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\1236\ Treas. Reg. sec. 1.162-27(e)(2)(vi).
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Explanation of Provision
Definition of covered employee
The provision revises the definition of covered employee to
include both the principal executive officer and the principal
financial officer. Further, an individual is a covered employee
if the individual holds one of these positions at any time
during the taxable year. The provision also defines as a
covered employee the three (rather than four) most highly
compensated officers for the taxable year (other than the
principal executive officer or principal financial officer) who
are required to be reported on the company's proxy statement
(i.e., the statement required pursuant to executive
compensation disclosure rules promulgated under the Exchange
Act) for the taxable year (or who would be required to be
reported on such a statement for a company not required to make
such a report to shareholders). This includes such officers of
a corporation not required to file a proxy statement but which
otherwise falls within the revised definition of a publicly
held corporation, as well as such officers of a publicly held
corporation that would otherwise have been required to file a
proxy statement for the year (for example, but for the fact
that the corporation delisted its securities or underwent a
transaction that resulted in the nonapplication of the proxy
statement requirement). The determination of the three most
highly compensated officers who are ``covered employees'' is
consistent between a publicly held corporation subject to the
executive compensation disclosure rules under the Exchange Act
and such a corporation not subject to these disclosure rules.
The compensation taken into account to make the determination
is total compensation pursuant to these disclosure rules.
Therefore, the three highest compensated officers who are
``covered employees'' under the provision include any employee
(other than the principal executive officer or principal
financial officer) whose total compensation for the taxable
year results in the employee being among the three highest
compensated officers for the taxable year, whether or not the
officer's compensation is required to be reported to
shareholders under the Exchange Act and whether or not such
individual was employed on the last day of the taxable year.
In addition, if an individual is a covered employee with
respect to a corporation for a taxable year beginning after
December 31, 2016, the individual remains a covered employee
for all future years. Thus, an individual remains a covered
employee with respect to compensation otherwise deductible for
subsequent years, including for years during which the
individual is no longer employed by the corporation and years
after the individual has died. The provision clarifies that
compensation does not fail to be compensation with respect to a
covered employee and thus subject to the deduction limit for a
taxable year merely because the compensation is includible in
the income of, or paid to, another individual, such as
compensation paid to a beneficiary after the employee's death,
or to a former spouse pursuant to a domestic relations order.
Definition of publicly held corporation
The provision expands the definition of publicly held
corporation to include an issuer that is required to file
reports under section 15(d) of the Exchange Act. Therefore, in
addition to applying to all domestic publicly traded
corporations and certain foreign companies publicly traded
through ADRs, the provision extends the applicability of
section 162(m) to include all foreign companies publicly traded
through ADRs.
The definition of an issuer that is required to file
reports under section 15(d) of the Exchange Act may also
include certain additional corporations that are not publicly
traded, such as large private C corporations or S corporations.
For example, entities that are required to report under section
15(d) of the Exchange Act include (1) any corporation, whether
publicly or non-publicly traded, that issues securities which
are held by more than 300 holders of record (1,200 holders of
record in the case of a bank, savings and loan holding company,
or a bank holding company), and (2) any S corporation or non-
publicly traded C corporation that has issued asset-backed
securities, regardless of the number of holders of record,
unless all of its asset-backed securities are held by
affiliates of the corporation.\1237\
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\1237\ See 15 U.S.C. sec. 78o.
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It is intended that Treasury apply anti-abuse rules
regarding the application of section 162(m) to issuers that
file reports under section 15(d) of the Exchange Act, including
rules to provide consistency in its application to such
issuers.
Performance-based compensation and commissions exceptions
The provision eliminates the exceptions for commissions and
performance-based compensation from the definition of
compensation subject to the deduction limit. As a result, such
compensation is taken into account in determining the amount of
compensation with respect to a covered employee for a taxable
year that exceeds $1 million and is thus not deductible under
section 162.
The Treasury Department has issued published guidance
addressing this provision.\1238\
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\1238\ Notice 2018-68, 2018-36 I.R.B. 418.
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017. A transition rule applies to remuneration
which is provided pursuant to a written binding contract which
was in effect on November 2, 2017, and which was not modified
in any material respect on or after such date.
For purposes of the transition rule, compensation paid
pursuant to a plan qualifies for this exception provided that
the right to participate in the plan is part of a written
binding contract with the covered employee in effect on
November 2, 2017. For example, suppose a covered employee was
hired by XYZ Corporation on October 2, 2017, and one of the
terms of the written employment contract is that the executive
is eligible to participate in the `XYZ Corporation Executive
Deferred Compensation Plan' in accordance with the terms of the
plan. Assume further that the terms of the plan provide for
participation after six months of employment, amounts payable
under the plan are not subject to discretion, and the
corporation does not have the right to amend materially the
plan or to terminate the plan (except on a prospective basis
before any services are performed with respect to the
applicable period for which such compensation is to be paid).
Provided that the other conditions of the binding contract
exception are met (e.g., the plan itself is in writing),
payments under the plan are grandfathered, even though the
employee was not actually a participant in the plan on November
2, 2017.\1239\
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\1239\ As discussed in the text below, the grandfather treatment
ceases to apply if the plan is materially amended.
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The fact that a plan was in existence on November 2, 2017
is not by itself sufficient to qualify the plan for the
exception for binding written contracts. The exception is
limited to amounts to which a contractual obligation applies on
November 2, 2017.
The exception for remuneration paid pursuant to a binding
written contract ceases to apply to amounts paid after there
has been a material modification to the terms of the contract.
The exception also does not apply to new contracts entered into
or renewed after November 2, 2017. For purposes of this rule,
any contract that is entered into on or before November 2, 2017
and that is renewed after such date is treated as a new
contract entered into on the day the renewal takes effect. A
contract that is terminable or cancelable unconditionally at
will by either party to the contract without the consent of the
other, or by both parties to the contract, is treated as a new
contract entered into on the date any such termination or
cancellation, if made, would be effective. However, a contract
is not treated as so terminable or cancelable if it can be
terminated or cancelled only by terminating the employment
relationship of the covered employee.
For an individual who would have been a covered employee
prior to the effective date of the amendments made to section
162(m), the transition rule is limited to the remuneration of
such a covered employee that otherwise satisfies the
performance-based and commission exceptions under prior law as
well as the requirements applicable to a written binding
contract in effect on November 2, 2017. As a result, the
transition rule generally does not extend to any other
remuneration, including salary, deferred compensation, or non-
performance-based cash or equity compensation, of such a
covered employee. For an individual who is a covered employee
as a result of the amendments made by section 13601 of Pub. L.
No. 115-97, remuneration that does not satisfy the requirements
applicable to a written binding contract in effect on November
2, 2017 is subject to section 162(m). Such remuneration may
include deferred compensation and severance that does not
satisfy the written binding contract requirements. Remuneration
subject to section 162(m) does include equity compensation and
other compensatory awards granted after November 2, 2017, even
if pursuant to a plan in existence on November 2, 2017.
B. Excise Tax on Excess Tax-Exempt Organization Executive Compensation
(sec. 13602 of the Act and new sec. 4960 of the Code)
Prior Law
Taxable employers and other service recipients generally
may deduct reasonable compensation expenses.\1240\ However, in
some cases, compensation in excess of specific levels is not
deductible.
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\1240\ Sec. 162(a)(1).
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A publicly held corporation generally cannot deduct more
than $1 million of compensation (that is not compensation
otherwise excepted from this limit) in a taxable year for each
``covered employee.'' \1241\ For this purpose, a covered
employee is the corporation's principal executive officer (or
an individual acting in such capacity) defined in reference to
the Securities Exchange Act of 1934 (``Exchange Act'') as of
the close of the taxable year, or any employee whose total
compensation is required to be reported to shareholders under
the Exchange Act by reason of being among the corporation's
three most highly compensated officers for the taxable year
(other than the principal executive officer or principal
financial officer).\1242\
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\1241\ Sec. 162(m)(1). Under section 162(m)(6), another limit
applies to deductions for compensation of individuals performing
services for certain health insurance providers.
\1242\ Notice 2007-49, 2007-2 I.R.B. 1429.
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Unless an exception applies, generally a corporation cannot
deduct that portion of the aggregate present value of a
``parachute payment'' which equals or exceeds three times the
``base amount'' of certain service providers. The nondeductible
excess is an ``excess parachute payment.'' \1243\ A parachute
payment is generally a payment of compensation that is
contingent on a change in corporate ownership or control made
to certain officers, shareholders, and highly compensated
individuals.\1244\ An individual's base amount is the average
annualized compensation includible in the individual's gross
income for the five taxable years ending before the date on
which the change in ownership or control occurs.\1245\ Certain
amounts are not considered parachute payments, including
payments under a qualified retirement plan, a simplified
employee pension plan, or a simple retirement account.\1246\
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\1243\ Secs. 280G(a) and (b)(1).
\1244\ Secs. 280G(b)(2) and (c).
\1245\ Sec. 280G(b)(3).
\1246\ Secs. 401(a), 403(a), 408(k), and 408(p).
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These deduction limits generally do not affect a tax-exempt
organization.
Explanation of Provision
Under the provision, an employer is liable for an excise
tax equal to the corporate tax rate (21 percent) multiplied by
the sum of (1) any remuneration (other than an excess parachute
payment) in excess of $1 million paid to a covered employee by
an applicable tax-exempt organization for a taxable year, and
(2) any excess parachute payment (under a new definition for
this purpose that relates solely to separation pay) paid by the
applicable tax-exempt organization to a covered employee.
Accordingly, the excise tax applies as a result of an excess
parachute payment, even if the covered employee's remuneration
does not exceed $1 million.
For purposes of the provision, a covered employee is an
employee (including any former employee) of an applicable tax-
exempt organization if the employee is one of the five highest
compensated employees of the organization for the taxable year
or was a covered employee of the organization (or a
predecessor) for any preceding taxable year beginning after
December 31, 2016.
For purposes of determining who is a covered employee, all
of the compensation of an employee of an applicable tax-exempt
organization (or a predecessor), including compensation
directly or indirectly paid to an employee by any related
person or governmental entity, is taken into account to
determine the five highest compensated employees of the
organization for the taxable year. \1247\ Also for purposes of
determining a covered employee, remuneration paid to a licensed
medical professional that is directly related to the
performance of medical or veterinary services by such
professional is not taken into account, whereas remuneration
paid to such a professional in any other capacity is taken into
account. A medical professional for this purpose includes a
doctor, nurse, or veterinarian. Therefore, if a surgeon
performs direct medical services as part of his or her medical
practice, and also performs services that are not direct
medical services (such as teaching, research, or acting as
dean, officer, or board member of a hospital), that portion of
such a medical professional's remuneration attributable to
those services that are direct medical services is not treated
as remuneration.
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\1247\ The compensation used for purposes of determining who is a
covered employee is intended to be expansive to most accurately
determine the five highest compensated employees, and includes
compensation from disregarded entities.
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An ``applicable tax-exempt organization'' is an
organization exempt from tax under section 501(a), an exempt
farmers' cooperative,\1248\ a Federal, State or local
governmental entity with excludable income,\1249\ or a
political organization.\1250\ Applicable tax-exempt
organizations are intended to include State colleges and
universities.\1251\
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\1248\ Sec. 521(b).
\1249\ Sec. 115(1).
\1250\ Sec. 527(e)(1).
\1251\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
For purposes of the timing of application of the excise
tax, remuneration is treated as paid when there is no
substantial risk of forfeiture of the rights to such
remuneration. For this purpose, the determination of when a
``substantial risk of forfeiture'' no longer exists is based on
the definition under section 457(f)(3)(B). Accordingly, the tax
imposed by this provision can apply to the value of
remuneration that is vested (and any increases in such value or
vested remuneration) under this definition, even if it is not
yet received. Therefore, the excise tax can apply to
remuneration at a time that is different than the time
remuneration is required to be included in gross income as
wages.\1252\
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\1252\ For example, even though remuneration may be vested in one
year but paid within the first two and one-half months of the following
year such that the income inclusion is required in the year paid, the
remuneration is treated as paid for this purpose in the year when
vested. Additionally, earnings on previously vested remuneration, even
if paid or payable in future years, are treated as paid for this
purpose as they accrue.
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Remuneration for this purpose means wages as defined for
income tax withholding purposes,\1253\ but does not include any
designated Roth contribution.\1254\ In addition, the definition
of remuneration for this purpose includes amounts required to
be included in gross income under section 457(f).\1255\ This
definition applies to determine the type of compensation that
is treated as remuneration but does not control the time when
the excise tax is assessed on remuneration that exceeds the $1
million threshold. As described above, the excise tax applies
when remuneration (once determined under this definition) is
treated as paid (i.e., when the right to the remuneration is no
longer subject to a substantial risk of forfeiture, as
defined), without regard to when such remuneration is actually
received or otherwise required to be included in gross income
as wages.
---------------------------------------------------------------------------
\1253\ Sec. 3401(a).
\1254\ Under section 402A(c), a designated Roth contribution is an
elective deferral (that is, a contribution to a tax-favored employer-
sponsored retirement plan made at the election of an employee) that the
employee designates as not being excludable from income.
\1255\ Such amounts may not be treated as wages under section
3401(a), but are treated as remuneration for purposes of the excise tax
application. See Technical Advice Memorandum 199903032, October 2,
1998. Sec. 457(f) applies to an ``ineligible'' deferred compensation
plan of a State or local government or a tax-exempt employer (that is,
a plan that does not meet the requirements to be an eligible plan under
section 457(b)). Under an ineligible plan, deferred amounts are treated
as nonqualified deferred compensation and includible in income for the
first taxable year in which there is no substantial risk of forfeiture
of the rights to such compensation. For this purpose, a person's rights
to compensation are subject to a substantial risk of forfeiture if the
rights are conditioned on the future performance of substantial
services by any individual. Earnings post-vesting are generally taxed
when paid.
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Remuneration of a covered employee includes any
remuneration paid with respect to employment of the covered
employee by any person or governmental entity related to the
applicable tax-exempt organization.\1256\ A person or
governmental entity is treated as related to an applicable tax-
exempt organization if the person or governmental entity (1)
controls, or is controlled by, the organization, (2) is
controlled by one or more persons that control the
organization, (3) is a supported organization \1257\ during the
taxable year with respect to the organization, (4) is a
supporting organization \1258\ during the taxable year with
respect to the organization, or (5) in the case of a voluntary
employees' beneficiary association (``VEBA''),\1259\
establishes, maintains, or makes contributions to the VEBA.
However, remuneration of a covered employee that is not
deductible by reason of the $1 million limit on deductible
compensation \1260\ is not taken into account for purposes of
the provision.
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\1256\ Sec. 4960(c)(4). A technical correction may be necessary to
reflect that the related organization rules also apply to excess
parachute payments and for purposes of determining covered employees.
\1257\ Sec. 509(f)(3).
\1258\ Sec. 509(a)(3).
\1259\ Sec. 501(c)(9).
\1260\ Sec. 162(m).
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Under the provision, an excess parachute payment is the
amount by which any parachute payment exceeds the portion of
the base amount allocated to the payment. A parachute payment
is a payment in the nature of compensation to (or for the
benefit of) a covered employee if the payment is contingent on
the employee's separation from employment and the aggregate
present value of all such payments equals or exceeds three
times the base amount. The base amount is the average
annualized compensation includible in the covered employee's
gross income for the five taxable years ending before the date
of the employee's separation from employment. Parachute
payments do not include payments under a qualified retirement
plan, a simplified employee pension plan, a simple retirement
account, a tax-deferred annuity,\1261\ or an eligible deferred
compensation plan of a State or local government
employer.\1262\ Parachute payments include amounts contingent
on separation from employment from severance and deferred
compensation plans (including supplemental executive retirement
plans), and do not exclude bona fide severance or separation
pay plans under section 457(f) or section 409A.
---------------------------------------------------------------------------
\1261\ Sec. 403(b).
\1262\ Sec. 457(b).
---------------------------------------------------------------------------
Payments to employees who are not highly compensated
employees (within the meaning of section 414(q)), and payments
attributable to medical services of certain licensed medical
professionals,\1263\ are exempt from the definition of
parachute payment.
---------------------------------------------------------------------------
\1263\ Sec. 4960(c)(5)(C). The principles of allocation described
above that apply to determine exempt remuneration attributable to
medical services also apply to determine exempt payments attributable
to medical services for purposes of parachute payments.
---------------------------------------------------------------------------
The employer of a covered employee is liable for the excise
tax. If remuneration of a covered employee from more than one
employer is taken into account in determining the excise tax,
each employer is liable for the tax in an amount that bears the
same ratio to the total tax as the remuneration paid by that
employer bears to the total remuneration paid by all of the
employers to the covered employee. For purposes of these rules,
the liability for the excise tax on an excess parachute payment
is intended to be treated the same as the liability for the
excise tax on remuneration.\1264\
---------------------------------------------------------------------------
\1264\ Sec. 4960(c)(4)(C). A technical correction may be necessary
to reflect this.
---------------------------------------------------------------------------
The provision directs the Secretary of the Treasury to
prescribe regulations as necessary to prevent avoidance of the
excise tax, including regulations to prevent avoidance of the
tax through self-employment or through payment or services via
a pass-through or other entity to avoid the tax. For example,
the excise tax cannot be avoided if an individual who is an
employee is classified as an independent contractor and paid as
such, or if payment is made to an LLC owned all or in part by
an employee or to or by a person or organization unrelated to
an applicable tax-exempt organization.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
C. Treatment of Qualified Equity Grants (sec. 13603 of the Act and new
sec. 83(i) of the Code)
Prior Law
Income tax treatment of employer stock transferred to an employee
Specific rules apply to property, including employer stock,
transferred to an employee in connection with the performance
of services.\1265\ These rules govern the amount and timing of
income inclusion by the employee and the amount and timing of
the employer's compensation deduction.
---------------------------------------------------------------------------
\1265\ Sec. 83. Section 83 applies generally to transfers of any
property, not just employer stock, in connection with the performance
of services by any service provider, not just an employee. However, the
provision described herein applies only with respect to certain
employer stock transferred to employees.
---------------------------------------------------------------------------
Under these rules, an employee generally must recognize
income in the taxable year in which the employee's right to the
stock is transferable or is not subject to a substantial risk
of forfeiture, whichever occurs earlier (referred to herein as
``substantially vested''). Thus, if the employee's right to the
stock is substantially vested when the stock is transferred to
the employee, the employee recognizes income in the taxable
year of such transfer, in an amount equal to the fair market
value of the stock as of the date of transfer (less any amount
paid for the stock). If at the time the stock is transferred to
the employee, the employee's right to the stock is not
substantially vested (referred to herein as ``nonvested''), the
employee does not recognize income attributable to the stock
transfer until the taxable year in which the employee's right
becomes substantially vested. In this case, the amount
includible in the employee's income is the fair market value of
the stock as of the date that the employee's right to the stock
is substantially vested (less any amount paid for the stock).
However, if the employee's right to the stock is nonvested at
the time the stock is transferred to the employee, under
section 83(b), the employee may elect within 30 days of
transfer to recognize income in the taxable year of transfer,
referred to as a ``section 83(b)'' election.\1266\ If a proper
and timely election under section 83(b) is made, the amount of
compensatory income is capped at the amount equal to the fair
market value of the stock as of the date of transfer (less any
amount paid for the stock). A section 83(b) election is
available with respect to grants of ``restricted stock''
(nonvested stock), and does not generally apply to the grant of
options.
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\1266\ Under Treas. Reg. sec. 1.83-2, the employee makes an
election by filing with the Internal Revenue Service a written
statement that includes the fair market value of the property at the
time of transfer and the amount (if any) paid for the property. The
employee must also provide a copy of the statement to the employer.
---------------------------------------------------------------------------
In general, an employee's right to stock or other property
is subject to a substantial risk of forfeiture if the
employee's right to full enjoyment of the property is subject
to a condition, such as the future performance of substantial
services.\1267\ An employee's right to stock or other property
is transferable if the employee can transfer an interest in the
property to any person other than the transferor of the
property.\1268\ Thus, generally, employer stock transferred to
an employee by an employer is not transferable merely because
the employee can sell it back to the employer.
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\1267\ See section 83(c)(1) and Treas. Reg. sec. 1.83-3(c) for the
definition of substantial risk of forfeiture for this purpose.
\1268\ Treas. Reg. sec. 1.83-3(d). In addition, under section
83(c)(2), the right to stock is transferable only if any transferee's
right to the stock would not be subject to a substantial risk of
forfeiture.
---------------------------------------------------------------------------
In the case of stock transferred to an employee, the
employer is allowed a deduction (to the extent a deduction for
a business expense is otherwise allowable) equal to the amount
included in the employee's income as a result of transfer of
the stock.\1269\ The employer deduction generally is permitted
in the employer's taxable year in which or with which ends the
employee's taxable year when the amount is included and
properly reported in the employee's income.\1270\
---------------------------------------------------------------------------
\1269\ Sec. 83(h).
\1270\ Treas. Reg. sec. 1.83-6.
---------------------------------------------------------------------------
These rules do not apply to the grant of a nonqualified
option on employer stock unless the option has a readily
ascertainable fair market value.\1271\ Instead, these rules
apply to the transfer of employer stock to the employee on
exercise of the option. That is, if the right to the stock is
substantially vested on transfer (the time of exercise), income
recognition applies for the taxable year of transfer. If the
right to the stock is nonvested on transfer, the timing of
income inclusion is determined under the rules applicable to
the transfer of nonvested stock. In either case, the amount
includible in income by the employee is the fair market value
of the stock as of the required time of income inclusion, less
the exercise price paid by the employee. A section 83(b)
election generally does not apply to the grant of options. If
upon the exercise of an option, nonvested stock is transferred
to the employee, a section 83(b) election may apply. The
employer's deduction is generally determined under the rules
that apply to transfers of restricted stock, but a special
accrual rule may apply under Treasury regulations when the
transferred stock is substantially vested.\1272\
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\1271\ See section 83(e)(3) and Treas. Reg. sec. 1.83-7. A
nonqualified option is an option on employer stock that is not a
statutory option, discussed below.
\1272\ Treas. Reg. sec. 1.83-6(a)(3).
---------------------------------------------------------------------------
Employment taxes and reporting
Employment taxes generally consist of taxes under the
Federal Insurance Contributions Act (``FICA''), tax under the
Federal Unemployment Tax Act (``FUTA''), and income taxes
required to be withheld by employers from wages paid to
employees (``income tax withholding'').\1273\ Unless an
exception applies under the applicable rules, compensation
provided to an employee constitutes wages subject to these
taxes.
---------------------------------------------------------------------------
\1273\ Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404
(income tax withholding). Instead of FICA taxes, railroad employers and
employees are subject, under the Railroad Retirement Tax Act
(``RRTA''), sections 3201-3241, to taxes equivalent to FICA taxes with
respect to compensation as defined for RRTA purposes. Sections 3501-
3510 provide additional rules relating to all these taxes.
---------------------------------------------------------------------------
FICA imposes tax on employers and employees, generally
based on the amount of wages paid to an employee during the
year. Special rules as to the timing and amount of FICA taxes
apply in the case of nonqualified deferred compensation, as
defined for FICA purposes.\1274\
---------------------------------------------------------------------------
\1274\ Sec. 3121(v); Treas. Reg. sec. 31.3121(v)(2)-1.
---------------------------------------------------------------------------
The tax imposed on the employer and on the employee is each
composed of two parts: (1) the Social Security or old age,
survivors, and disability insurance (``OASDI'') tax equal to
6.2 percent of covered wages up to the OASDI wage base
($127,200 for 2017); and (2) the Medicare or hospital insurance
(``HI'') tax equal to 1.45 percent of all covered wages.\1275\
The employee portion of FICA tax generally must be withheld
and, along with the employer portion, remitted to the Federal
government by the employer. FICA tax withholding applies
regardless of whether compensation is provided in the form of
cash or a noncash form, such as a transfer of property
(including employer stock) or in-kind benefits.\1276\
---------------------------------------------------------------------------
\1275\ The employee portion of the HI tax under FICA (not the
employer portion) is increased by an additional tax of 0.9 percent on
wages received in excess of a threshold amount. The threshold amount is
$250,000 in the case of a joint return, $125,000 in the case of a
married individual filing a separate return, and $200,000 in any other
case.
\1276\ Under section 3501(b), employment taxes with respect to
noncash fringe benefits are to be collected (or paid) by the employer
at the time and in the manner prescribed by the Secretary of the
Treasury. Announcement 85-113, 1985-31 I.R.B. 31, provides guidance on
the application of employment taxes with respect to noncash fringe
benefits.
---------------------------------------------------------------------------
FUTA imposes a tax on employers of six percent of wages up
to the FUTA wage base of $7,000.
Income tax withholding generally applies when wages are
paid by an employer to an employee, based on graduated
withholding rates set out in tables published by the Internal
Revenue Service (``IRS'').\1277\ Like FICA tax withholding,
income tax withholding applies regardless of whether
compensation is provided in the form of cash or a noncash form,
such as a transfer of property (including employer stock) or
in-kind benefits.
---------------------------------------------------------------------------
\1277\ Sec. 3402. Specific withholding rates apply in the case of
supplemental wages.
---------------------------------------------------------------------------
An employer is required to furnish each employee with a
statement of compensation information for a calendar year,
including taxable compensation, FICA wages, and withheld income
and FICA taxes.\1278\ In addition, information relating to
certain nontaxable items must be reported, such as certain
retirement and health plan contributions. The statement, made
on Form W-2, Wage and Tax Statement, must be provided to each
employee by January 31 of the succeeding year.\1279\
---------------------------------------------------------------------------
\1278\ Secs. 6041 and 6051.
\1279\ Employers send Form W-2 information to the Social Security
Administration, which records information relating to Social Security
and Medicare and forwards the Form W-2 information to the IRS.
Employees include a copy of Form W-2 with their income tax returns.
---------------------------------------------------------------------------
Statutory options
Two types of statutory options apply with respect to
employer stock: incentive stock options (``ISOs''') and options
provided under an employee stock purchase plan
(``ESPP'').\1280\ Stock received pursuant to a statutory option
is subject to special rules, rather than the rules for
nonqualified options, discussed above. No amount is includible
in an employee's income on the grant, vesting, or exercise of a
statutory option.\1281\ In addition, generally no deduction is
allowed to the employer with respect to the option or the stock
transferred to an employee.
---------------------------------------------------------------------------
\1280\ Sections 421-424 govern statutory options. Section 423(b)(5)
requires that, under the terms of an ESPP, all employees granted
options generally must have the same rights and privileges.
\1281\ Under section 56(b)(3), this income tax treatment with
respect to stock received on exercise of an ISO does not apply for
purposes of the alternative minimum tax under section 55.
---------------------------------------------------------------------------
If a holding requirement is met with respect to the stock
transferred on exercise of a statutory option and the employee
later disposes of the stock, the employee's gain generally is
treated as capital gain rather than ordinary income. Under the
holding requirement, the employee must not dispose of the stock
within two years after the date the option is granted and also
must not dispose of the stock within one year after the date
the option is exercised. If a disposition occurs before the end
of the required holding period (a ``disqualifying
disposition''), the employee recognizes ordinary income in the
taxable year in which the disqualifying disposition occurs, and
the employer may be allowed a corresponding deduction in the
taxable year in which such disposition occurs. The amount of
ordinary income recognized when a disqualifying disposition
occurs generally equals the fair market value of the stock on
the date of exercise (that is, when the stock was transferred
to the employee) less the exercise price paid.
Employment taxes do not apply with respect to the grant or
vesting of a statutory option, transfer of stock pursuant to
the option, or a disposition (including a disqualifying
disposition) of the stock.\1282\ However, certain special
reporting requirements apply.
---------------------------------------------------------------------------
\1282\ Secs. 3121(a)(22), 3306(b)(19), and the last sentence of
section 421(b).
---------------------------------------------------------------------------
Nonqualified deferred compensation
Compensation is generally includible in an employee's
income when paid to the employee. However, in the case of a
nonqualified deferred compensation plan,\1283\ unless the
arrangement either is exempt from or meets the requirements of
section 409A, the amount of deferred compensation is first
includible in income for the taxable year when not subject to a
substantial risk of forfeiture (as defined \1284\), even if
payment will not occur until a later year.\1285\ In general, to
meet the requirements of section 409A, the time when
nonqualified deferred compensation will be paid, as well as the
amount, must be specified at the time of deferral with limits
on further deferral after the time for payment. Various other
requirements apply, including that payment can only occur on
specific defined events.
---------------------------------------------------------------------------
\1283\ Compensation earned by an employee is generally paid to the
employee shortly after being earned. However, in some cases, payment is
deferred to a later period, referred to as ``deferred compensation.''
Deferred compensation may be provided through a plan that receives tax-
favored treatment, such as a qualified retirement plan under section
401(a). Deferred compensation provided through a plan that is not
eligible for tax-favored treatment is referred to as ``nonqualified''
deferred compensation.
\1284\ Treas. Reg. sec. 1.409A-1(d).
\1285\ Section 409A and the regulations thereunder provide rules
for nonqualified deferred compensation. Compensation that fails to meet
the requirements of section 409A is also subject to an additional
income tax of 20 percent on amounts includible in income and a
potential interest factor tax (``409A taxes''). Section 409A and the
additional 409A taxes apply to increases in the value of the failed
compensation each year until it is paid.
---------------------------------------------------------------------------
Various exemptions from section 409A apply, including
transfers of property subject to section 83.\1286\ Nonqualified
options are not automatically exempt from section 409A, but may
be structured so as not to be considered nonqualified deferred
compensation.\1287\ A restricted stock unit (``RSU'') is a term
used for an arrangement under which an employee has the right
to receive at a specified time in the future an amount
determined by reference to the value of one or more shares of
employer stock. An employee's right to receive the future
amount may be subject to a condition, such as continued
employment for a certain period or the attainment of certain
performance goals. The payment to the employee of the amount
due under the arrangement is referred to as settlement of the
RSU. The arrangement may provide for the settlement amount to
be paid in cash or as a transfer of employer stock (or both).
An arrangement providing RSUs is generally considered a
nonqualified deferred compensation plan and is subject to the
rules, including the limits, of section 409A. The employer
deduction generally is permitted in the employer's taxable year
in which or with which ends the employee's taxable year when
the amount is included and properly reported in the employee's
income.\1288\
---------------------------------------------------------------------------
\1286\ Treas. Reg. sec. 1.409A-1(b)(6).
\1287\ Treas. Reg. sec. 1.409A-1(b)(5). In addition, statutory
option arrangements are not nonqualified deferred compensation
arrangements.
\1288\ Sec. 404(a)(5).
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Explanation of Provision
In general
The provision allows a qualified employee to elect to
defer, for income tax purposes, the inclusion in income
attributable to qualified stock transferred to the employee by
the employer. An election to defer income inclusion
(``inclusion deferral election'') with respect to qualified
stock must be made no later than 30 days after the first time
the employee's right to the stock is substantially vested or is
transferable, whichever occurs earlier.
Similar to statutory options, employers are not required to
offer elections to employees under the new provision unless the
employer has made the determination that the various
requirements have been or can be met, as applicable. As
described below in more detail, an employer must satisfy
various requirements and make certain determinations in order
for the provision to apply, including information that an
employee may not necessarily know in order to make an election.
This includes whether the employer is an ``eligible
corporation,'' whether the employee is a ``qualified employee''
(or is instead an ``excluded employee'' who may not make an
election), and whether ``qualified stock'' has been
transferred. This also includes certain requirements that the
employer must satisfy under a written plan, and must notify and
certify (subject to transition rules) to employees, before an
election may be made. In addition, specific employer
withholding and reporting obligations cannot be properly met by
an employer unless the employer satisfies the various
requirements and makes the necessary determinations, and has
implemented appropriate procedures to ensure that the
withholding and reporting requirements are met.
If an employee elects to defer income inclusion under the
provision, the income must be included in the employee's income
for the taxable year that includes the earliest of (1) the
first date the qualified stock becomes transferable, including,
solely for this purpose, transferable to the employer; \1289\
(2) the date the employee first becomes an excluded employee
(as described below); (3) the first date on which any stock of
the employer becomes readily tradable on an established
securities market; \1290\ (4) the date five years after the
first date the employee's right to the stock becomes
substantially vested; or (5) the date on which the employee
revokes her inclusion deferral election.\1291\ It is intended
that the limited circumstances outlined in section 83(c)(3) and
applicable regulations apply with respect to the determination
of when stock first becomes transferrable or is no longer
subject to a substantial risk of forfeiture. For example,
income inclusion cannot be delayed due to a lock-up period as a
result of an initial public offering.
---------------------------------------------------------------------------
\1289\ For purposes of the inclusion deferral election, if shares
are substantially vested under the rules of section 83 but the employee
has the right to sell such shares to the employer or any other person,
the qualified stock is considered transferable and therefore income
inclusion immediately applies. Therefore, section 83(i)(1)(B)(i)
operates to effectively invalidate the deferral of income inclusion
when an employee has been transferred shares that the employee has a
right to sell.
\1290\ An established securities market is determined for this
purpose by the Secretary, but does not include any market unless the
market is recognized as an established securities market for purposes
of another Code provision.
\1291\ An inclusion deferral election is revoked at the time and in
the manner as the Secretary provides.
---------------------------------------------------------------------------
An inclusion deferral election is made in a manner similar
to the manner in which a section 83(b) election is made.\1292\
The provision does not apply to income with respect to
nonvested stock that is includible as a result of a section
83(b) election. The provision clarifies that other than
subsection (i), the provisions of section 83 including
subsection (b) shall not apply to RSUs. Therefore, RSUs are not
eligible for a section 83(b) election. This is the case
because, absent this provision, RSUs are nonqualified deferred
compensation and therefore subject to the rules that apply to
nonqualified deferred compensation.
---------------------------------------------------------------------------
\1292\ Thus, as in the case of a section 83(b) election, the
employee must file with the IRS the inclusion deferral election and
provide the employer with a copy.
---------------------------------------------------------------------------
An employee may not make an inclusion deferral election for
a year with respect to qualified stock if, in the preceding
calendar year, the corporation purchased any of its outstanding
stock unless at least 25 percent of the total dollar amount of
the stock so purchased is stock with respect to which an
inclusion deferral election is in effect (``deferral stock'')
and the determination of which individuals from whom deferral
stock is purchased is made on a reasonable basis.\1293\ For
purposes of this requirement, stock purchased from an
individual is not treated as deferral stock (and the purchase
is not treated as a purchase of deferral stock) if, immediately
after the purchase, the individual holds any deferral stock
with respect to which an inclusion deferral election has been
in effect for a longer period than the election with respect to
the purchased stock. Thus, in general, in applying the purchase
requirement, an individual's deferral stock with respect to
which an inclusion deferral election has been in effect for the
longest periods must be purchased first. A corporation that has
deferral stock outstanding as of the beginning of any calendar
year and that purchases any of its outstanding stock during the
calendar year must report on its income tax return for the
taxable year in which, or with which, the calendar year ends
the total dollar amount of the outstanding stock purchased
during the calendar year and such other information as the
Secretary may require for purposes of administering this
requirement.
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\1293\ This requirement is met if the stock purchased by the
corporation includes all the corporation's outstanding deferral stock.
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A qualified employee may make an inclusion deferral
election with respect to qualified stock attributable to a
statutory option.\1294\ In that case, the option is not treated
as a statutory option and the rules relating to statutory
options and related stock do not apply. In addition, an
arrangement under which an employee may receive qualified stock
is not treated as a nonqualified deferred compensation plan
under section 409A with respect to that employee solely because
of the employee's election, or ability to make an election, to
defer income recognition with respect to such stock.
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\1294\ For purposes of the requirement that an ESPP provide
employees with the same rights and privileges, the rules of the
provision apply in determining which employees have the right to make
an inclusion deferral election with respect to stock received under the
ESPP.
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Deferred income inclusion applies also for purposes of the
employer's deduction of the amount of income attributable to
the qualified stock. That is, if an employee makes an inclusion
deferral election, the employer's deduction is deferred until
the employer's taxable year in which or with which ends the
taxable year of the employee for which the amount is included
in the employee's income as described in (1)-(5) above.\1295\
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\1295\ Note that the deduction rule under Treas. Reg. sec. 1.83-
6(a)(3), which allows an employer a deduction in accordance with its
method of accounting when property is substantially vested upon
transfer, is not applicable.
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Qualified employee and qualified stock
Under the provision, a qualified employee means an
individual who is not an excluded employee and who agrees, in
the inclusion deferral election, to meet the requirements
necessary (as determined by the Secretary) to ensure the income
tax withholding requirements of the employer corporation with
respect to the qualified stock (as described below) are met.
For this purpose, an excluded employee with respect to a
corporation is any individual (1) who was a one-percent owner
of the corporation at any time during the 10 preceding calendar
years,\1296\ (2) who is, or has been at any prior time, the
chief executive officer or chief financial officer of the
corporation or an individual acting in either capacity, (3) who
is a family member of an individual described in (1) or
(2),\1297\ or (4) who has been one of the four highest
compensated officers of the corporation for any of the 10
preceding taxable years.\1298\ An excluded employee includes an
individual who first becomes a one-percent owner or one of the
four highest compensated officers in a taxable year,
notwithstanding that such individual may not have been among
such categories for the 10 preceding taxable years.
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\1296\ One-percent owner status is determined under the top-heavy
rules for qualified retirement plans, under section 416(i)(1)(B)(ii).
\1297\ In the case of one-percent owners, this results from
application of the attribution rules of section 318 under section
416(i)(1)(B)(i)(I). Family members are determined under section
318(a)(1) and generally include an individual's spouse, children,
grandchildren, and parents.
\1298\ These officers are determined on the basis of shareholder
disclosure rules for compensation under the Securities Exchange Act of
1934, as if such rules applied to the corporation.
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Qualified stock is any stock of a corporation if--
an employee receives the stock in connection
with the exercise of an option or in settlement of an
RSU, and
the option or RSU was granted by the
corporation to the employee in connection with the
performance of services and in a year in which the
corporation was an eligible corporation (as described
below).
However, qualified stock does not include any stock if, at
the time the employee's right to the stock becomes
substantially vested, the employee may sell the stock to, or
otherwise receive cash in lieu of stock from, the corporation.
Stock is qualified stock only if it relates to stock received
in connection with options or RSUs, and does not include stock
received in connection with other forms of equity compensation,
including stock appreciation rights or restricted stock.
A corporation is an eligible corporation with respect to a
calendar year if (1) no stock of the employer corporation (or
any predecessor) is readily tradable on an established
securities market during any preceding calendar year,\1299\ and
(2) the corporation has a written plan under which, in the
calendar year, the corporation grants stock options or grants
restricted stock units (``RSUs'') with the same rights and
privileges to receive qualified stock to not less than 80
percent of all employees who provide services to the
corporation in the United States or any U.S. possession (``80-
percent requirement'').\1300\ For this purpose, in general, the
determination of rights and privileges with respect to stock is
determined in a similar manner as provided under the ESPP
rules.\1301\ However, employees will not fail to be treated as
having the same rights and privileges to receive qualified
stock solely because the number of shares available to all
employees is not equal in amount, provided that the number of
shares available to each employee is more than a de minimis
amount. In addition, rights and privileges with respect to the
exercise of a stock option are not treated for this purpose as
the same as rights and privileges with respect to the
settlement of an RSU.\1302\ The requirement that 80 percent of
all applicable employees be granted stock options or restricted
stock units with the same rights and privileges cannot be
satisfied in a calendar year by granting a combination of stock
options and RSUs; instead all such employees must either be
granted stock options or be granted restricted stock units for
that year. It is intended that the requirement that 80 percent
of all applicable employees be granted stock options or be
granted restricted stock units apply consistently to eligible
employees in each calendar year, whether they are new hires or
existing employees in the relevant year.
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\1299\ This requirement continues to apply up to the time an
inclusion deferral election is made. That is, under the provision, no
inclusion deferral election may be made with respect to qualified stock
if any stock of the corporation is readily tradable on an established
securities market at any time before the election is made.
\1300\ In applying the requirement that 80 percent of employees
receive stock options or RSUs, excluded employees and part-time
employees are not taken into account. For this purpose, a part-time
employee is defined under section 4980G(d)(4), as an employee who is
customarily employed for fewer than 30 hours per week.
\1301\ Sec. 423(b)(5).
\1302\ Under a transition rule, in the case of a calendar year
beginning before January 1, 2018, the 80-percent requirement is applied
without regard to whether the rights and privileges with respect to the
qualified stock are the same.
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For purposes of the provision, corporations that are
members of the same controlled group \1303\ are treated as one
corporation.
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\1303\ As defined in section 414(b).
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Notice, withholding, and reporting requirements
Under the provision, a corporation that transfers qualified
stock to a qualified employee must provide a notice to the
qualified employee at the time (or a reasonable period before)
the employee's right to the qualified stock is substantially
vested (and income attributable to the stock would first be
includible absent an inclusion deferral election). The notice
must (1) certify to the employee that the stock is qualified
stock, and (2) notify the employee (a) that the employee may
(if eligible) elect to defer income inclusion with respect to
the stock and (b) that, if the employee makes an inclusion
deferral election, the amount of income required to be included
at the end of the deferral period will be based on the value of
the stock at the time the employee's right to the stock first
becomes substantially vested, notwithstanding whether the value
of the stock has declined during the deferral period (including
whether the value of the stock has declined below the
employee's tax liability with respect to such stock). The
notice must also notify the employee that if the employee makes
an inclusion deferral election, the amount of income to be
included at the end of the deferral period will be subject to
withholding as provided under the provision,\1304\ and outline
the employee's responsibilities with respect to the required
withholding. Failure to provide the notice may result in the
imposition of a penalty of $100 for each failure, subject to a
maximum penalty of $50,000 for all failures during any calendar
year.
---------------------------------------------------------------------------
\1304\ As described in section 3401(i) and at the rate determined
in section 3402(t).
---------------------------------------------------------------------------
An inclusion deferral election applies only for income tax
purposes. The provision includes specific income tax
withholding and reporting requirements with respect to income
subject to an inclusion deferral election. The application of
FICA and FUTA are not affected. However, when an inclusion
deferral election is made with respect to stock transferred in
connection with the exercise of an ISO or ESPP (a statutory
option), the option is not treated as a statutory option but
rather as a nonqualified stock option for FICA and FUTA
purposes (in addition to being subject to section 83(i) for
income tax purposes).
For the taxable year for which income subject to an
inclusion deferral election is required to be included in
income by the employee (as described above), the amount
required to be included in income is treated as wages with
respect to which the employer is required to withhold income
tax at a rate not less than the highest income tax rate
applicable to individual taxpayers.\1305\ The employer must
report on Form W-2 the amount of income covered by an inclusion
deferral election (1) for the year of deferral and (2) for the
year the income is required to be included in income by the
employee. In addition, for any calendar year, the employer must
report on Form W-2 the aggregate amount of income covered by
inclusion deferral elections, determined as of the close of the
calendar year.
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\1305\ That is, the maximum rate of tax in effect for the year
under section 1. The provision specifies that qualified stock is
treated as a noncash fringe benefit for income tax withholding
purposes. Sec. 3402(t).
The Treasury Department has issued published guidance
addressing this provision.\1306\
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\1306\ Notice 2018-97, 2018-52 I.R.B., December 24, 2018.
---------------------------------------------------------------------------
Effective Date
The provision generally applies with respect to stock
attributable to options exercised or RSUs settled after
December 31, 2017. Therefore, an election under the provision
could apply to options or restricted stock units that were
previously granted. Under a transition rule, until the
Secretary issues regulations or other guidance implementing the
80-percent and employer notice requirements \1307\ under the
provision, a corporation will be treated as complying with
those requirements (respectively) if it complies with a
reasonable good faith interpretation of the requirements. It is
intended for the transition rule provided with respect to
compliance with the 80-percent and employer notice requirements
to not be expanded beyond these specific items, and for the 80-
percent requirement for purposes of the transition rule to
apply on a calendar year basis in the same manner as it does
for purposes of the provision generally. The penalty for a
failure to provide the notice required under the provision
applies to failures after December 31, 2017.
---------------------------------------------------------------------------
\1307\ Secs. 83(i)(2)(C)(i)(II) and 83(i)(6). The 80-percent
requirement includes a written plan requirement.
---------------------------------------------------------------------------
D. Increase in Excise Tax Rate for Stock Compensation of Insiders in
Expatriated Corporations (sec. 13604 of the Act and sec. 4985 of the
Code)
Prior Law
Income tax treatment of employee stock compensation
In general
Employers may grant various forms of stock compensation to
employees,\1308\ including nonstatutory and statutory stock
options, restricted stock, restricted stock units, and stock
appreciation rights. The tax treatment of these various forms
of stock compensation depends on the specific terms and
conditions of the arrangement and applicable rules.
---------------------------------------------------------------------------
\1308\ The terms ``employer'' and ``employee'' are used, although
the provision herein also applies to individuals who are not employees
and the service recipients of such non-employee individuals.
---------------------------------------------------------------------------
Stock compensation treated as property transferred in
connection with the performance of services
Section 83 generally governs the taxation of transfers of
any property in connection with the performance of services by
any service provider. Typically, this encompasses the transfer
of stock to an employee which is subject to conditions that
amount to a substantial risk of forfeiture, called ``restricted
stock.'' Section 83 also generally governs the taxation of
nonstatutory (or nonqualified) stock options. In general, an
employee's right to stock or other property is subject to a
substantial risk of forfeiture if the employee's right to full
enjoyment of the property is subject to a condition, such as
the future performance of substantial services.\1309\
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\1309\ See section 83(c)(1) and Treas. Reg. sec. 1.83-3(c) for the
definition of substantial risk of forfeiture for this purpose.
---------------------------------------------------------------------------
Generally, an employee must recognize income in the taxable
year in which the employee's right to the stock is transferable
or is not subject to a substantial risk of forfeiture,
whichever occurs earlier (referred to herein as ``substantially
vested''). Thus, if the employee's right to the stock is
substantially vested when the stock is transferred to the
employee, the employee recognizes income in the taxable year of
such transfer, in an amount equal to the fair market value of
the stock as of the date of transfer (less any amount paid for
the stock). If at the time the stock is transferred to the
employee, the employee's right to the stock is not
substantially vested (referred to herein as ``nonvested''), the
employee does not recognize income attributable to the stock
transfer until the taxable year in which the employee's right
becomes substantially vested. In this case, the amount
includible in the employee's income is the fair market value of
the stock as of the date that the employee's right to the stock
is substantially vested (less any amount paid for the
stock).\1310\
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\1310\ Under section 83(b), the employee may elect within 30 days
of transfer to recognize income in the taxable year of transfer,
referred to as a ``section 83(b)'' election. If a proper and timely
election under section 83(b) is made, the amount of compensatory income
is capped at the amount equal to the fair market value of the stock as
of the date of transfer (less any amount paid for the stock).
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These rules do not apply to the grant of a nonqualified
option unless the option has a readily ascertainable fair
market value.\1311\ Instead, these rules generally apply to the
transfer of employer stock to the employee on exercise of the
option. That is, if the right to the stock is substantially
vested on transfer (the time of exercise), income recognition
applies for the taxable year of transfer. If the right to the
stock is nonvested on transfer, the timing of income inclusion
is determined under the rules applicable to the transfer of
nonvested stock. In either case, the amount includible in
income by the employee is the fair market value of the stock as
of the required time of income inclusion, less the exercise
price paid by the employee.
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\1311\ See section 83(e)(3) and Treas. Reg. sec. 1.83-7. A
nonqualified option is an option on employer stock that is not a
statutory option, discussed below.
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Statutory stock options
Two types of statutory options apply with respect to
employer stock: incentive stock options (``ISOs''') and options
provided under an employee stock purchase plan
(``ESPP'').\1312\ Stock received pursuant to a statutory option
is subject to special rules, rather than the rules for
nonqualified options, discussed above. Unlike nonqualified
options, statutory options may only be considered as such if
granted to employees.\1313\ No amount is includible in an
employee's income on the grant, vesting, or exercise of a
statutory option.
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\1312\ Sections 421-424 govern statutory options. Section 423(b)(5)
requires that, under the terms of an ESPP, all employees granted
options generally must have the same rights and privileges.
\1313\ Secs. 422(a)(2) and 423(a)(2).
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If a holding requirement is met with respect to the stock
transferred on exercise of a statutory option and the employee
later disposes of the stock, the employee's gain generally is
treated as capital gain rather than ordinary income. Under the
holding requirement, the employee must not dispose of the stock
within two years after the date the option is granted and also
must not dispose of the stock within one year after the date
the option is exercised. If a disposition occurs before the end
of the required holding period (a ``disqualifying
disposition''), the employee recognizes ordinary income in the
taxable year in which the disqualifying disposition occurs. The
amount of ordinary income recognized when a disqualifying
disposition occurs generally equals the fair market value of
the stock on the date of exercise (that is, when the stock was
transferred to the employee) less the exercise price paid.
Stock compensation treated as deferred compensation
A restricted stock unit (``RSU'') is a term used for an
arrangement under which an employee has the right to receive at
a specified time in the future an amount determined by
reference to the value of one or more shares of employer stock.
An employee's right to receive the future amount may be subject
to a condition, such as continued employment for a certain
period or the attainment of certain performance goals. The
payment to the employee of the amount due under the arrangement
is referred to as settlement of the RSU. The arrangement may
provide for the settlement amount to be paid in cash or as a
transfer of employer stock. An arrangement providing RSUs is
generally considered a nonqualified deferred compensation plan
and is subject to the rules, including the limits, of section
409A,\1314\ unless it meets an exemption from section 409A. If
the RSU either is exempt from or complies with section 409A,
the employee is subject to income taxation on receipt of cash
or the transfer of shares attributable to the RSU.
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\1314\ Section 409A and the regulations thereunder provide rules
for nonqualified deferred compensation. Unless an arrangement either is
exempt from or meets the requirements of section 409A, the amount of
deferred compensation is first includible in income for the taxable
year when not subject to a substantial risk of forfeiture (as defined),
even if payment will not occur until a later year. In general, to meet
the requirements of section 409A, the time when nonqualified deferred
compensation will be paid, as well as the amount, must be specified at
the time of deferral with limits on further deferral after the time for
payment. Various other requirements apply, including that payment can
only occur on specific defined events. Compensation that fails to meet
the requirements of section 409A is also subject to an additional
income tax of 20 percent on amounts includible in income and a
potential interest factor tax (``409A taxes''). Section 409A and the
additional 409A taxes apply to increases in the value of the failed
compensation each year until it is paid.
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A stock appreciation right (``SAR'') is an arrangement
under which an employee has the right to receive an amount (in
the form of cash or stock) determined by reference to the
appreciation in value of one or more shares of employer stock,
based on the difference in the stock's value when the employee
chooses to exercise the right and the value of the stock on the
date of grant of the SAR. An SAR is generally taxable at the
time of exercise on the amount of cash or value of stock
transferred at the time of exercise of the SAR.\1315\
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\1315\ Rev. Rul. 80-300, 1980-2 C.B. 165.
---------------------------------------------------------------------------
Various exemptions from section 409A apply, including
transfers of property subject to section 83, such as restricted
stock.\1316\ Nonqualified options and SARs are not
automatically exempt from section 409A, but may be structured
so as not to be considered nonqualified deferred
compensation.\1317\ In addition, ISOs and ESPPs are exempt from
section 409A.\1318\
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\1316\ Treas. Reg. sec. 1.409A-1(b)(6).
\1317\ Treas. Reg. sec. 1.409A-1(b)(5).
\1318\ Treas. Reg. sec. 1.409A-1(b)(5)(ii).
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Section 4985 excise tax on stock compensation of insiders of
expatriated corporations
Under section 4985, certain holders of stock options and
other stock-based compensation are subject to an excise tax
upon certain transactions that result in an expatriated
corporation \1319\ (also referred to as corporate
inversions).\1320\ The provision imposes an excise tax,
currently at the rate of 15 percent, on the value of specified
stock compensation held (directly or indirectly) by or for the
benefit of a disqualified individual, or a member of such
individual's family, at any time during the 12-month period
beginning six months before the corporation's expatriation
date. Specified stock compensation is treated as held for the
benefit of a disqualified individual if such compensation is
held by an entity, e.g., a partnership or trust, in which the
individual, or a member of the individual's family, has an
ownership interest.
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\1319\ Sec. 7874(a)(2).
\1320\ For further discussion of the tax treatment of expatriated
entities before the effective date of section 7874 and concerns that
led to the enactment of sections 7874 and 4985, see Joint Committee on
Taxation, General Explanation of Tax Legislation Enacted in the 108th
Congress (JCS-5-05), May 2005.
---------------------------------------------------------------------------
A disqualified individual is any individual who, with
respect to a corporation, is, at any time during the 12-month
period beginning on the date which is six months before the
expatriation date, subject to the requirements of section 16(a)
of the Securities and Exchange Act of 1934 with respect to the
corporation, or any member of the corporation's expanded
affiliated group,\1321\ or would be subject to such
requirements if the corporation (or member) were an issuer of
equity securities referred to in section 16(a). Disqualified
individuals generally include officers (as defined by section
16(a)),\1322\ directors, and 10-percent owners of private and
publicly-held corporations.
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\1321\ An expanded affiliated group is an affiliated group (under
section 1504) except that such group is determined without regard to
the exceptions for certain corporations and is determined by
substituting ``more than 50 percent'' for ``at least 80 percent.''
\1322\ An officer is defined as the president, principal financial
officer, principal accounting officer (or, if there is no such
accounting officer, the controller), any vice-president in charge of a
principal business unit, division or function (such as sales,
administration or finance), any other officer who performs a policy-
making function, or any other person who performs similar policy-making
functions.
---------------------------------------------------------------------------
The excise tax is imposed on a disqualified individual of
an expatriated corporation (as defined for this purpose) only
if gain is recognized in whole or part by any shareholder by
reason of the acquisition resulting in the corporate
inversion.\1323\
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\1323\ As referred to in section 7874(a)(2)(B)(i).
---------------------------------------------------------------------------
Specified stock compensation subject to the excise tax
includes any payment (or right to payment) \1324\ granted by
the expatriated corporation (or any member of the corporation's
expanded affiliated group) to any person in connection with the
performance of services by a disqualified individual for such
corporation (or member of the corporation's expanded affiliated
group) if the value of the payment or right is based on, or
determined by reference to, the value or change in value of
stock of such corporation (or any member of the corporation's
expanded affiliated group). In determining whether such
compensation exists and valuing such compensation, all
restrictions, other than non-lapse restrictions, are ignored.
Thus, the excise tax applies, and the value subject to the tax
is determined, without regard to whether such specified stock
compensation is subject to a substantial risk of forfeiture or
is exercisable at the time of the corporate inversion.
Specified stock compensation includes compensatory stock and
restricted stock grants, compensatory stock options, and other
forms of stock-based compensation, including stock appreciation
rights, restricted stock units, phantom stock, and phantom
stock options. Specified stock compensation also includes
nonqualified deferred compensation that is treated as though it
were invested in stock or stock options of the expatriating
corporation (or member). For example, the provision applies to
a disqualified individual's nonqualified deferred compensation
if company stock is one of the actual or deemed investment
options under the nonqualified deferred compensation plan.
---------------------------------------------------------------------------
\1324\ Under the provision, any transfer of property is treated as
a payment and any right to a transfer of property is treated as a right
to a payment.
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Specified stock compensation includes a compensation
arrangement that gives the disqualified individual an economic
stake substantially similar to that of a corporate shareholder.
A payment directly tied to the value of the stock is specified
stock compensation.
The excise tax applies to any such specified stock
compensation previously granted to a disqualified individual
but cancelled or cashed-out within the six-month period ending
with the expatriation date, and to any specified stock
compensation awarded in the six-month period beginning with the
expatriation date. As a result, for example, if a corporation
cancels outstanding options three months before the transaction
and then reissues comparable options three months after the
transaction, the tax applies both to the cancelled options and
the newly granted options.
Specified stock compensation subject to the tax does not
include a statutory stock option or any payment or right from a
qualified retirement plan or annuity, a tax-sheltered annuity,
a simplified employee pension, or a simple retirement account.
In addition, under the provision, the excise tax does not apply
to any stock option that is exercised during the six-month
period before the expatriation date or to any stock acquired
pursuant to such exercise, if income is recognized under
section 83 on or before the expatriation date with respect to
the stock acquired pursuant to such exercise. The excise tax
also does not apply to any specified stock compensation that is
exercised, sold, exchanged, distributed, cashed out, or
otherwise paid during such period in a transaction in which
income, gain, or loss is recognized in full.
For specified stock compensation held on the expatriation
date, the amount of the tax is determined based on the value of
the compensation on such date. The tax imposed on specified
stock compensation cancelled during the six-month period before
the expatriation date is determined based on the value of the
compensation on the day before such cancellation, while
specified stock compensation granted after the expatriation
date is valued on the date granted. Under the provision, the
cancellation of a non-lapse restriction is treated as a grant.
The value of the specified stock compensation on which the
excise tax is imposed is the fair value in the case of stock
options (including warrants and other similar rights to acquire
stock) and stock appreciation rights and the fair market value
for all other forms of compensation. For purposes of the tax,
the fair value of an option (or a warrant or other similar
right to acquire stock) or a stock appreciation right is
determined using an appropriate option-pricing model, as
specified or permitted by the Secretary of the Treasury, that
takes into account the stock price at the valuation date; the
exercise price under the option; the remaining term of the
option; the volatility of the underlying stock and the expected
dividends on it; and the risk-free interest rate over the
remaining term of the option. Options that have no intrinsic
value (or ``spread'') because the exercise price under the
option equals or exceeds the fair market value of the stock at
valuation nevertheless have a fair value and are subject to tax
under the provision. The value of other forms of compensation,
such as phantom stock or restricted stock, is the fair market
value of the stock as of the date of the expatriation
transaction. The value of any deferred compensation that can be
valued by reference to stock is the amount that the
disqualified individual would receive if the plan were to
distribute all such deferred compensation in a single sum on
the date of the expatriation transaction (or the date of
cancellation or grant, if applicable).
The excise tax also applies to any payment by the
expatriated corporation or any member of the expanded
affiliated group made to an individual, directly or indirectly,
in respect of the tax. Whether a payment is made in respect of
the tax is determined under all of the facts and circumstances.
Any payment made to keep the individual in the same after-tax
position that the individual would have been in had the tax not
applied is a payment made in respect of the tax. This includes
direct payments of the tax and payments to reimburse the
individual for payment of the tax. Any payment made in respect
of the tax is includible in the income of the individual, but
is not deductible by the corporation.
To the extent that a disqualified individual is also a
covered employee under section 162(m), the limit on the
deduction allowed for employee remuneration for such employee
is reduced by the amount of any payment (including
reimbursements) made in respect of the tax under the provision.
As discussed above, this includes direct payments of the tax
and payments to reimburse the individual for payment of the
tax.
The payment of the excise tax has no effect on the
subsequent tax treatment of any specified stock compensation.
Thus, the payment of the tax has no effect on the individual's
basis in any specified stock compensation and no effect on the
tax treatment for the individual at the time of exercise of an
option or payment of any specified stock compensation, or at
the time of any lapse or forfeiture of such specified stock
compensation. The payment of the excise tax is not deductible
and has no effect on any deduction that might be allowed at the
time of any future exercise or payment.
Explanation of Provision
The provision increases the 15-percent rate of excise tax,
imposed on the value of stock compensation held by insiders of
an expatriated corporation, to 20 percent.
Effective Date
The provision applies to corporations first becoming
expatriated corporations after the date of enactment (i.e.,
December 22, 2017).
SUBPART B--RETIREMENT PLANS
A. Repeal of Special Rule Permitting Recharacterization of Roth
Conversions (sec. 13611 of the Act and sec. 408A(d) of the Code)
Prior Law
Individual retirement arrangements
There are two basic types of individual retirement
arrangements (``IRAs'''): traditional IRAs,\1325\ to which both
deductible and nondeductible contributions may be made,\1326\
and Roth IRAs, to which only nondeductible contributions may be
made.\1327\ The principal difference between these two types of
IRAs is the timing of income tax inclusion.
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\1325\ Sec. 408.
\1326\ Secs. 219(a) and 408(o).
\1327\ Sec. 408A.
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An annual limit applies to contributions to IRAs. The
contribution limit is coordinated so that the aggregate maximum
amount that can be contributed to all of an individual's IRAs
(both traditional and Roth) for a taxable year is the lesser of
a certain dollar amount ($5,500 for 2017) or the individual's
compensation. In the case of a married couple, contributions
can be made up to the dollar limit for each spouse if the
combined compensation of the spouses is at least equal to the
contributed amount. The dollar limit is increased annually
(``indexed'') as needed to reflect increases in the cost-of
living. An individual who has attained age 50 before the end of
the taxable year may also make catch-up contributions up to
$1,000 to an IRA. The IRA catch-up contribution limit is not
indexed.
Traditional IRAs
An individual may make deductible contributions to a
traditional IRA up to the IRA contribution limit (reduced by
any contributions to Roth IRAs) if neither the individual nor
the individual's spouse is an active participant in an
employer-sponsored retirement plan. If an individual (or the
individual's spouse) is an active participant in an employer-
sponsored retirement plan, the deduction is phased out for
taxpayers with adjusted gross income (``AGI'') for the taxable
year over certain indexed levels.\1328\ To the extent an
individual cannot or does not make deductible contributions to
a traditional IRA or contributions to a Roth IRA for the
taxable year, the individual may make nondeductible after-tax
contributions to a traditional IRA (that is, no AGI limits
apply), subject to the same contribution limits as the limits
on deductible contributions, including catch-up contributions.
An individual who has attained age 70\1/2\ before the close of
a year is not permitted to make contributions to a traditional
IRA for that year.
---------------------------------------------------------------------------
\1328\ Sec. 219(g).
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Amounts held in a traditional IRA are includible in income
when withdrawn, except to the extent the withdrawal is a return
of the individual's basis.\1329\ All traditional IRAs of an
individual are treated as a single contract for purposes of
recovering basis in the IRAs.
---------------------------------------------------------------------------
\1329\ Basis results from after-tax contributions to traditional
IRAs or rollovers to traditional IRAs of after-tax amounts from other
eligible retirement plans.
---------------------------------------------------------------------------
Roth IRAs
Individuals with AGI below certain levels may make
nondeductible contributions to a Roth IRA. The maximum annual
contribution that can be made to a Roth IRA is phased out for
taxpayers with AGI for the taxable year over certain indexed
levels.\1330\
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\1330\ Although an individual with AGI exceeding certain limits is
not permitted to make a contribution directly to a Roth IRA, the
individual can make a contribution to a traditional IRA and convert the
traditional IRA to a Roth IRA, as discussed below.
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Amounts held in a Roth IRA that are withdrawn as a
qualified distribution are not includible in income. A
qualified distribution is a distribution that (1) is made after
the five-taxable-year period beginning with the first taxable
year for which the individual first made a contribution to a
Roth IRA, and (2) is made after attainment of age 59\1/2\, on
account of death or disability, or is made for first-time
homebuyer expenses of up to $10,000.
Distributions from a Roth IRA that are not qualified
distributions are includible in income to the extent
attributable to earnings; amounts that are attributable to a
return of contributions to the Roth IRA are not includible in
income. All Roth IRAs are treated as a single contract for
purposes of determining the amount that is a return of
contributions.
Separation of traditional and Roth IRA accounts
Contributions to traditional IRAs and to Roth IRAs must be
segregated into separate IRAs, meaning arrangements with
separate trusts, accounts, or contracts, and separate IRA
documents. Except in the case of a conversion or
recharacterization, amounts cannot be transferred or rolled
over between the two types of IRAs.
Taxpayers generally may convert an amount in a traditional
IRA to a Roth IRA. The amount converted is includible in the
taxpayer's income as if a withdrawal had been made.\1331\ The
conversion is accomplished by a trustee-to-trustee transfer of
the amount from the traditional IRA to the Roth IRA, or by a
distribution from the traditional IRA and contribution to the
Roth IRA within 60 days.
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\1331\ Subject to various exceptions, distributions from an IRA
before age 59\1/2\ that are includible in income are subject to a 10-
percent early distribution tax under section 72(t). An exception
applies to an amount includible in income as a result of the conversion
from a traditional IRA into a Roth IRA. However, the early distribution
tax applies if the taxpayer withdraws the converted amount within five
years of the conversion.
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Rollovers to IRAs of distributions from tax-favored
employer-sponsored retirement plans (that is, qualified
retirement plans, tax-deferred annuity plans, and governmental
eligible deferred compensation plans \1332\) are also
permitted. For tax-free rollovers, distributions from pretax
accounts under an employer-sponsored plan generally must be
contributed to a traditional IRA, and distributions from a
designated Roth account under an employer-sponsored plan must
be contributed only to a Roth IRA. However, a distribution from
an employer-sponsored plan that is not from a designated Roth
account is also permitted to be rolled over into a Roth IRA,
subject to the rules that apply to conversions from a
traditional IRA into a Roth IRA. Thus, a rollover from a tax-
favored employer-sponsored plan to a Roth IRA is includible in
gross income (except to the extent it represents a return of
after-tax contributions).\1333\
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\1332\ Secs. 401(a), 403(a), 403(b) and 457(b).
\1333\ As in the case of a conversion of an amount from a
traditional IRA to a Roth IRA, the special recapture rule relating to
the 10-percent additional tax on early distributions applies for
distributions made from the Roth IRA within a specified five-year
period after the rollover.
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Recharacterization of IRA contributions
If an individual makes a contribution to an IRA
(traditional or Roth) for a taxable year, the individual is
permitted to recharacterize the contribution as a contribution
to the other type of IRA (traditional or Roth) by making a
trustee-to-trustee transfer to the other type of IRA before the
due date (including extensions) for the individual's income tax
return for that year.\1334\ In the case of a
recharacterization, the contribution will be treated as having
been made to the transferee IRA (and not the original,
transferor IRA) as of the date of the original contribution.
Both regular contributions and conversion contributions to a
Roth IRA can be recharacterized as having been made to a
traditional IRA.
---------------------------------------------------------------------------
\1334\ Sec. 408A(d)(6).
---------------------------------------------------------------------------
The amount transferred in a recharacterization must be
accompanied by any net income allocable to the contribution. In
general, even if a recharacterization is accomplished by
transferring a specific asset, net income is calculated as a
pro rata portion of income on the entire account rather than
income allocable to the specific asset transferred. However,
when doing a Roth conversion of an amount for a year, an
individual may establish multiple Roth IRAs, for example, Roth
IRAs with different investment strategies, and divide the
amount being converted among the IRAs. The individual can then
choose whether to recharacterize any of the Roth IRAs as a
traditional IRA by transferring the entire amount in the
particular Roth IRA to a traditional IRA.\1335\ For example, if
the value of the assets in a particular Roth IRA declines after
the conversion, the conversion can be reversed by
recharacterizing that IRA as a traditional IRA. The individual
may then later convert that traditional IRA to a Roth IRA
(referred to as a reconversion), including only the lower value
in income. Treasury regulations prevent the reconversion from
taking place immediately after the recharacterization, by
requiring a minimum period to elapse before the reconversion.
Generally the reconversion cannot occur sooner than the later
of 30 days after the recharacterization or a date during the
taxable year following the taxable year of the original
conversion.\1336\
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\1335\ Treas. Reg. sec. 1.408A-5, Q&A-2(b).
\1336\ Treas. Reg. sec. 1.408A-5, Q&A-9.
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Explanation of Provision
Under the provision, the special rule that allows a
contribution to one type of IRA to be recharacterized as a
contribution to the other type of IRA does not apply to a
conversion contribution to a Roth IRA. Thus, recharacterization
cannot be used to unwind a Roth conversion. However,
recharacterization is still permitted with respect to other
contributions. For example, an individual may make a
contribution for a year to a Roth IRA and, before the due date
for the individual's income tax return for that year,
recharacterize it as a contribution to a traditional IRA. In
addition, an individual may still make a contribution to a
traditional IRA and convert the traditional IRA to a Roth IRA,
but the provision precludes the individual from later unwinding
the conversion through a recharacterization.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
B. Modification of Rules Applicable to Length of Service Award Plans
(sec. 13612 of the Act and sec. 457(e) of the Code)
Prior Law
Special rules apply to deferred compensation plans of State
and local government and private, tax-exempt employers.\1337\
However, an exception to these rules applies in the case of a
plan paying solely length of service awards to bona fide
volunteers (or their beneficiaries) on account of qualified
services performed by the volunteers. For this purpose,
qualified services consist of firefighting and fire prevention
services, emergency medical services, and ambulance services.
An individual is treated as a bona fide volunteer for this
purpose if the only compensation received by the individual for
performing qualified services is in the form of (1)
reimbursement or a reasonable allowance for reasonable expenses
incurred in the performance of such services, or (2) reasonable
benefits (including length of service awards) and nominal fees
for the services, customarily paid in connection with the
performance of such services by volunteers. The exception
applies only if the aggregate amount of length of service
awards accruing for a bona fide volunteer with respect to any
year of service does not exceed $3,000.
---------------------------------------------------------------------------
\1337\ Sec. 457.
---------------------------------------------------------------------------
Explanation of Provision
The provision increases the aggregate amount of length of
service awards that may accrue for a bona fide volunteer with
respect to any year of service to $6,000 and adjusts that
amount in $500 increments to reflect changes in cost-of-living
for years after the first year the provision is effective. In
addition, under the provision, if the plan is a defined benefit
plan, the limit applies to the actuarial present value of the
aggregate amount of length of service awards accruing with
respect to any year of service. Actuarial present value is to
be calculated using reasonable actuarial assumptions and
methods, assuming payment will be made under the most valuable
form of payment under the plan with payment commencing at the
later of the earliest age at which unreduced benefits are
payable under the plan or the participant's age at the time of
the calculation.
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
C. Extended Rollover Period for Plan Loan Offset Amounts (sec. 13613 of
the Act and sec. 402(c) of the Code)
Prior Law
Taxation of retirement plan distributions
A distribution from a tax-favored employer-sponsored
retirement plan (that is, a qualified retirement plan, section
403(b) plan, or a governmental section 457(b) plan) is
generally includible in gross income, except in the case of a
qualified distribution from a designated Roth account or to the
extent the distribution is a recovery of basis under the plan
or the distribution is contributed to another such plan or an
IRA (referred to as eligible retirement plans) in a tax-free
rollover.\1338\ In the case of a distribution from a retirement
plan to an employee under age 59 \1/2\, the distribution (other
than a distribution from a governmental section 457(b) plan) is
also subject to a 10-percent early distribution tax unless an
exception applies.\1339\
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\1338\ Secs. 402(a) and (c), 402A(d), 403(a) and (b), 457(a) and
(e)(16).
\1339\ Sec. 72(t).
---------------------------------------------------------------------------
A distribution from a tax-favored employer-sponsored
retirement plan that is an eligible rollover distribution may
be rolled over to an eligible retirement plan.\1340\ The
rollover generally can be achieved by direct rollover (direct
payment from the distributing plan to the recipient plan) or by
contributing the distribution to the eligible retirement plan
within 60 days of receiving the distribution (``60-day
rollover'').
---------------------------------------------------------------------------
\1340\ Certain distributions are not eligible rollover
distributions, such as annuity payments, required minimum
distributions, hardship distributions, and loans that are treated as
deemed distributions under section 72(p).
---------------------------------------------------------------------------
Employer-sponsored retirement plans are required to offer
an employee a direct rollover with respect to any eligible
rollover distribution before paying the amount to the employee.
If an eligible rollover distribution is not directly rolled
over to an eligible retirement plan, the taxable portion of the
distribution generally is subject to mandatory 20-percent
income tax withholding.\1341\ Employees who do not elect a
direct rollover but who roll over eligible distributions within
60 days of receipt also defer tax on the rollover amounts;
however, the 20 percent that is withheld remains taxable unless
the employee substitutes funds within the 60-day period.
---------------------------------------------------------------------------
\1341\ Treas. Reg. sec. 1.402(c)-2, Q&A-1(b)(3).
---------------------------------------------------------------------------
Plan loans
Employer-sponsored retirement plans may provide loans to
employees. Unless the loan satisfies certain requirements in
both form and operation, the amount of a retirement plan loan
is a deemed distribution from the retirement plan. Among the
requirements that the loan must satisfy are that the loan's
terms must provide for a repayment period of not more than five
years (except for a loan specifically to purchase a home) and
for level amortization of loan payments to be made not less
frequently than quarterly.\1342\ Thus, if an employee stops
making payments on a loan before the loan is repaid, a deemed
distribution of the outstanding loan balance generally occurs.
A deemed distribution of an unpaid loan balance is generally
taxed as though an actual distribution occurred, including
being subject to a 10-percent early distribution tax, if
applicable. A deemed distribution is not eligible for rollover
to another eligible retirement plan.
---------------------------------------------------------------------------
\1342\ Sec. 72(p).
---------------------------------------------------------------------------
A plan may also provide that, in certain circumstances (for
example, if an employee terminates employment), an employee's
obligation to repay a loan is accelerated and, if the loan is
not repaid, the loan is cancelled and the amount in an
employee's account balance is offset by the amount of the
unpaid loan balance, referred to as a loan offset. A loan
offset is treated as an actual distribution from the plan equal
to the unpaid loan balance (rather than a deemed distribution),
and (unlike a deemed distribution) the amount of the
distribution is eligible for tax-free rollover to another
eligible retirement plan within 60 days. However, the plan is
not required to offer a direct rollover with respect to a plan
loan offset amount that is an eligible rollover distribution,
and the plan loan offset amount is generally not subject to 20-
percent income tax withholding.
Explanation of Provision
Under the provision, the period during which a plan loan
offset amount may be contributed to an eligible retirement plan
as a rollover contribution is extended from 60 days after the
date of the offset, if the plan loan is a qualified plan loan
offset. The extended deadline is the due date (including
extensions) for filing the Federal income tax return for the
taxable year in which the plan loan offset occurs, that is, the
taxable year in which the amount is treated as distributed from
the plan. Under the provision, a qualified plan loan offset
amount is a plan loan offset amount that is treated as
distributed from a qualified retirement plan, a section 403(b)
plan, or a governmental section 457(b) plan solely by reason of
the termination of the plan or the failure to meet the
repayment terms of the loan because of the employee's severance
from employment. As under prior law, a loan offset amount under
the provision is the amount by which an employee's account
balance under the plan is reduced to repay a loan from the
plan.
Effective Date
The provision is effective for plan loan offset amounts
treated as distributed in taxable years beginning after
December 31, 2017.
PART VIII--EXEMPT ORGANIZATIONS
A. Excise Tax Based on Investment Income of Private Colleges and
Universities (sec. 13701 of the Act and new sec. 4968 of the Code)
Prior Law
Public charities and private foundations
An organization qualifying for tax-exempt status under
section 501(c)(3) is further classified as either a public
charity or a private foundation. An organization may qualify as
a public charity in several ways.\1343\ Certain organizations
are classified as public charities per se, regardless of their
sources of support. These include churches, certain schools,
hospitals and other medical organizations, certain
organizations providing assistance to colleges and
universities, and governmental units.\1344\ Other organizations
qualify as public charities because they are broadly publicly
supported. First, a charity may qualify as publicly supported
if at least one-third of its total support is from gifts,
grants, or other contributions from governmental units or the
general public.\1345\ Alternatively, it may qualify as publicly
supported if it receives more than one-third of its total
support from a combination of gifts, grants, and contributions
from governmental units and the public plus revenue arising
from activities related to its exempt purposes (e.g., fee for
service income). In addition, this category of public charity
must not rely excessively on endowment income as a source of
support.\1346\ A supporting organization, i.e., an organization
that provides support to another section 501(c)(3) entity that
is not a private foundation and meets the requirements of the
Code, also is classified as a public charity.\1347\
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\1343\ The Code does not expressly define the term ``public
charity,'' but rather provides exceptions to those entities that are
treated as private foundations.
\1344\ Sec. 509(a)(1) (referring to sections 170(b)(1)(A)(i)
through (iv) for a description of these organizations).
\1345\ Treas. Reg. sec. 1.170A-9(f)(2). Failing this mechanical
test, the organization may qualify as a public charity if it passes a
``facts and circumstances'' test. Treas. Reg. sec. 1.170A-9(f)(3).
\1346\ To meet this requirement, the organization must normally
receive more than one-third of its support from a combination of (1)
gifts, grants, contributions, or membership fees and (2) certain gross
receipts from admissions, sales of merchandise, performance of
services, and furnishing of facilities in connection with activities
that are related to the organization's exempt purposes. Sec.
509(a)(2)(A). In addition, the organization must not normally receive
more than one-third of its public support in each taxable year from the
sum of (1) gross investment income and (2) the excess of unrelated
business taxable income as determined under section 512 over the amount
of unrelated business income tax imposed by section 511. Sec.
509(a)(2)(B).
\1347\ Sec. 509(a)(3). Supporting organizations are further
classified as Type I, II, or III depending on the relationship they
have with the organizations they support. Supporting organizations must
support public charities listed in one of the other categories (i.e.,
per se public charities, broadly supported public charities, or revenue
generating public charities), and they are not permitted to support
other supporting organizations or testing for public safety
organizations. Organizations organized and operated exclusively for
testing for public safety also are classified as public charities. Sec.
509(a)(4). Such organizations, however, are not eligible to receive
deductible charitable contributions under section 170.
---------------------------------------------------------------------------
A section 501(c)(3) organization that does not fit within
any of the above categories is a private foundation. In
general, private foundations receive funding from a limited
number of sources (e.g., an individual, a family, or a
corporation).
Excise tax on investment income of private foundations
Under section 4940(a), private foundations that are
recognized as exempt from Federal income tax under section
501(a) (other than exempt operating foundations) \1348\ are
subject to a two-percent excise tax on their net investment
income. Net investment income generally includes interest,
dividends, rents, royalties (and income from similar sources),
and capital gain net income, and is reduced by expenses
incurred to earn this income. The two-percent rate of tax is
reduced to one-percent in any year in which a foundation
exceeds the average historical level of its charitable
distributions. Specifically, the excise tax rate is reduced if
the foundation's qualifying distributions (generally, amounts
paid to accomplish exempt purposes) \1349\ equal or exceed the
sum of (1) the amount of the foundation's assets for the
taxable year multiplied by the average percentage of the
foundation's qualifying distributions over the five taxable
years immediately preceding the taxable year in question, and
(2) one percent of the net investment income of the foundation
for the taxable year.\1350\ In addition, the foundation cannot
have been subject to tax in any of the five preceding years for
failure to meet minimum qualifying distribution requirements in
section 4942.
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\1348\ Exempt operating foundations are exempt from the section
4940 tax. Sec. 4940(d)(1). Exempt operating foundations generally
include organizations such as museums or libraries that devote their
assets to operating charitable programs but have difficulty meeting the
``public support'' tests necessary not to be classified as a private
foundation. To be an exempt operating foundation, an organization must:
(1) be an operating foundation (as defined in section 4942(j)(3)); (2)
be publicly supported for at least 10 taxable years; (3) have a
governing body no more than 25 percent of whom are disqualified persons
and that is broadly representative of the general public; and (4) have
no officers who are disqualified persons. Sec. 4940(d)(2).
\1349\ Sec. 4942(g).
\1350\ Sec. 4940(e).
---------------------------------------------------------------------------
Private foundations that are not exempt from tax under
section 501(a), such as certain charitable trusts, are subject
to an excise tax under section 4940(b). The tax is equal to the
excess of the sum of the excise tax that would have been
imposed under section 4940(a) if the foundation were tax exempt
and the amount of the tax on unrelated business income that
would have been imposed if the foundation were tax exempt, over
the income tax imposed on the foundation under subtitle A of
the Code.
Private foundations are required to make a minimum amount
of qualifying distributions each year to avoid tax under
section 4942. The minimum amount of qualifying distributions a
foundation has to make to avoid tax under section 4942 is
reduced by the amount of section 4940 excise taxes paid.\1351\
---------------------------------------------------------------------------
\1351\ Sec. 4942(d)(2).
---------------------------------------------------------------------------
Private colleges and universities
Private colleges and universities generally are treated as
public charities rather than private foundations \1352\ and
thus are not subject to the private foundation excise tax on
net investment income.
---------------------------------------------------------------------------
\1352\ Secs. 509(a)(1) and 170(b)(1)(A)(ii).
---------------------------------------------------------------------------
Explanation of Provision
The provision imposes an excise tax on an applicable
educational institution for each taxable year equal to 1.4
percent of the net investment income of the institution for the
taxable year. Net investment income is determined using rules
similar to the rules of section 4940(c) (relating to the net
investment income of a private foundation).
For purposes of the provision, an applicable educational
institution is an eligible education institution (as described
in section 25A of the Code): \1353\ (1) that has at least 500
students \1354\ during the preceding taxable year; (2) more
than 50 percent of the students \1355\ of which are located in
the United States; (3) that is not described in the first
section of section 511(a)(2)(B) of the Code (generally
describing State colleges and universities); and (4) the
aggregate fair market value of the assets of which at the end
of the preceding taxable year (other than those assets that are
used directly in carrying out the institution's exempt purpose)
\1356\ is at least $500,000 per student. For these purposes,
the number of students of an institution is based on the
average daily number of full-time students attending the
institution, with part-time students being taken into account
on a full-time student equivalent basis.
---------------------------------------------------------------------------
\1353\ Section 25A defines an eligible educational institution as
an institution (1) which is described in section 481 of the Higher
Education Act of 1965 (20 U.S.C. sec. 1088), as in effect on August 5,
1977, and (2) which is eligible to participate in a program under title
IV of such Act.
\1354\ The December 15, 2017, conference agreement required that an
applicable educational institution have at least 500 tuition paying
students and that more than 50 percent of the tuition paying students
be located in the United States, but the phrase ``tuition paying'' was
stricken before final passage of the Act. In subsequently enacted
legislation, the phrase ``tuition paying'' was reinstated in both
places where it had originally appeared (Code sections 4968(b)(1)(A)
and (b)(1)(B)). Sec. 41109 of the Bipartisan Budget Act of 2018, Pub.
L. No. 115-123, February 9, 2018.
\1355\ See ibid.
\1356\ Assets used directly in carrying out the institution's
exempt purpose include, for example, classroom buildings and physical
facilities used for educational activities and office equipment or
other administrative assets used by employees of the institution in
carrying out exempt activities, among other assets.
---------------------------------------------------------------------------
For purposes of determining whether an educational
institution meets the asset-per-student threshold \1357\ and
for purposes of determining net investment income, assets and
net investment income of a related organization with respect to
the educational institution are treated as assets and net
investment income, respectively, of the educational
institution, except that:
---------------------------------------------------------------------------
\1357\ In cross-referencing the asset-per-student threshold for
this purpose, new section 4968(d)(1) includes a reference to subsection
(b)(1)(C) that should instead read ``(b)(1)(D).'' A clerical correction
may be necessary to correct this cross-reference.
---------------------------------------------------------------------------
No such amount is taken into account with
respect to more than one educational institution; and
Unless the related organization is
controlled by the educational institution or is a
supporting organization (described in section
509(a)(3)) with respect to the institution for the
taxable year, assets and net investment income that are
not intended or available for the use or benefit of the
educational institution are not taken into account. For
example, assets of a related organization that are
earmarked or restricted for (or fairly attributable to)
the educational institution would be treated as assets
of the educational institution, whereas assets of a
related organization that are held for unrelated
purposes (and are not fairly attributable to the
educational institution) would be disregarded.
An organization is treated as related to the
institution for this purpose if the organization: (1)
controls, or is controlled by, the institution; (2) is
controlled by one or more persons that control the
institution; or (3) is a supported organization \1358\
or a supporting organization \1359\ during the taxable
year with respect to the institution.
---------------------------------------------------------------------------
\1358\ Sec. 509(f)(3).
\1359\ Sec. 509(a)(3).
---------------------------------------------------------------------------
It is intended that the Secretary promulgate regulations to
carry out the intent of the provision, including regulations
that describe: (1) assets that are used directly in carrying
out the educational institution's exempt purpose; (2) the
computation of net investment income; and (3) assets that are
intended or available for the use or benefit of the educational
institution.
The IRS and Treasury Department have issued a notice
addressing this provision.\1360\
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\1360\ Notice 2018-55, 2018-26 I.R.B. 773, June 25, 2018.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
B. Unrelated Business Taxable Income Separately Computed for Each Trade
or Business Activity (sec. 13702 of the Act and sec. 512(a) of the
Code)
Prior Law
Tax exemption for certain organizations
Section 501(a) exempts certain organizations from Federal
income tax. Such organizations include: (1) tax-exempt
organizations described in section 501(c) (including among
others section 501(c)(3) charitable organizations and section
501(c)(4) social welfare organizations); (2) religious and
apostolic organizations described in section 501(d); and (3)
trusts forming part of a pension, profit-sharing, or stock
bonus plan of an employer described in section 401(a).
Unrelated business income tax, in general
The unrelated business income tax (``UBIT'') generally
applies to income derived from a trade or business regularly
carried on by the organization that is not substantially
related to the performance of the organization's tax-exempt
functions.\1361\ An organization that is subject to UBIT and
that has $1,000 or more of gross unrelated business taxable
income must report that income on Form 990-T (Exempt
Organization Business Income Tax Return).
---------------------------------------------------------------------------
\1361\ Secs. 511-514.
---------------------------------------------------------------------------
Most exempt organizations may operate an unrelated trade or
business so long as the organization remains primarily engaged
in activities that further its exempt purposes. Therefore, an
organization may generally engage in a substantial amount of
unrelated business activity without jeopardizing exempt status.
A section 501(c)(3) (charitable) organization, however, may not
operate an unrelated trade or business as a substantial part of
its activities.\1362\ Therefore, the unrelated trade or
business activity of a section 501(c)(3) organization must be
insubstantial.
---------------------------------------------------------------------------
\1362\ Treas. Reg. sec. 1.501(c)(3)-1(e).
---------------------------------------------------------------------------
Organizations subject to tax on unrelated business income
Most exempt organizations are subject to UBIT.
Specifically, organizations subject to UBIT generally include:
(1) organizations exempt from tax under section 501(a),
including organizations described in section 501(c) (except for
U.S. instrumentalities and certain charitable trusts); \1363\
(2) qualified pension, profit-sharing, and stock bonus plans
described in section 401(a); \1364\ and (3) certain State
colleges and universities.\1365\
---------------------------------------------------------------------------
\1363\ Sec. 511(a)(2)(A).
\1364\ Sec. 511(a)(2)(A).
\1365\ Sec. 511(a)(2)(B).
---------------------------------------------------------------------------
Exclusions from unrelated business taxable income
Certain types of income are specifically excluded from
unrelated business taxable income, such as dividends, interest,
royalties, and certain rents,\1366\ unless derived from debt-
financed property or from certain 50-percent controlled
subsidiaries.\1367\ Certain types of activities are not
considered unrelated trade or business activities, such as
activities in which substantially all the work is performed by
volunteers, which involve the sale of donated goods, or which
are carried on for the convenience of members, students,
patients, officers, or employees of a charitable
organization.\1368\ Additional activities exempt from UBIT
include certain activities of trade shows and State
fairs,\1369\ conducting bingo games,\1370\ and the distribution
of low-cost items incidental to the solicitation of charitable
contributions.\1371\ Organizations liable for UBIT may also be
liable for alternative minimum tax determined after taking into
account adjustments and tax preference items.\1372\
---------------------------------------------------------------------------
\1366\ Sec. 512(b).
\1367\ Sec. 512(b)(13).
\1368\ Sec. 513(a).
\1369\ Sec. 513(d)
\1370\ Sec. 513(f).
\1371\ Sec. 513(h).
\1372\ See section 55 prior to amendment by the Act. For a
discussion of the repeal of the corporate alternative minimum tax for
taxable years beginning after December 31, 2017, see the description of
sections 12001-12003 of the Act (Alternative Minimum Tax).
---------------------------------------------------------------------------
Specific deduction against unrelated business taxable income
In computing unrelated business taxable income, an exempt
organization may take a specific deduction of $1,000. This
specific deduction may not be used to create a net operating
loss that will be carried back or forward to another
year.\1373\
---------------------------------------------------------------------------
\1373\ Sec. 512(b)(12).
---------------------------------------------------------------------------
In the case of a diocese, province of a religious order, or
a convention or association of churches, there is also allowed
a specific deduction with respect to each parish, individual
church, district, or other local unit. The specific deduction
is equal to the lower of $1,000 or the gross income derived
from any unrelated trade or business regularly carried on by
the local unit.\1374\
---------------------------------------------------------------------------
\1374\ Ibid.
---------------------------------------------------------------------------
Operation of multiple unrelated trades or businesses
An organization determines its unrelated business taxable
income by subtracting from its gross unrelated business income
the deductions directly connected with the unrelated trade or
business.\1375\ In determining unrelated business taxable
income, an organization that operates multiple unrelated trades
or businesses aggregates income from all such activities and
subtracts from the aggregate gross income the aggregate of the
deductions allowed with respect to such activities.\1376\ As a
result, an organization may use a deduction from one unrelated
trade or business to offset income from another, thereby
reducing total unrelated business taxable income.
---------------------------------------------------------------------------
\1375\ Sec. 512(a).
\1376\ Treas. Reg. sec. 1.512(a)-1(a).
---------------------------------------------------------------------------
Explanation of Provision
For an organization with more than one unrelated trade or
business, the provision requires that unrelated business
taxable income first be computed separately with respect to
each trade or business and without regard to the specific
deduction generally allowed under section 512(b)(12). The
organization's unrelated business taxable income for a taxable
year is the sum of the amounts (not less than zero) computed
for each separate unrelated trade or business, less the
specific deduction allowed under section 512(b)(12).\1377\ A
net operating loss deduction is allowed only with respect to a
trade or business from which the loss arose.
---------------------------------------------------------------------------
\1377\ An exempt organization that makes charitable contributions
generally is permitted to deduct its charitable contributions in
computing its unrelated business taxable income whether or not the
contributions are directly connected with an unrelated trade or
business. It is not intended that an exempt organization that has more
than one unrelated trade or business be required to allocate its
deductible charitable contributions among its various unrelated trades
or businesses.
---------------------------------------------------------------------------
The result of the provision is that a deduction from one
trade or business for a taxable year may not be used to offset
income from a different unrelated trade or business for the
same taxable year. The provision generally does not, however,
prevent an organization from using a deduction from one taxable
year to offset income from the same unrelated trade or business
activity in another taxable year, where appropriate.
It is intended that the Secretary issue guidance concerning
when an activity will be treated as a separate unrelated trade
or business for purposes of the provision. For example, it is
intended that the Secretary consider whether it would be
appropriate in certain cases to permit an organization that
maintains an investment portfolio to treat multiple investment
activities as one unrelated trade or business.
The IRS and Treasury Department have issued a notice
addressing this provision.\1378\
---------------------------------------------------------------------------
\1378\ Notice 2018-67, 2018-36 I.R.B. 409, September 4, 2018.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017. Under a special transition rule, net
operating losses arising in a taxable year beginning before
January 1, 2018, that are carried forward to a taxable year
beginning on or after such date are not subject to the
provision.
C. Unrelated Business Taxable Income Increased by Amount of Certain
Fringe Benefit Expenses for which Deduction is Disallowed (sec. 13703
of the Act and sec. 512 of the Code)
Prior Law
Tax exemption for certain organizations
Section 501(a) exempts certain organizations from Federal
income tax. Such organizations include: (1) tax-exempt
organizations described in section 501(c) (including among
others section 501(c)(3) charitable organizations and section
501(c)(4) social welfare organizations); (2) religious and
apostolic organizations described in section 501(d); and (3)
trusts forming part of a pension, profit-sharing, or stock
bonus plan of an employer described in section 401(a).
Unrelated business income tax, in general
The unrelated business income tax (``UBIT'') generally
applies to income derived from a trade or business regularly
carried on by the organization that is not substantially
related to the performance of the organization's tax-exempt
functions.\1379\ An organization that is subject to UBIT and
that has $1,000 or more of gross unrelated business taxable
income must report that income on Form 990-T (Exempt
Organization Business Income Tax Return).
---------------------------------------------------------------------------
\1379\ Secs. 511-514.
---------------------------------------------------------------------------
Most exempt organizations may operate an unrelated trade or
business so long as the organization remains primarily engaged
in activities that further its exempt purposes. Therefore, an
organization may generally engage in a substantial amount of
unrelated business activity without jeopardizing exempt status.
A section 501(c)(3) (charitable) organization, however, may not
operate an unrelated trade or business as a substantial part of
its activities.\1380\ Therefore, the unrelated trade or
business activity of a section 501(c)(3) organization must be
insubstantial.
---------------------------------------------------------------------------
\1380\ Treas. Reg. sec. 1.501(c)(3)-1(e).
---------------------------------------------------------------------------
An organization determines its unrelated business taxable
income by subtracting from its gross unrelated business income
the deductions directly connected with the unrelated trade or
business.\1381\ In determining unrelated business taxable
income, an organization that operates multiple unrelated trades
or businesses aggregates income from all such activities and
subtracts from the aggregate gross income the aggregate of the
deductions allowed with respect to such activities.\1382\ As a
result, an organization may use a deduction from one unrelated
trade or business to offset income from another, thereby
reducing total unrelated business taxable income.
---------------------------------------------------------------------------
\1381\ Sec. 512(a).
\1382\ Treas. Reg. sec. 1.512(a)-1(a).
---------------------------------------------------------------------------
Organizations subject to tax on unrelated business income
Most exempt organizations are subject to UBIT.
Specifically, organizations subject to UBIT generally include:
(1) organizations exempt from tax under section 501(a),
including organizations described in section 501(c) (except for
U.S. instrumentalities and certain charitable trusts); \1383\
(2) qualified pension, profit-sharing, and stock bonus plans
described in section 401(a); \1384\ and (3) certain State
colleges and universities.\1385\
---------------------------------------------------------------------------
\1383\ Sec. 511(a)(2)(A).
\1384\ Sec. 511(a)(2)(A).
\1385\ Sec. 511(a)(2)(B).
---------------------------------------------------------------------------
Exclusions from unrelated business taxable income
Certain types of income are specifically excluded from
unrelated business taxable income, such as dividends, interest,
royalties, and certain rents,\1386\ unless derived from debt-
financed property or from certain 50-percent controlled
subsidiaries.\1387\ Certain types of activities are not
considered unrelated trade or business activities, such as
activities in which substantially all the work is performed by
volunteers, which involve the sale of donated goods, or which
are carried on for the convenience of members, students,
patients, officers, or employees of a charitable
organization.\1388\ Additional activities exempt from UBIT
include certain activities of trade shows and State
fairs,\1389\ conducting bingo games,\1390\ and the distribution
of low-cost items incidental to the solicitation of charitable
contributions.\1391\ Organizations liable for UBIT may also be
liable for alternative minimum tax determined after taking into
account adjustments and tax preference items.\1392\
---------------------------------------------------------------------------
\1386\ Sec. 512(b).
\1387\ Sec. 512(b)(13).
\1388\ Sec. 513(a).
\1389\ Sec. 513(d).
\1390\ Sec. 513(f).
\1391\ Sec. 513(h).
\1392\ See section 55 prior to amendment by the Act. For a
discussion of the repeal of the corporate alternative minimum tax for
taxable years beginning after December 31, 2017, see the description of
sections 12001-12003 of the Act (Alternative Minimum Tax).
---------------------------------------------------------------------------
Specific deduction against unrelated business taxable income
In computing unrelated business taxable income, an exempt
organization may take a specific deduction of $1,000. This
specific deduction may not be used to create a net operating
loss that will be carried back or forward to another
year.\1393\
---------------------------------------------------------------------------
\1393\ Sec. 512(b)(12). For a discussion of changes made to the net
operating loss rules after 2017, see the description of section 13302
of the Act (Modification of Net Operating Loss Deduction).
---------------------------------------------------------------------------
In the case of a diocese, province of a religious order, or
a convention or association of churches, there is also allowed
a specific deduction with respect to each parish, individual
church, district, or other local unit. The specific deduction
is equal to the lower of $1,000 or the gross income derived
from any unrelated trade or business regularly carried on by
the local unit.\1394\
---------------------------------------------------------------------------
\1394\ Ibid.
---------------------------------------------------------------------------
Explanation of Provision
Under the provision, unrelated business taxable income of a
tax-exempt organization is increased to the extent that a
deduction is not allowable by reason of section 274 for any
item with respect to qualified transportation fringe benefits
\1395\ or any parking facility used in connection with
qualified parking.\1396\ The determination of unrelated
business taxable income associated with providing qualified
transportation fringes, including parking facilities used in
connection with qualified parking, is intended to be consistent
with the determination of the deduction disallowance under
section 274.\1397\ The amendments to section 274, as enacted,
do not result in a deduction disallowance for items with
respect to on-premises athletic facilities,\1398\ and
therefore, such items are not included in unrelated business
taxable income.
---------------------------------------------------------------------------
\1395\ See sec. 132(f).
\1396\ See sec. 132(f)(5)(C).
\1397\ A technical correction may be needed to reflect this intent.
For a discussion on qualified transportation fringe items no longer
deductible by reason of section 274, including appropriate allocation
of depreciation and other costs, see description of section 13304 of
the Act (Limitation on Deduction by Employers of Expenses for Fringe
Benefits).
\1398\ Sec. 132(j)(4).
---------------------------------------------------------------------------
The provision does not apply to any item directly connected
with an unrelated trade or business that is regularly carried
on by the organization. The provision grants the Secretary
specific authority to issue regulations or other guidance
necessary or appropriate to carry out the provision, including
regulations or guidance providing for the appropriate
allocation of depreciation and other costs with respect to
facilities used for parking. The $1,000 specific deduction
available to organizations under section 512(b)(12) remains in
effect and may be used to offset unrelated business taxable
income resulting from this provision.
Effective Date
The provision is effective for amounts paid or incurred
after December 31, 2017.
PART IX--OTHER PROVISIONS
SUBPART A--CRAFT BEVERAGE MODERNIZATION AND TAX REFORM
A. Production Period for Beer, Wine, and Distilled Spirits (sec. 13801
of the Act and sec. 263A(f) of the Code)
Prior Law
In general
The uniform capitalization (``UNICAP'') rules require
certain direct and indirect costs allocable to real property or
tangible personal property produced by the taxpayer to be
included in either inventory or capitalized into the basis of
such property, as applicable.\1399\ For real or personal
property acquired by the taxpayer for resale, section 263A
generally requires certain direct and indirect costs allocable
to such property to be included in inventory.
---------------------------------------------------------------------------
\1399\ Sec. 263A.
---------------------------------------------------------------------------
In the case of interest expense, the uniform capitalization
rules apply only to interest paid or incurred during the
property's production period \1400\ and that is allocable to
property produced by the taxpayer or acquired for resale which
(1) is either real property or property with a class life of at
least 20 years, (2) has an estimated production period
exceeding two years, or (3) has an estimated production period
exceeding one year and a cost exceeding $1,000,000.\1401\ The
production period with respect to any property is the period
beginning on the date on which production of the property
begins,\1402\ and ending on the date on which the property is
ready to be placed in service or held for sale.\1403\ In the
case of property that is customarily aged (e.g., tobacco, wine,
and whiskey) before it is sold, the production period includes
the aging period.\1404\
---------------------------------------------------------------------------
\1400\ See Treas. Reg. sec. 1.263A-12.
\1401\ Sec. 263A(f).
\1402\ In the case of tangible personal property, the production
period begins on the first date the taxpayer's accumulated production
expenditures, including planning and design expenditures, are at least
five percent of the taxpayer's total estimated accumulated production
expenditures for the property unit. Treas. Reg. sec. 1.263A-12(c)(3).
Thus, the production period may begin before physical production
activity has commenced. See Treas. Reg. sec. 1.263A-12(c)(3). For
example, in the case of the beer, wine, and distilled spirits industry,
the production period may include time spent planning and designing
ingredients, production space, or production personnel.
\1403\ Sec. 263A(f)(4)(B), prior to amendment by the Act. The
production period for a unit of property produced for sale ends on the
date that the unit is ready to be held for sale and all production
activities reasonably expected to be undertaken by, or for, the
taxpayer or a related person are complete. Treas. Reg. sec. 1.263A-
12(d)(1).
\1404\ See Treas. Reg. sec. 1.263A-12(d)(1). See also Tech. Adv.
Mem. 9327007, Mar. 31, 1993 (holding that producers of wine must
include the time that wine ages in bottles as part of the production
period, which concludes when the wine vintage is officially released to
the distribution chain). For beer, the aging period occurs between the
fermentation period and bottling (or other types of packaging, such as
kegs), and can vary based on the type of yeast and the strength of the
beer. In the case of distilled spirits, aging is the period after
distillation and before bottling.
---------------------------------------------------------------------------
Exceptions from UNICAP
Section 263A provides a number of exceptions to the general
capitalization requirements. One such exception exists for
certain small taxpayers who acquire property for resale and
have $10 million or less of average annual gross receipts for
the preceding three-taxable year period; \1405\ such taxpayers
are not required to include additional section 263A costs in
inventory.
---------------------------------------------------------------------------
\1405\ Sec. 263A(b)(2)(B). Under prior law, no statutory exception
is available for small taxpayers who produce property subject to
section 263A. However, a de minimis rule under Treasury regulations
treats producers that use the simplified production method and incur
total indirect costs of $200,000 or less in a taxable year as having no
additional indirect costs beyond those normally capitalized for
financial accounting purposes. Treas. Reg. sec. 1.263A-2(b)(3)(iv).
However, section 13102 of the Act (Small Business Accounting Method
Reform and Simplification) expands the exception for small taxpayers
from the uniform capitalization rules. Under that provision, any
producer or reseller that meets the $25 million gross receipts test is
exempted from the application of section 263A.
---------------------------------------------------------------------------
Another exception exists for taxpayers who raise, harvest,
or grow trees.\1406\ Under this exception, section 263A does
not apply to trees raised, harvested, or grown by the taxpayer
(other than trees bearing fruit, nuts, or other crops, or
ornamental trees) and any real property underlying such trees.
Similarly, the UNICAP rules do not apply to any animal or plant
having a reproductive period of two years or less, which is
produced by a taxpayer in a farming business (unless the
taxpayer is required to use an accrual method of accounting
under section 447 or 448(a)(3)).\1407\
---------------------------------------------------------------------------
\1406\ Sec. 263A(c)(5).
\1407\ Sec. 263A(d). See also section 13102 of the Act (Small
Business Accounting Method Reform and Simplification) which expands the
universe of farming C corporations that may use the cash method to
include any farming C corporation that meets the $25 million gross
receipts test.
---------------------------------------------------------------------------
Freelance authors, photographers, and artists also are
exempt from section 263A for any qualified creative
expenses.\1408\ Qualified creative expenses are defined as
amounts paid or incurred by an individual in the trade or
business of being a writer, photographer, or artist. However,
such term does not include any expense related to printing,
photographic plates, motion picture files, video tapes, or
similar items.
---------------------------------------------------------------------------
\1408\ Sec. 263A(h).
---------------------------------------------------------------------------
Explanation of Provision
The provision temporarily excludes the aging periods for
beer,\1409\ wine,\1410\ and distilled spirits \1411\ from the
production period as determined for purposes of the UNICAP
interest capitalization rules. Thus, under the provision,
producers of beer, wine and distilled spirits (other than
spirits unfit for beverage purposes) are able to deduct
interest expenses (subject to any other applicable limitation)
attributable to a shorter production period that does not
include the aging period of the beer, wine, or distilled
spirits.\1412\
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\1409\ As defined in section 5052(a).
\1410\ As defined in section 5041(a).
\1411\ As defined in section 5002(a)(8), except such spirits that
are unfit for use for beverage purposes.
\1412\ The provision defines a period of time during which section
263A does not apply to interest costs incurred during the aging period.
Application of the provision is not a change in method of accounting
subject to section 481 as a taxpayer's method of accounting for
capitalizable interest costs is unchanged. However, if a taxpayer
capitalizes aging period interest costs paid or accrued after December
31, 2017, and before January 1, 2020, and wants to no longer capitalize
such costs, such a change is a change in method of accounting subject
to section 481.
---------------------------------------------------------------------------
The provision does not apply to interest costs paid or
accrued after December 31, 2019.
Effective Date
The provision is effective for interest costs paid or
accrued after December 31, 2017, and before January 1, 2020.
B. Reduced Rate of Excise Tax on Beer (sec. 13802 of the Act and sec.
5051(a) of the Code)
Prior Law
Federal excise taxes are imposed at different rates on
distilled spirits, wine, and beer and are imposed on these
products when produced or imported. Generally, these excise
taxes are administered, collected, and enforced by the Alcohol
and Tobacco Tax and Trade Bureau (``TTB''), except the taxes on
imported bottled distilled spirits, wine, and beer are
collected by the Customs and Border Protection Bureau of the
Department of Homeland Security (under delegation by the
Secretary of the Treasury).
Liability for the excise tax on beer arises when the
alcohol is produced or imported but is not payable until the
beer is removed from the brewery or customs custody for
consumption or sale. Generally, beer may be transferred between
commonly owned breweries without payment of tax; however, tax
liability follows these products. Imported bulk beer may be
released from customs custody without payment of tax and
transferred in bond to a brewery, which becomes liable for the
tax on such beer. Beer may be exported without payment of tax
and may be withdrawn from a brewery without payment of tax or
free of tax for certain authorized uses, including industrial
uses and non-beverage uses.\1413\
---------------------------------------------------------------------------
\1413\ Sec. 5053.
---------------------------------------------------------------------------
The rate of tax on beer is $18 per barrel (31
gallons).\1414\ Brewers producing fewer than two million
barrels of beer during a calendar year (``small brewers'') are
subject to a reduced tax rate of $7 per barrel on the first
60,000 barrels of beer domestically produced and removed each
year.\1415\ The credit reduces the effective per-gallon tax
rate from approximately 58 cents per gallon to approximately
22.6 cents per gallon for this beer.
---------------------------------------------------------------------------
\1414\ Sec. 5051.
\1415\ Sec. 5051(a)(2).
---------------------------------------------------------------------------
In the case of a controlled group, the two million barrel
limitation for small brewers is applied to the controlled
group, and the 60,000 barrels eligible for the reduced rate of
tax, are apportioned among the brewers who are component
members of such group. The term ``controlled group'' has the
meaning assigned to it by sec. 1563(a), except that the phrase
``more than 50 percent'' is substituted for the phrase ``at
least 80 percent'' in each place it appears in sec. 1563(a).
Individuals may produce limited quantities of beer for
personal or family use without payment of tax during each
calendar year. The limit is 200 gallons per calendar year for
households of two or more adults and 100 gallons per calendar
year for single-adult households.
Explanation of Provision
The provision temporarily lowers the rate of tax on beer to
$16 per barrel on the first six million barrels brewed by the
brewer or imported by the importer. In general, in the case of
a controlled group of brewers, the six million barrel
limitation is applied and apportioned at the level of the
controlled group. Beer brewed or imported in excess of the six
million barrel limit continues to be taxed at $18 per barrel.
In the case of small brewers, such brewers are taxed at a rate
of $3.50 per barrel on the first 60,000 barrels domestically
produced, and $16 per barrel on any further barrels produced.
The same rules applicable to controlled groups under prior law
apply with respect to this limitation.
For barrels of beer that have been brewed or produced
outside of the United States and imported into the United
States, the reduced tax rate may be assigned by the brewer to
any importer of such barrels pursuant to requirements set forth
by the Secretary of the Treasury in consultation with the
Secretary of Health and Human Services and the Secretary of the
Department of Homeland Security. These requirements are to
include: (1) a limitation to ensure that the number of barrels
of beer for which the reduced tax rate has been assigned by a
brewer to any importer does not exceed the number of barrels of
beer brewed or produced by such brewer during the calendar year
which were imported into the United States by such importer;
(2) procedures that allow a brewer and an importer to elect
whether to receive the reduced tax rate; (3) requirements that
the brewer provide any information as the Secretary of the
Treasury determines necessary and appropriate for purposes of
assignment of the reduced tax rate; and (4) procedures that
allow for revocation of eligibility of the brewer and the
importer for the reduced tax rate in the case of erroneous or
fraudulent information provided in (3) which the Secretary of
the Treasury deems to be material for qualifying for the
reduced tax rate.
Any importer making an election to receive the reduced tax
rate shall be deemed to be a member of the controlled group of
the brewer, within the meaning of section 1563(a), except that
the phrase ``more than 50 percent'' is substituted for the
phrase ``at least 80 percent'' in each place it appears in
section 1563(a).\1416\
---------------------------------------------------------------------------
\1416\ Members of the controlled group may include foreign
corporations.
---------------------------------------------------------------------------
Under rules issued by the Secretary of the Treasury, two or
more entities (whether or not under common control) that
produce beer marketed under a similar brand, license,
franchise, or other arrangement shall be treated as a single
taxpayer for purposes of the excise tax on beer.
The provision does not apply to beer removed after December
31, 2019.
Effective Date
The provision is effective for beer removed after December
31, 2017.
C. Transfer of Beer Between Bonded Facilities (sec. 13803 of the Act
and sec. 5414 of the Code)
Prior Law
Federal excise taxes are imposed at different rates on
distilled spirits, wine, and beer and are imposed on these
products when produced or imported. Generally, these excise
taxes are administered, collected, and enforced by the Alcohol
and Tobacco Tax and Trade Bureau (``TTB''), except the taxes on
imported bottled distilled spirits, wine, and beer are
collected by the Customs and Border Protection Bureau of the
Department of Homeland Security (under delegation by the
Secretary of the Treasury).
Liability for the excise tax on beer arises when the
alcohol is produced or imported but is not payable until the
beer is removed from the brewery or customs custody for
consumption or sale. Generally, beer may be transferred between
commonly owned breweries without payment of tax; however, tax
liability follows these products. Imported bulk beer may be
released from customs custody without payment of tax and
transferred in bond to a brewery, which becomes liable for the
tax on such beer. Beer may be exported without payment of tax
and may be withdrawn from a brewery without payment of tax or
free of tax for certain authorized uses, including industrial
uses and non-beverage uses.\1417\
---------------------------------------------------------------------------
\1417\ Sec. 5053.
---------------------------------------------------------------------------
The rate of tax on beer is $18 per barrel (31
gallons).\1418\ Brewers producing fewer than two million
barrels of beer during a calendar year (``small brewers'') are
subject to a reduced tax rate of $7 per barrel on the first
60,000 barrels of beer domestically produced and removed each
year.\1419\ The credit reduces the effective per-gallon tax
rate from approximately 58 cents per gallon to approximately
22.6 cents per gallon for this beer.
---------------------------------------------------------------------------
\1418\ Sec. 5051.
\1419\ Sec. 5051(a)(2).
---------------------------------------------------------------------------
Individuals may produce limited quantities of beer for
personal or family use without payment of tax during each
calendar year. The limit is 200 gallons per calendar year for
households of two or more adults and 100 gallons per calendar
year for single-adult households.
Transfer rules and removals without tax
Certain removals or transfers of beer are exempt from tax.
Beer may be transferred without payment of the tax between
bonded premises under certain conditions specified in the
regulations.\1420\ The tax liability accompanies the beer that
is transferred in bond. However, beer may only be transferred
without payment of tax between breweries if both breweries are
owned by the same brewer.
---------------------------------------------------------------------------
\1420\ Sec. 5414.
---------------------------------------------------------------------------
Explanation of Provision
The provision temporarily relaxes the shared ownership
requirement of section 5414. Thus, under the provision, a
brewer may transfer beer from one brewery to another without
payment of tax, provided that: (i) the breweries are owned by
the same person; (ii) one brewery owns a controlling interest
in the other; (iii) the same person or persons have a
controlling interest in both breweries; or (iv) the proprietors
of the transferring and receiving premises are independent of
each other, and the transferor has divested itself of all
interest in the beer so transferred, and the transferee has
accepted responsibility for payment of the tax.
For purposes of transferring the tax liability pursuant to
(iv) above, such relief from liability shall be effective from
the time of removal from the transferor's bonded premises, or
from the time of divestment, whichever is later.
The provision does not apply for calendar quarters
beginning after December 31, 2019.
Effective Date
The provision applies to any calendar quarters beginning
after December 31, 2017.
D. Reduced Rate of Excise Tax on Certain Wine (sec. 13804 of the Act
and sec. 5041(c) of the Code)
Prior Law
In general
Excise taxes are imposed on the wine, according to the
wine's alcohol content and carbonation levels. The following
table outlines the rates of tax on wine.
------------------------------------------------------------------------
Tax (and Code Section) Tax Rates
------------------------------------------------------------------------
Wines (sec. 5041):
``Still wines'' \1421\ not more than $1.07 per wine gallon \1422\
14 percent alcohol.
``Still wines'' more than 14 percent, $1.57 per wine gallon
but not more than 21 percent, alcohol.
``Still wines'' more than 21 percent, $3.15 per wine gallon
but not more than 24 percent, alcohol.
``Still wines'' more than 24 percent $13.50 per proof gallon
alcohol. (taxed as distilled
spirits)
Champagne and other sparkling wines... $3.40 per wine gallon
Artificially carbonated wines......... $3.30 per wine gallon
------------------------------------------------------------------------
Liability for the excise taxes on wine arises when the wine
is produced or imported but is not payable until the wine is
removed from the bonded wine cellar or winery, or from customs
control, for consumption or sale. Generally, bulk and bottled
wine may be transferred between bonded premises; however, the
tax liability on such wine becomes the responsibility of the
transferee. Bulk natural wine may be released from customs
custody without payment of tax and transferred in bond to a
winery. Wine may be exported without payment of tax and may be
withdrawn from a wine cellar or winery without payment of tax
or free of tax for certain authorized uses, including
industrial uses and non-beverage uses.\1423\
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\1421\ A ``still wine'' is a non-effervescent or minimally
effervescent wine containing no more than 0.392 grams of carbon dioxide
per hundred milliliters of wine. Champagne wine typically contains more
than twice that amount.
\1422\ A wine gallon is a U.S. liquid gallon.
\1423\ Sec. 5042.
---------------------------------------------------------------------------
Reduced rates and exemptions for certain wine producers
Domestic wine producers having aggregate annual production
not exceeding 250,000 gallons (``small domestic producers'')
receive a credit against the wine excise tax equal to 90 cents
per gallon (the amount of a wine tax increase enacted in 1990)
on the first 100,000 gallons of wine domestically produced and
removed during a calendar year.\1424\ The credit is reduced
(but not below zero) by one percent for each 1,000 gallons
produced in excess of 150,000 gallons; the credit may not be
applied to the tax liability on sparkling wines. In the case of
a controlled group, the 250,000 gallon limitation for wineries
is applied to the controlled group, and the 100,000 gallons
eligible for the credit, are apportioned among the wineries who
are component members of such group. The term ``controlled
group'' has the meaning assigned to it by section 1563(a),
except that the phrase ``more than 50 percent'' is substituted
for the phrase ``at least 80 percent'' in each place it appears
in section 1563(a).
---------------------------------------------------------------------------
\1424\ Sec. 5041(c).
---------------------------------------------------------------------------
Individuals may produce limited quantities of wine for
personal or family use without payment of tax during each
calendar year. The limit is 200 gallons per calendar year for
households of two or more adults and 100 gallons per calendar
year for single-adult households.
Explanation of Provision
The provision temporarily modifies the credit against the
wine excise tax for small domestic producers, by removing the
250,000 wine gallon domestic production limitation (and thus
making the credit available for all wine producers and
importers). Additionally, under the provision, the credit may
be applied to the tax liability on sparkling wine. With respect
to wine produced in, or imported into, the United States during
a calendar year, the credit amount is (1) $1.00 per wine gallon
for the first 30,000 wine gallons of wine, plus; (2) 90 cents
per wine gallon on the next 100,000 wine gallons of wine, plus;
(3) 53.5 cents per wine gallon on the next 620,000 wine gallons
of wine.\1425\ There is no phaseout of the credit.
---------------------------------------------------------------------------
\1425\ The credit rate for hard cider is tiered at the same level
of production or importation, but is equal to 6.2 cents, 5.6 cents and
3.3 cents, respectively.
---------------------------------------------------------------------------
In the case of any wine gallons of wine that have been
produced outside of the United States and imported into the
United States, the tax credit allowable may be assigned by the
person who produced such wine (the ``foreign producer'') to any
electing importer of such wine gallons pursuant to requirements
established by the Secretary of the Treasury, in consultation
with the Secretary of Health and Human Services and the
Secretary of the Department of Homeland Security. These
requirement are to include: (1) a limitation to ensure that the
number of wine gallons of wine for which the tax credit has
been assigned by a foreign producer to any importer does not
exceed the number of wine gallons of wine produced by such
foreign producer, during the calendar year, which were imported
into the United States by such importer; (2) procedures that
allow the election of a foreign producer to assign, and an
importer to receive, the tax credit; (3) requirements that the
foreign producer provide any information that the Secretary of
the Treasury determines to be necessary and appropriate for
purposes of assigning the tax credit; and (4) procedures that
allow for revocation of eligibility of the foreign producer and
the importer for the tax credit in the case of erroneous or
fraudulent information provided in (3) which the Secretary of
the Treasury deems to be material for qualifying for the
reduced tax rate.
Any importer making an election to receive the reduced tax
rate shall be deemed to be a member of the controlled group of
the winemaker, within the meaning of section 1563(a), except
that the phrase ``more than 50 percent'' is substitute for the
phrase ``at least 80 percent'' in each place it appears in
section 1563(a).\1426\
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\1426\ Members of the controlled group may include foreign
corporations.
---------------------------------------------------------------------------
The provision does not apply to wine removed after December
31, 2019.
Effective Date
The provision applies to wine removed after December 31,
2017.
E. Adjustment of Alcohol Content Level for Application of Excise Tax
Rates (sec. 13805 of the Act and sec. 5041(b) of the Code)
Prior Law
In general
Excise taxes are imposed on the wine, according to the
wine's alcohol content and carbonation levels. The following
table outlines the rates of tax on wine.
------------------------------------------------------------------------
Tax (and Code Section) Tax Rates
------------------------------------------------------------------------
Wines (sec. 5041).........................
``Still wines'' \1427\ not more than $1.07 per wine gallon \1428\
14 percent alcohol.
``Still wines'' more than 14 percent, $1.57 per wine gallon
but not more than 21 percent, alcohol.
``Still wines'' more than 21 percent, $3.15 per wine gallon
but not more than 24 percent, alcohol.
``Still wines'' more than 24 percent $13.50 per proof gallon
alcohol. (taxed as distilled
spirits)
Champagne and other sparkling wines... $3.40 per wine gallon
Artificially carbonated wines......... $3.30 per wine gallon
------------------------------------------------------------------------
Liability for the excise taxes on wine arises when the wine
is produced or imported but is not payable until the wine is
removed from the bonded wine cellar or winery, or from customs
control, for consumption or sale. Generally, bulk and bottled
wine may be transferred between bonded premises; however, the
tax liability on such wine becomes the responsibility of the
transferee. Bulk natural wine may be released from customs
custody without payment of tax and transferred in bond to a
winery. Wine may be exported without payment of tax and may be
withdrawn from a wine cellar or winery without payment of tax
or free of tax for certain authorized uses, including
industrial uses and non-beverage uses.\1429\
---------------------------------------------------------------------------
\1427\ A ``still wine'' is a non-effervescent or minimally
effervescent wine containing no more than 0.392 grams of carbon dioxide
per hundred milliliters of wine. Champagne wine typically contains more
than twice that amount.
\1428\ A wine gallon is a U.S. liquid gallon.
\1429\ Sec. 5042.
---------------------------------------------------------------------------
Reduced rates and exemptions for certain wine producers
Domestic wine producers having aggregate annual production
not exceeding 250,000 gallons (``small domestic producers'')
receive a credit against the wine excise tax equal to 90 cents
per gallon (the amount of a wine tax increase enacted in 1990)
on the first 100,000 gallons of wine domestically produced and
removed during a calendar year.\1430\ The credit is reduced
(but not below zero) by one percent for each 1,000 gallons
produced in excess of 150,000 gallons; the credit may not be
applied to the tax liability on sparkling wines. In the case of
a controlled group, the 250,000 gallon limitation for wineries
is applied to the controlled group, and the 100,000 gallons
eligible for the credit, are apportioned among the wineries who
are component members of such group. The term ``controlled
group'' has the meaning assigned to it by section 1563(a),
except that the phrase ``more than 50 percent'' is substituted
for the phrase ``at least 80 percent'' in each place it appears
in section 1563(a).
---------------------------------------------------------------------------
\1430\ Sec. 5041(c).
---------------------------------------------------------------------------
Individuals may produce limited quantities of wine for
personal or family use without payment of tax during each
calendar year. The limit is 200 gallons per calendar year for
households of two or more adults and 100 gallons per calendar
year for single-adult households.
Explanation of Provision
The provision temporarily modifies alcohol-by-volume levels
of the first two tiers of the excise tax on wine, by changing
14 percent to 16 percent. Thus, under the provision, a wine
producer or importer may produce or import ``still wine'' that
has an alcohol-by-volume level of up to 16 percent and remain
subject to the lowest rate of $1.07 per wine gallon.
The provision does not apply to wine removed after December
31, 2019.
Effective Date
The provision applies to wine removed after December 31,
2017.
F. Definition of Mead and Low Alcohol by Volume Wine (sec. 13806 of the
Act and sec. 5041 of the Code)
Prior Law
In general
Excise taxes are imposed on the wine, according to the
wine's alcohol content and carbonation levels. The following
table outlines the rates of tax on wine.
---------------------------------------------------------------------------
\1431\ A ``still wine'' is a non-effervescent or minimally
effervescent wine containing no more than 0.392 grams of carbon dioxide
per hundred milliliters of wine. Champagne wine typically contains more
than twice that amount.
\1432\ A wine gallon is a U.S. liquid gallon.
------------------------------------------------------------------------
Tax (and Code Section) Tax Rates
------------------------------------------------------------------------
Wines (sec. 5041).........................
``Still wines'' \1431\ not more than $1.07 per wine gallon \1432\
14 percent alcohol.
``Still wines'' more than 14 percent, $1.57 per wine gallon
but not more than 21 percent, alcohol.
``Still wines'' more than 21 percent, $3.15 per wine gallon
but not more than 24 percent, alcohol.
``Still wines'' more than 24 percent $13.50 per proof gallon
alcohol. (taxed as distilled
spirits)
Champagne and other sparkling wines... $3.40 per wine gallon
Artificially carbonated wines......... $3.30 per wine gallon
------------------------------------------------------------------------
Liability for the excise taxes on wine arises when the wine
is produced or imported but is not payable until the wine is
removed from the bonded wine cellar or winery, or from customs
control, for consumption or sale. Generally, bulk and bottled
wine may be transferred between bonded premises; however, the
tax liability on such wine becomes the responsibility of the
transferee. Bulk natural wine may be released from customs
custody without payment of tax and transferred in bond to a
winery. Wine may be exported without payment of tax and may be
withdrawn from a wine cellar or winery without payment of tax
or free of tax for certain authorized uses, including
industrial uses and non-beverage uses.\1433\
---------------------------------------------------------------------------
\1433\ Sec. 5042.
---------------------------------------------------------------------------
Reduced rates and exemptions for certain wine producers
Domestic wine producers having aggregate annual production
not exceeding 250,000 gallons (``small domestic producers'')
receive a credit against the wine excise tax equal to 90 cents
per gallon (the amount of a wine tax increase enacted in 1990)
on the first 100,000 gallons of wine domestically produced and
removed during a calendar year.\1434\ The credit is reduced
(but not below zero) by one percent for each 1,000 gallons
produced in excess of 150,000 gallons; the credit may not be
applied to the tax liability on sparkling wines. In the case of
a controlled group, the 250,000 gallon limitation for wineries
is applied to the controlled group, and the 100,000 gallons
eligible for the credit, are apportioned among the wineries who
are component members of such group. The term ``controlled
group'' has the meaning assigned to it by section 1563(a),
except that the phrase ``more than 50 percent'' is substituted
for the phrase ``at least 80 percent'' in each place it appears
in section 1563(a).
---------------------------------------------------------------------------
\1434\ Sec. 5041(c).
---------------------------------------------------------------------------
Individuals may produce limited quantities of wine for
personal or family use without payment of tax during each
calendar year. The limit is 200 gallons per calendar year for
households of two or more adults and 100 gallons per calendar
year for single-adult households.
Explanation of Provision
The provision temporarily designates mead and certain
sparkling, low alcohol-by-volume wines to be taxed at the
lowest rate applicable to ``still wine,'' of $1.07 per wine
gallon of wine. Mead is defined as a wine that contains not
more than 0.64 grams of carbon dioxide per hundred milliliters
of wine,\1435\ which is derived solely from honey and water,
contains no fruit product or fruit flavoring, and contains less
than 8.5 percent alcohol-by-volume. The sparkling wines
eligible to be taxed at the lowest rate are those wines that
contain not more than 0.64 grams of carbon dioxide per hundred
milliliters of wine,\1436\ which are derived primarily from
grapes or grape juice concentrate and water, which contain no
fruit flavoring other than grape, and which contain less than
8.5 percent alcohol by volume.
---------------------------------------------------------------------------
\1435\ The Secretary is authorized to prescribe tolerances to this
limitation as may be reasonably necessary in good commercial practice.
\1436\ The Secretary is authorized to prescribe tolerances to this
limitation as may be reasonably necessary in good commercial practice.
---------------------------------------------------------------------------
The provision does not apply to wine removed after December
31, 2019.
Effective Date
The provision applies to wine removed after December 31,
2017.
G. Reduced Rate of Excise Tax on Certain Distilled Spirits (sec. 13807
of the Act and sec. 5001 of the Code)
Prior Law
An excise tax is imposed on all distilled spirits produced
in, or imported into, the United States.\1437\ The tax
liability arises the moment the alcohol is produced or imported
but payment of the tax is not required until a subsequent
withdrawal or removal from the distillery, or, in the case of
an imported product, from customs custody or bond.\1438\
---------------------------------------------------------------------------
\1437\ Secs. 5001.
\1438\ Secs. 5006, 5043, and 5054.
---------------------------------------------------------------------------
Distilled spirits are taxed at a rate of $13.50 per proof
gallon.\1439\ Liability for the excise tax on distilled spirits
arises when the alcohol is produced but is not determined and
payable until bottled distilled spirits are removed from the
bonded premises of the distilled spirits plant where they are
produced, or customs custody. Generally, bulk distilled spirits
may be transferred in bond between bonded premises; however,
tax liability follows these products. Imported bulk distilled
spirits may be released from customs custody without payment of
tax and transferred in bond to a distillery. Distilled spirits
may be exported without payment of tax and may be withdrawn
from a distillery without payment of tax or free of tax for
certain authorized uses, including industrial uses and non-
beverage uses.
---------------------------------------------------------------------------
\1439\ A ``proof gallon'' is a U.S. liquid gallon of proof spirits,
or the alcoholic equivalent thereof. Generally a proof gallon is a U.S.
liquid gallon consisting of 50 percent alcohol. On lesser quantities,
the tax is paid proportionately. Credits are allowed for wine content
and flavors content of distilled spirits. Sec. 5010.
---------------------------------------------------------------------------
A portion of the revenues from the distilled spirits excise
tax imposed on rum imported or brought into \1440\ the United
States (less certain administrative costs) is transferred
(``covered over'') to Puerto Rico and the U.S. Virgin
Islands.\1441\ The amount covered over is $10.50 per proof
gallon ($13.25 per proof gallon during the period from July 1,
1999, through December 31, 2016).
---------------------------------------------------------------------------
\1440\ Because Puerto Rico is inside U.S. customs territory,
articles entering the United States from that commonwealth are
``brought into'' rather than ``imported into'' the U.S.
\1441\ Sec. 7652.
---------------------------------------------------------------------------
Eligible distilled spirits wholesale distributors and
distillers receive an income tax credit for the average cost of
carrying previously imposed excise tax on beverages stored in
their warehouses.\1442\
---------------------------------------------------------------------------
\1442\ Sec. 5011. Section 5011 is administered and enforced by the
IRS.
---------------------------------------------------------------------------
Explanation of Provision
The provision temporarily institutes a tax rate schedule
for distilled spirits based on annual quantity removed or
imported. The rate of tax is lowered to $2.70 per proof gallon
on the first 100,000 proof gallons of distilled spirits
produced, $13.34 for all proof gallons in excess of that amount
but below 22,130,000 proof gallons, and $13.50 for amounts
thereafter. The provision contains rules so as to prevent
members of the same controlled group from receiving the lower
rate on more than 100,000 proof gallons of distilled spirits.
Importers of distilled spirits are eligible for the lower
rates.
The provision does not apply to distilled spirits removed
after December 31, 2019.
Effective Date
The provision applies to distilled spirits removed after
December 31, 2017.
H. Bulk Distilled Spirits (sec. 13808 of the Act and sec. 5212 of the
Code)
Prior Law
An excise tax is imposed on all distilled spirits produced
in, or imported into, the United States.\1443\ The tax
liability arises the moment the alcohol is produced or imported
but payment of the tax is not required until a subsequent
withdrawal or removal from the distillery, or, in the case of
an imported product, from customs custody or bond.\1444\
---------------------------------------------------------------------------
\1443\ Secs. 5001.
\1444\ Secs. 5006, 5043, and 5054.
---------------------------------------------------------------------------
Distilled spirits are taxed at a rate of $13.50 per proof
gallon.\1445\ Liability for the excise tax on distilled spirits
arises when the alcohol is produced but is not determined and
payable until bottled distilled spirits are removed from the
bonded premises of the distilled spirits plant where they are
produced, or customs custody. Generally, bulk distilled spirits
may be transferred in bond between bonded premises; however,
tax liability follows these products. Imported bulk distilled
spirits may be released from customs custody without payment of
tax and transferred in bond to a distillery. Distilled spirits
may be exported without payment of tax and may be withdrawn
from a distillery without payment of tax or free of tax for
certain authorized uses, including industrial uses and non-
beverage uses.
---------------------------------------------------------------------------
\1445\ A ``proof gallon'' is a U.S. liquid gallon of proof spirits,
or the alcoholic equivalent thereof. Generally a proof gallon is a U.S.
liquid gallon consisting of 50 percent alcohol. On lesser quantities,
the tax is paid proportionately. Credits are allowed for wine content
and flavors content of distilled spirits. Sec. 5010.
---------------------------------------------------------------------------
A portion of the revenues from the distilled spirits excise
tax imposed on rum imported or brought into \1446\ the United
States (less certain administrative costs) is transferred
(``covered over'') to Puerto Rico and the U.S. Virgin
Islands.\1447\ The amount covered over is $10.50 per proof
gallon ($13.25 per proof gallon during the period from July 1,
1999, through December 31, 2016).
---------------------------------------------------------------------------
\1446\ Because Puerto Rico is inside U.S. customs territory,
articles entering the United States from that commonwealth are
``brought into'' rather than ``imported into'' the U.S.
\1447\ Sec. 7652.
---------------------------------------------------------------------------
Eligible distilled spirits wholesale distributors and
distillers receive an income tax credit for the average cost of
carrying previously imposed excise tax on beverages stored in
their warehouses.\1448\
---------------------------------------------------------------------------
\1448\ Sec. 5011. Section 5011 is administered and enforced by the
IRS.
---------------------------------------------------------------------------
Explanation of Provision
The provision temporarily allows distillers to transfer
spirits in bond in containers other than bulk containers
without payment of tax.
The provision does not apply to distilled spirits
transferred in bond after December 31, 2019.
Effective Date
The provision applies to distilled spirits transferred in
bond after December 31, 2017.
SUBPART B--MISCELLANEOUS PROVISIONS
A. Modification of Tax Treatment of Alaska Native Corporations and
Settlement Trusts (sec. 13821 of the Act and secs. 646 and 6039H and
new secs. 139G and 247 of the Code)
Prior Law
The Alaska Native Claims Settlement Act (``ANCSA'') \1449\
established Native Corporations \1450\ to hold property for
Alaska Natives. Alaska Natives are generally the only permitted
common shareholders of those corporations under section 7(h) of
ANCSA, unless a Native Corporation specifically allows other
shareholders under specified procedures.
---------------------------------------------------------------------------
\1449\ 43 U.S.C. 1601 et seq.
\1450\ Defined at 43 U.S.C. 1602(m). Sec. 646(h)(2).
---------------------------------------------------------------------------
ANCSA permits a Native Corporation to transfer money or
other property to an Alaska Native Settlement Trust
(``Settlement Trust'') \1451\ for the benefit of beneficiaries
who constitute all or a class of the shareholders of the Native
Corporation, to promote the health, education and welfare of
beneficiaries, and to preserve the heritage and culture of
Alaska Natives.\1452\
---------------------------------------------------------------------------
\1451\ Defined at 43 U.S.C. 1602(t). Sec. 646(h)(4).
\1452\ With certain exceptions, once an Alaska Native Corporation
has made a conveyance to a Settlement Trust, the assets conveyed shall
not be subject to attachment, distraint, or sale or execution of
judgment, except with respect to the lawful debts and obligations of
the Settlement Trust.
---------------------------------------------------------------------------
Native Corporations and Settlement Trusts, as well as their
shareholders and beneficiaries, are generally subject to tax
under the same rules and in the same manner as other taxpayers
that are corporations, trusts, shareholders, or beneficiaries.
Special rules allow an election to use a more favorable tax
regime for transfers of property by a Native Corporation to a
Settlement Trust and for income taxation of the Settlement
Trust.\1453\ There is also simplified reporting to
beneficiaries.\1454\
---------------------------------------------------------------------------
\1453\ Sec. 646.
\1454\ Sec. 6039H.
---------------------------------------------------------------------------
Under the special tax rules, a Settlement Trust may make an
irrevocable election to pay tax on taxable income at the lowest
rate specified for individuals (rather than the highest rate
that is generally applicable to trusts) and to pay tax on
capital gains at a rate consistent with being subject to such
lowest rate of tax.\1455\ As described further below,
beneficiaries may generally thereafter exclude from gross
income distributions from a trust that has made this
election.\1456\ Also, contributions from a Native Corporation
to an electing Settlement Trust \1457\ generally will not
result in the recognition of gross income by beneficiaries on
account of the contribution.\1458\ An electing Settlement Trust
remains subject to generally applicable requirements for
classification and taxation as a trust.
---------------------------------------------------------------------------
\1455\ Sec. 646(b) and (c).
\1456\ Sec. 646(e).
\1457\ Defined at sec. 646(h)(1).
\1458\ Sec. 646(d)(1).
---------------------------------------------------------------------------
A Settlement Trust distribution is excludable from the
gross income of beneficiaries to the extent of the taxable
income of the Settlement Trust for the taxable year and all
prior taxable years for which an election was in effect,
decreased by income tax paid by the Trust, plus tax-exempt
interest from State and local bonds for the same period.\1459\
Amounts distributed in excess of the amount excludable are
taxed to the beneficiaries as if distributed by the sponsoring
Native Corporation in the year of distribution by the Trust,
which means that the beneficiaries must include in gross income
as dividends the amount of the distribution, up to the current
and accumulated earnings and profits of the Native
Corporation.\1460\ Amounts distributed in excess of the current
and accumulated earnings and profits are not included in gross
income by the beneficiaries.
---------------------------------------------------------------------------
\1459\ Sec. 646(e)(1).
\1460\ Sec. 646(e)(3).
---------------------------------------------------------------------------
A special loss disallowance rule reduces (but not below
zero) any loss that would otherwise be recognized upon
disposition of stock of a sponsoring Native Corporation by a
proportion, determined on a per share basis, of all
contributions to all electing Settlement Trusts by the
sponsoring Native Corporation.\1461\ This rule prevents a
stockholder from being able to take advantage of a decrease in
value of a Native Corporation that is caused by a transfer of
assets from the Native Corporation to a Settlement Trust.
---------------------------------------------------------------------------
\1461\ Sec. 646(i).
---------------------------------------------------------------------------
The fiduciary of an electing Settlement Trust is obligated
to provide certain information relating to distributions from
the trust in lieu of reporting requirements under section
6034A.\1462\
---------------------------------------------------------------------------
\1462\ Sec. 6039H.
---------------------------------------------------------------------------
The election to pay tax at the lowest rate is not available
in certain disqualifying cases where transfer restrictions have
been modified to allow a transfer of either: (a) a beneficial
interest that would not be permitted by section 7(h) of ANCSA
if the interest were Settlement common stock,\1463\ or (b) any
stock in an Alaska Native Corporation that would not be
permitted by section 7(h) of ANCSA if it were Settlement common
stock and the Native Corporation thereafter makes a transfer to
the Trust.\1464\ Where an election is already in effect at the
time of such disqualifying transfer, the special rules
applicable to an electing trust cease to apply and rules
generally applicable to trusts apply. In addition, the
distributable net income of the trust is increased by
undistributed current and accumulated earnings and profits of
the trust, limited by the fair market value of trust assets at
the date the trust becomes so disposable. The effect is to
cause the trust to be taxed at regular trust rates on the
amount of recomputed distributable net income not distributed
to beneficiaries, and to cause the beneficiaries to be taxed on
the amount of any distributions received consistent with the
applicable tax rate bracket.
---------------------------------------------------------------------------
\1463\ Defined at 43 U.S.C. 1602(p). Sec. 646(h)(3).
\1464\ Sec. 646(f).
---------------------------------------------------------------------------
Explanation of Provision
The provision comprises three separate but related
sections.\1465\
---------------------------------------------------------------------------
\1465\ The Act does not amend section 646.
---------------------------------------------------------------------------
Assignments to Alaska Native Settlement Trusts
The first section allows a Native Corporation to assign
certain payments described in ANCSA to a Settlement Trust
without having to recognize gross income from those payments,
provided the assignment is in writing and the Native
Corporation has not received the payment prior to
assignment.\1466\ The Settlement Trust is required to include
the assigned payment in gross income when received with the
same character as if such payment was received by the Native
Corporation. The Native Corporation is not allowed a deduction
for the assigned payment.
---------------------------------------------------------------------------
\1466\ The amount and scope of any assignment must be described
with reasonable particularity and may either be in a percentage of one
or more such payments or in a fixed dollar amount. Further, such
assignment must specify a duration either in perpetuity or for a period
of time, and whether it is revocable.
---------------------------------------------------------------------------
Contributions to Alaska Native Settlement Trusts
The second section allows a Native Corporation to elect
annually to deduct contributions made to a Settlement
Trust.\1467\ If the contribution is in cash, the deduction is
in the amount of cash contributed. If the contribution is in
property other than cash, the deduction is the amount of the
Native Corporation's adjusted basis in the contributed property
(or the fair market value of such property, if less than the
Native Corporation's adjusted basis), and no gain or loss may
be recognized on the contribution. The Native Corporation's
deduction is limited to the amount of its taxable income \1468\
for that year, and any excess may be carried forward 15
succeeding years. The Native Corporation's earnings and profits
for the taxable year are reduced by the amount of any deduction
claimed for that year.
---------------------------------------------------------------------------
\1467\ A Native Corporation makes the election to deduct
contributions to a Settlement Trust for a specific taxable year by
including a statement with its original or amended income tax return.
See IRS News Release IR-2018-16, January 30, 2018. Any election may be
revoked on a timely filed amendment or supplement to the Native
Corporation's income tax return.
\1468\ As determined without regard to such deduction.
---------------------------------------------------------------------------
Generally, the Settlement Trust must include income equal
to the deduction by the Native Corporation. For contributions
of property other than cash, the Settlement Trust takes a basis
in the property equal to the adjusted basis of such property in
the hands of the Native Corporation immediately before the
contribution (or the fair market value of such property
immediately before such contribution, if less than the Native
Corporation's adjusted basis), and may elect to defer
recognition of the income associated with such property until
the Settlement Trust sells or exchanges the property, in whole
or in part.\1469\ In that case, any income that is deferred
(i.e., the amount of income that would have been included upon
contribution absent the election to defer) is treated as
ordinary income, while any gain in excess of the amount of
income that is deferred takes the same character as if the
election had not been made. The provision permits the amendment
of the terms of any Settlement Trust agreement within one year
of the enactment of the provision (i.e., within one year of
December 22, 2017) to allow this election, with certain
restrictions.
---------------------------------------------------------------------------
\1469\ To make such election, the Settlement Trust must identify
and describe with reasonable particularity the contributed property on
a statement attached to its original or amended income tax return for
the year in which the property was contributed. See IRS News Release
IR-2018-16, January 30, 2018.
---------------------------------------------------------------------------
If property subject to this election is disposed of within
the first taxable year subsequent to the taxable year in which
the property was contributed to the Settlement Trust, the
election is voided with respect to such property, and the
Settlement Trust is required to pay any tax applicable to the
disposition of the property, including any applicable interest,
and an additional amount equal to 10 percent of the amount of
the tax with interest. The provision provides for a four-year
assessment period in which to assess the tax, interest, and
penalty amounts.
Information reporting
The third section of the provision requires any Native
Corporation which has made an election to deduct contributions
to a Settlement Trust as described above to furnish a statement
to the Settlement Trust not later than January 31 of the
calendar year subsequent to the calendar year in which the
contribution was made. The statement must include: (1) the
total amount of contributions to which the election applies;
(2) for each contribution, whether the contribution was in
cash; (3) for each non-cash contribution, the date that the
contributed property was acquired by the Native Corporation and
the adjusted basis and fair market value of such property on
the contribution date; (4) the date on which each contribution
was made to the Settlement Trust; and (5) such information as
the Secretary determines is necessary or appropriate for the
identification of each contribution and the accurate inclusion
of income relating to such contributions by the Settlement
Trust.
Effective Date
The provision relating to the exclusion for ANCSA payments
assigned to Settlement Trusts is effective to taxable years
beginning after December 31, 2016.
The provision relating to the deduction of contributions to
Settlement Trusts is effective for taxable years for which the
Native Corporation's refund or credit statute of limitations
period has not expired, and the provision provides a limited
waiver of the refund or credit statute of limitations period in
the event that the limitation period expires before the end of
the one-year period beginning on the date of enactment (i.e.,
the one-year period beginning on December 22, 2017). The waiver
period ends at the termination of that one-year period.
The provision relating to the reporting requirement applies
to taxable years beginning after December 31, 2016.
B. Amounts Paid for Aircraft Management Services (sec. 13822 of the Act
and sec. 4621(e) of the Code)
Prior Law
Excise tax on taxable transportation by air
For domestic passenger transportation, section 4261 imposes
an excise tax on amounts paid for taxable transportation. In
general, for domestic flights, the tax consists of two parts: a
7.5 percent ad valorem tax applied to the amount paid and a
flat dollar amount for each flight segment (consisting of one
takeoff and one landing). ``Taxable transportation'' generally
means transportation by air which begins and ends in the United
States. The tax is paid by the person making the payment
subject to tax and the tax is collected by the person receiving
the payment. For commercial freight aviation, the ad valorem
tax is 6.25 percent of the amount paid for transportation
In determining whether a flight constitutes taxable
transportation and whether the amounts paid for such
transportation are subject to tax, the Internal Revenue Service
(``IRS'') has looked at who has ``possession, command, and
control'' of the aircraft based on the relevant facts and
circumstances.\1470\
---------------------------------------------------------------------------
\1470\ See, e.g., Rev. Rul. 60-311, 1960-2 C.B. 341, which held
that, since the company in question retains the elements of possession,
command, and control of the aircraft and performs all services in
connection with the operation of the aircraft, the company is, in fact,
furnishing taxable transportation to the lessee; and the tax on the
transportation of persons applies to the portion of the total payment
which is allocable to the transportation of persons, provided such
allocation is made on a fair and reasonable basis. If no allocation is
made, the tax applies to the total payment for the lease of the
aircraft.
---------------------------------------------------------------------------
Applicability to aircraft management services
Generally, an aircraft management services company
(``management company'') has as its business purpose the
management of aircraft owned by other corporations or
individuals (``aircraft owners'''). In this function,
management companies provide aircraft owners, among other
things, with administrative and support services (such as
scheduling, flight planning, and weather forecasting), aircraft
maintenance services, the provision of pilots and crew, and
compliance with regulatory standards. Although the arrangement
between management companies and aircraft owners may vary,
aircraft owners generally pay management companies a monthly
fee to cover the fixed expenses of maintaining the aircraft
(such as insurance, maintenance, and recordkeeping) and a
variable fee to cover the cost of using the aircraft (such as
the provision of pilots, crew, and fuel).
In March 2012, the IRS issued a Chief Counsel Advice
determining that a management company provided all of the
essential elements necessary for providing transportation by
air and the owner relinquished possession, command and control
to the management company.\1471\ Thus, the management company
was determined to be providing taxable transportation to the
owner and was required to collect the appropriate federal
excise tax from the aircraft owner and remit it to the IRS. The
Chief Counsel Advice resulted in increased audit activity by
the IRS on aircraft management companies.
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\1471\ Chief Coun. Adv. 201210026, March, 2012.
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In May 2013, the IRS suspended assessment of the federal
excise tax with respect to aircraft management services while
it developed guidance on the tax treatment of aircraft
management issues. In a 2015 opinion,\1472\ an Ohio district
court held that the existing revenue rulings (in effect for the
tax period April 1, 2005, through June 30, 2009, the period
that was the subject of the litigation) regarding the
possession, command and control test, failed to provide precise
and not speculative notice of a collection obligation as it
related to whole-aircraft management contracts.\1473\ As a
result, the court ruled as a matter of law that because precise
and not speculative notice was not received, the aircraft
management company plaintiff did not have a collection
obligation with respect to the Federal excise tax on payments
received for whole-aircraft management services.
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\1472\ Netjets Large Aircraft Inc. v. United States, 116 A.F.T.R.
2d. 2015-6776 (S.D. Ohio, 2015).
\1473\ The district court held that such notice is required to
persons having a deputy tax collection obligation under the rationale
of the Supreme Court's holding in Central Illinois Public Service
Company v. United States, 435 U.S. 21 (1978).
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In 2017, the IRS decided not to pursue examination of the
issue of whether amounts paid to aircraft companies by the
owners or lessors of the aircraft are taxable until further
guidance is made available. According to the IRS, for any exam
in suspense the aircraft management fee issue was conceded and
the taxpayers were notified accordingly.\1474\ The IRS has not
issued further guidance on this issue.
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\1474\ See also, Kerry Lynch, IRS To Shelve Pending Audits on
Aircraft Management Fees, AINonline (July 17, 2017) http://
www.ainonline.com/aviation-news/business-aviation/2017-07-17/irs-
shelve-pending-audits-aircraft-management-fees.
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Explanation of Provision
The provision exempts certain payments related to the
management of private aircraft from the excise taxes imposed on
taxable transportation by air. Exempt payments are those
amounts paid by an aircraft owner for management services
related to maintenance and support of the owner's aircraft or
flights on the owner's aircraft. Applicable services include
support activities related to the aircraft itself, such as its
storage, maintenance, and fueling, and those related to its
operation, such as the hiring and training of pilots and crew,
as well as administrative services such as scheduling, flight
planning, weather forecasting, obtaining insurance, and
establishing and complying with safety standards. Aircraft
management services also include such other services as are
necessary to support flights operated by an aircraft owner.
Payments for flight services are exempt only to the extent
that they are attributable to flights on an aircraft owner's
own aircraft.\1475\ Thus, if an aircraft owner makes a payment
to a management company for the provision of a pilot and the
pilot provides his services on the aircraft owner's aircraft,
such payment is not subject to Federal excise tax. However, if
the pilot provides his services to the aircraft owner on an
aircraft other than the aircraft owner's (for instance, on an
aircraft that is part of a fleet of aircraft available for
third-party charter services), then such payment is subject to
Federal excise tax.
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\1475\ Examples of arrangements that cannot qualify a person as an
``aircraft owner'' include ownership of stock in a commercial airline
and participation in a fractional ownership aircraft program. Ownership
of stock in a commercial airline cannot qualify an individual as an
``aircraft owner'' of a commercial airline's aircraft, and amounts paid
for transportation on such flights remain subject to the tax under
section 4261. Similarly, participation in a fractional ownership
aircraft program does not constitute ``aircraft ownership'' for
purposes of this standard. Amounts paid to a fractional ownership
aircraft program for transportation under such a program are exempt
from the ticket tax under section 4261(j) if the aircraft is operating
under subpart K of part 91 of title 14 of the Code of Federal
Regulations (``subpart K''), and flights under such program are subject
to both the fuel tax levied on non-commercial aviation an additional
fuel surtax under section 4043 of the Code. A business arrangement
seeking to circumvent that surtax by operating outside of subpart K,
allowing an aircraft owner the right to use any of a fleet of aircraft,
be it through an aircraft interchange agreement, through holding
nominal shares in a fleet of aircraft, or any other arrangement that
does not reflect true tax ownership of the aircraft being flown upon,
is not considered ownership for purposes of the provision.
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The provision provides a pro rata allocation rule in the
event that a monthly payment made to a management company is
allocated in part to exempt services and flights on the
aircraft owner's aircraft, and in part to flights on aircraft
other than the aircraft owner's. In such a circumstance,
Federal excise tax must be collected on that portion of the
payment attributable to flights on aircraft not owned by the
aircraft owner.
Under the provision, a lessee of an aircraft is considered
an aircraft owner provided that the lease is not a
``disqualified lease.'' A disqualified lease is any lease of an
aircraft from a management company (or a related party) for a
term of 31 days or less.
Effective Date
The provision is effective for amounts paid after the date
of enactment.
C. Opportunity Zones (sec. 13823 of the Act and new secs. 1400Z-1 and
1400Z-2 of the Code)
Prior Law
Congress has occasionally provided incentives aimed at
encouraging economic growth and investment in distressed
communities by providing Federal tax benefits to businesses
located within designated boundaries.\1476\
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\1476\ Such designated areas were referred to as empowerment zones,
the District of Columbia Enterprise (``DC'') Zone, and the Gulf
Opportunity (``GO'') Zone, and each of these designations and attendant
tax incentives have expired. The designations and tax incentives for
the DC Zone and the GO Zone generally expired after December 31, 2011.
See secs. 1400(f), 1400N(h), 1400N(c)(5), 1400N(a)(2)(D),
1400N(a)(7)(C), and 1400N(d). The empowerment zones program and
attendant tax incentives were extended in the Bipartisan Budget Act of
2018 through December 31, 2017. Secs. 1391(d)(1). Pub. L. No. 115-123,
sec. 40311. Additional areas that were designated as renewal
communities under section 1400E received tax benefits that expired as
of December 31, 2009, except that a zero-percent capital gains rate
applies with respect to gain from the sale through December 31, 2014,
of a qualified community asset acquired after December 31, 2001, and
before January 1, 2010, and held for more than five years. For more
information on these programs and attendant tax incentives, see Joint
Committee on Taxation, Incentives for Distressed Communities:
Empowerment Zones and Renewal Communities (JCX-38-09), October 5, 2009.
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One of these incentives is a Federal income tax credit, the
new markets tax credit, which totals 39 percent of a taxpayer
investment in a qualified community development entity
(``CDE'').\1477\ In general, the credit is allowed to a
taxpayer who makes a qualified equity investment in a CDE which
further invests in a qualified active low-income community
business. CDEs are required to make investments in low-income
communities (generally communities with poverty rates that
equal or exceed 20 percent or whose median family income is
less than 80 percent of the statewide median income). The
credit is allowed over seven years, five percent in each of the
first three years and six percent in each of the next four
years. The credit is recaptured if at any time during the
seven-year period that begins on the date of the original issue
of the investment the entity (1) ceases to be a qualified CDE,
(2) the proceeds of the investment cease to be used as
required, or (3) the equity investment is redeemed. The
Department of Treasury's Community Development Financial
Institutions Fund (``CDFI'') allocates the new markets tax
credits.
---------------------------------------------------------------------------
\1477\ Sec. 45D.
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The maximum annual amount of qualified equity investments
is $3.5 billion for calendar years 2010 through 2019. Any
amount of unused allocation may be carried forward for five
calendar years. The new markets tax credit expires on December
31, 2019. No amount of unused allocation limitation may be
carried to any calendar year after 2024.
Explanation of Provision
In general
The provision allows taxpayers to make an election when
investing in a qualified opportunity fund. The election results
in the following three tax benefits: (1) the temporary deferral
of inclusion in gross income of capital gains,\1478\ (2) the
partial exclusion of such capital gains from gross income to
the extent invested in the qualified opportunity fund for a
certain length of time, and (3) the permanent exclusion of
post-acquisition capital gains from the sale or exchange of an
interest in a qualified opportunity fund held for at least 10
years.
---------------------------------------------------------------------------
\1478\ A technical correction may be needed to reflect this intent.
---------------------------------------------------------------------------
The provision allows for the designation of certain low-
income community population census tracts as qualified
opportunity zones.\1479\ In addition, a limited number of other
census tracts that are not low-income communities can be
designated if they are contiguous to a designated low-income
community and the median family income of such tracts does not
exceed 125 percent of the median family income of the
contiguous low-income community. The designation of a
population census tract as a qualified opportunity zone remains
in effect for the period beginning on the date of the
designation and ending at the close of the tenth calendar year
beginning on or after the date of designation.
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\1479\ See sec. 45D(e) for the definition of low-income community.
---------------------------------------------------------------------------
The chief executive officer of the State, possession, or
the District of Colombia (i.e., Governor or mayor in the case
of the District of Columbia) may submit nominations for a
limited number of opportunity zones to the Secretary for
certification and designation. If the number of low-income
communities in a State is less than 100, the Governor may
designate up to 25 tracts, otherwise the Governor may designate
tracts not exceeding 25 percent of the number of low-income
communities in the State.\1480\
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\1480\ In subsequently enacted legislation, Congress passed a
special rule for Puerto Rico such that each population census tract in
Puerto Rico that is a low-income community is deemed certified and
designated as a qualified opportunity zone, effective on the date of
enactment of Pub. L. No. 115-97 (December 22, 2017). Sec. 41115 of the
Bipartisan Budget Act of 2018, Pub. L. No. 115-123, February 9, 2018.
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Qualified opportunity funds
A qualified opportunity fund is an investment vehicle
organized as a corporation or a partnership for the purpose of
investing in qualified opportunity zone property (other than
another qualified opportunity fund) that holds at least 90
percent of its assets in qualified opportunity zone property.
The provision intends that the certification process for a
qualified opportunity fund will be carried out in a manner
similar to the process for allocating the new markets tax
credit. The Secretary is granted the authority to administer
this process.
If a qualified opportunity fund fails to meet the 90
percent requirement, unless the fund establishes reasonable
cause, the fund is required to pay a monthly penalty of the
excess of the amount equal to 90 percent of its aggregate
assets, over the aggregate amount of qualified opportunity zone
property held by the fund multiplied by the underpayment rate
in the Code.\1481\ If the fund is a partnership, the penalty is
taken into account proportionately as part of each partner's
distributive share.
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\1481\ Sec. 6621.
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Qualified opportunity zone property
Qualified opportunity zone property means: (1) qualified
opportunity zone stock, (2) qualified opportunity zone
partnership interest, and (3) qualified opportunity zone
business property.
Qualified opportunity zone stock consists of stock in a
domestic corporation that is a qualified opportunity zone
business. There are three requirements that must be met for
property to be considered qualified opportunity zone
stock.\1482\ First, the stock must be acquired at original
issuance (directly or indirectly through an underwriter) solely
for cash after December 31, 2017. Second, the corporation must
have been a qualified opportunity zone business when the stock
was issued (or, for a new corporation, was being organized to
be a qualified opportunity zone business). Third, the
corporation must qualify as a qualified opportunity zone
business during substantially all of the qualified opportunity
fund's holding period for the stock.
---------------------------------------------------------------------------
\1482\ Sec. 1400Z-2(d)(2)(B).
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Qualified opportunity zone partnership interest consists of
capital or profits interests in a domestic partnership that is
a qualified opportunity zone business. There are three
requirements that must be met for property to be considered a
qualified opportunity zone partnership interest.\1483\ First,
the interest must be acquired from the partnership solely for
cash after December 31, 2017. Second, the partnership must have
been a qualified opportunity zone business when the interest
was acquired (or, for a new partnership, was being organized to
be a qualified opportunity zone business). Third, the
partnership must qualify as a qualified opportunity zone
business during substantially all of the qualified opportunity
fund's holding period for the interest.
---------------------------------------------------------------------------
\1483\ Sec. 1400Z-2(d)(2)(C).
---------------------------------------------------------------------------
Qualified opportunity zone business property consists of
tangible property used in the trade or business of a qualified
opportunity fund or qualified opportunity zone business. There
are three main requirements that must be met for property to be
considered qualified opportunity zone business property.\1484\
First, the property must be acquired by purchase \1485\ after
December 31, 2017. Second, the original use of the property in
the qualified opportunity zone must begin with the qualified
opportunity fund or qualified opportunity zone business, or the
qualified opportunity fund or qualified opportunity zone
business must substantially improve the property. Only new or
substantially improved property qualifies as opportunity zone
business property.\1486\ Third, substantially all of the
property must be in a qualified opportunity zone during
substantially all of qualified opportunity fund or qualified
opportunity zone business's holding period for the property.
Property is treated as substantially improved only if capital
expenditures on the property in the 30 months after acquisition
exceeds the property's adjusted basis on the date of
acquisition.
---------------------------------------------------------------------------
\1484\ Sec. 1400Z-2(d)(2)(D).
\1485\ Certain related party purchases are excluded. See secs.
1400Z-2(d)(2)(D)(i)(I), 1400Z-2(d)(2)(D)(iii), and 1400Z-2(e)(2).
\1486\ A technical correction may be necessary to reflect this
intent.
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A qualified opportunity zone business is any trade or
business in which substantially all of the underlying value of
the tangible property owned or leased by the business is
qualified opportunity zone business property.
In addition, (1) at least 50 percent of the total gross
income of the trade or business must be derived from the active
conduct of business in the qualified opportunity zone, (2) a
substantial portion of the business's intangible property must
be used in the active conduct of business in the qualified
opportunity zone, and (3) less than 5 percent of the average of
the aggregate adjusted bases of the property of the business is
attributable to nonqualified financial property.\1487\
Nonqualified financial property means debt, stock, partnership
interests, annuities, and derivative financial instruments
(including options, futures, forward contracts, and notional
principal contracts), other than (1) reasonable amounts of
working capital held in cash, cash equivalents, or debt
instruments with a term of no more than 18 months, and (2)
accounts or notes receivable acquired in the ordinary course of
a trade or business for services rendered or from the sale of
inventory property.\1488\ Seventh, the business cannot be a
golf course, country club, massage parlor, hot tub or suntan
facility, racetrack or other facility used for gambling, or
store whose principal business is the sale of alcoholic
beverages for consumption off premises.\1489\
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\1487\ Sec. 1400Z-2(d)(3)(A)(ii).
\1488\ Secs. 1400Z-2(d)(3)(A)(ii), 1397C(b)(8), and 1397C(e).
\1489\ Secs. 1400Z-2(d)(3)(A)(iii) and 144(c)(6)(B).
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Tangible property that ceases to be a qualified opportunity
zone business property continues to be treated as a qualified
opportunity zone business property for the lesser of five years
after the date on which such tangible property ceases to be so
qualified, or the date on which such tangible property is no
longer held by the qualified opportunity zone business.\1490\
---------------------------------------------------------------------------
\1490\ Sec. 1400Z-2(d)(3)(B).
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Tax treatment of a deferred-gain investment
A taxpayer may elect to temporarily defer and partially
exclude capital gains from gross income to the extent that the
taxpayer invests the amount of those gains in a qualified
opportunity fund. The maximum amount of the deferred gain is
equal to the amount invested in a qualified opportunity fund by
the taxpayer during the 180-day period beginning on the date of
the asset sale that produced the gain to be deferred. Capital
gains in excess of the deferred amount must be recognized and
included in gross income.
In the case of any investment in a qualified opportunity
fund, only a portion of which consists of the investment of
gain with respect to which an election is made, such investment
is treated as two separate investments, consisting of one
investment that includes only amounts to which the election
applies (herein ``deferred-gain investment''), and a separate
investment consisting of other amounts. The temporary deferral
and permanent exclusion provisions do not apply to the separate
investment. For example, if a taxpayer sells stock at a gain
and invests the entire sales proceeds (capital and return of
basis) in a qualified opportunity zone fund, an election may be
made only with respect to the capital gain amount. No election
may be made with respect to amounts attributable to a return of
basis, and no special tax benefits apply to such amounts.
The basis of a deferred-gain investment in a qualified
opportunity zone fund immediately after its acquisition is
zero. If the deferred-gain investment in the qualified
opportunity zone fund is held by the taxpayer for at least five
years, the basis in the deferred-gain investment is increased
by 10 percent of the original deferred gain. If the opportunity
zone asset or investment is held by the taxpayer for at least
seven years, the basis in the deferred gain investment is
increased by an additional five percent of the original
deferred gain. Some or all of the deferred gain is recognized
on the earlier of the date on which the qualified opportunity
zone investment is disposed of or December 31, 2026. The amount
of gain recognized is the excess of the lesser of the amount
deferred and the current fair market value of the investment
(taking into account any increases at the end of five or seven
years). The taxpayer's basis in the investment is increased by
the amount of gain recognized. No election under the provision
may be made after December 31, 2026.
Exclusion of capital gains from the sale or exchange of an investment
in a qualified opportunity fund
The provision excludes from gross income the post-
acquisition capital gains on deferred-gain investments in
opportunity zone funds that are held for at least 10 years.
Specifically, in the case of the sale or exchange of an
investment in a qualified opportunity zone fund held for more
than 10 years, a further election is allowed by the taxpayer to
modify the basis of such deferred-gain investment in the hands
of the taxpayer to be the fair market value of the deferred-
gain investment at the date of such sale or exchange.
In the case of a fund organized as a pass-through entity,
investors recognize gains and losses associated with both
deferred-gain and non-deferred gain investments in the fund,
under the rules generally applicable to pass-through entities.
Thus, for example, investor-partners in a fund organized as a
partnership would recognize income and increase their basis
with respect to their distributive share of the fund's taxable
income.
The Treasury Department has proposed guidance addressing
this provision.\1491\
---------------------------------------------------------------------------
\1491\ Notice 2018-48, 2018-28 I.R.B. 9, (July 9, 2018), and Prop.
Treas. Reg. sec. 1.1400Z-2.
---------------------------------------------------------------------------
Example
Assume a taxpayer sells stock for a gain of $1,000 on
January 1, 2019, and invests $1,000 in the stock of a qualified
opportunity fund. Assume also that the taxpayer holds the
investment for 10 years and then sells the investment for
$1,500.
The taxpayer's initial basis in the deferred-gain
investment is zero. After five years, the basis is increased to
$100. After seven years, the basis is increased to $150. At the
end of 2026, assume that the fair market value of the deferred-
gain investment is at least $1,000, and thus the taxpayer has
to recognize $850 of the deferred capital gain. So at that
point the basis in the deferred-gain investment is $1,000 ($150
+ $850). If the taxpayer holds the deferred-gain investment for
10 years and makes the election to increase the basis, the $500
post-acquisition capital gain on the sale is excluded.
Effective Date
The provision is effective on the date of enactment (i.e.,
on December 22, 2017).
SUBTITLE D--INTERNATIONAL TAX PROVISIONS
PRIOR LAW
The following discussion provides an overview of general
principles of taxation of cross-border activity as well as a
detailed explanation of provisions in prior law that are
relevant to the provisions in the Act.
A. General Overview of International Principles of Taxation
International law generally recognizes the right of each
sovereign nation to prescribe rules to regulate conduct and
persons (whether natural or juridical) with a sufficient nexus
to the sovereign nation. The nexus may be based on nationality,
i.e., a nexus based on a connection between the relevant person
and the sovereign nation, or may be territorial, i.e., a nexus
based on a connection between the relevant conduct and the
sovereign nation.\1492\ Nonetheless, most legal systems respect
limits on the extent to which their laws may be given
extraterritorial effect. The broad acceptance of such norms
extends to authority to regulate cross-border trade and
economic dealings, including taxation.
---------------------------------------------------------------------------
\1492\ See American Law Institute, Restatement (Third) of Foreign
Relations Law of the United States, secs. 402 and 403 (1987).
---------------------------------------------------------------------------
The exercise of sovereign jurisdiction to tax is usually
based on either the nationality of the person taxed or the
jurisdiction in which the taxed conduct occurs. These concepts
have been refined and adapted to form the principles for
determining whether sufficient nexus with a jurisdiction exists
to conclude that the jurisdiction may enforce its right to tax.
The elements of nexus and the nomenclature of the principles
may differ based on whether the tax is a direct tax or an
indirect tax. A direct tax is imposed directly on a person
(known as a capitation tax), property, or income from property,
the burden of which the taxpayer bears and generally cannot
shift to another. In contrast, indirect taxes are taxes on
consumption or the production of goods or services, such as
sales or use taxes, value-added taxes, or customs duties.\1493\
Taxpayers may be able to shift the burden of indirect taxes to
others (e.g., by raising prices).
---------------------------------------------------------------------------
\1493\ Maria S. Cox, Fritz Neumark, et al., ``Taxation,''
Encyclopedia Britannica, https://www.britannica.com/topic/taxation/
Classes-of-taxes. Whether a tax is considered a direct tax or indirect
tax has varied over time, and no single definition is used. For a
review of the significance of these terms in Federal tax history, see
Alan O. Dixler, ``Direct Taxes Under the Constitution: A Review of the
Precedents,'' Tax History Project, Tax Analysts, available at http://
www.taxhistory.org/thp/readings.nsf/ArtWeb/
2B34C7FBDA41D9DA8525730800067017?OpenDocument.
---------------------------------------------------------------------------
Although governments since ancient times have imposed
direct taxes on property and indirect taxes and duties on
specific transactions, the history of direct taxes in the form
of income taxes is relatively recent.\1494\ When determining
how to allocate the right to tax a particular item of income,
most jurisdictions consider principles based on either the
source of the income or the residence of the person earning the
income. By contrast, when determining how to allocate the right
to collect indirect taxes, most jurisdictions consider either
the origin or the destination of the item being taxed. The
balance of this Part A describes the source, residence, origin,
and destination principles in more detail and how jurisdictions
resolve overlapping claims of jurisdiction.
---------------------------------------------------------------------------
\1494\ The earliest western income tax system is traceable to the
British Tax Act of 1798, enacted in 1799 to raise funds needed to
prosecute the Napoleonic Wars, and rescinded in 1816. See A.M.
Bardopoulos, eCommerce and the Effects of Technology on Taxation, Law,
Governance and Technology Series 22, DOI 10.1007/978-3-319-15449-7--2,
(Springer 2015), at Section 2.2. ``History of Tax,'' pp. 23-24; see
also http://www.parliament.uk/about/living-heritage/
transformingsociety/private-lives/taxation/overview/incometax/.
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1. Source and residence principles
Direct taxes based on a person's citizenship, nationality,
or residence are residence-based taxes. Such taxes may reach
the worldwide activities of such person, and, for that reason,
are the broadest assertion of taxing authority. For
individuals, the test for residence may depend on citizenship,
nationality, a physical presence test, or some combination. For
all other persons, determining residency may be as simple as
determining the person's place of organization, or may require
more complex consideration of the person's management and
control, or even level of activities in a jurisdiction.
Direct taxes based on where activities occur, or where
property is located, are source-based taxes. If a person
conducts activities or owns property in a jurisdiction, taxing
such activities or property may require allocation and
apportionment of expenses attributable to the activity or
property to ensure that only the portion of profits that have
the required nexus with the jurisdiction are subject to tax.
Most jurisdictions, including the United States, have rules for
determining the source of items of income and expense in a
broad range of categories, such as compensation for services,
dividends, interest, royalties, and gains.
2. Origin and destination principles
Indirect taxes based on the place where goods are produced
or services are performed--irrespective of the residence of the
owners of the means of production, where the goods go after
being produced, or the residence of the recipients of the
services--are origin-based taxes. Indirect taxes based on where
goods or services are used or consumed are destination-based
taxes. The most common form of indirect tax is the destination-
based value-added tax (``VAT''). Over 160 countries have
adopted a VAT,\1495\ which is generally a tax imposed and
collected on the value added at every stage in the production
and distribution of a good or service. Although there are
several ways to compute the taxable base for a VAT, the amount
of value added can generally be thought of as the difference
between the value of sales (outputs) and purchases (inputs) of
a business.\1496\ The United States does not have a VAT, nor is
there a Federal sales or use tax. However, the majority of the
States have enacted sales or use taxes, including both origin-
based taxes and destination-based taxes.\1497\
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\1495\ Alan Schenk, Victor Thuronyi, and Wei Cui, Value Added Tax:
A Comparative Approach, Cambridge University Press, 2015. Consistent
with the OECD International VAT/GST Guidelines, the term VAT refers to
all broad-based final consumption taxes, regardless of the acronym used
to identify any particular one. Thus, many countries that call their
national consumption tax a GST (general sales tax) are included in the
estimate of the number of countries with a VAT.
\1496\ Nearly all jurisdictions use the credit-invoice method of
calculating value added to determine VAT liability. Under the credit-
invoice method, a tax is imposed on the seller for all of its sales.
The tax is calculated by applying the tax rate to the sales price of
the good or service, and the amount of tax is generally disclosed on
the sales invoice. A business credit is provided for all VAT levied on
purchases of taxable goods and services (i.e., ``inputs'') used in the
seller's business. The ultimate consumer (i.e., a nonbusiness
purchaser), however, does not receive a credit with respect to his or
her purchases. The VAT credit for inputs prevents the imposition of
multiple layers of tax with respect to the total final purchase price
(i.e., a ``cascading'' of the VAT). As a result, the net tax paid at a
particular stage of production or distribution is based on the value
added by that taxpayer at that stage of production or distribution. In
theory, the total amount of tax paid with respect to a good or service
from all levels of production and distribution should equal the sales
price of the good or service to the ultimate consumer multiplied by the
VAT rate.
To receive an input credit with respect to any purchase, a business
purchaser is generally required to possess an invoice from a seller
that contains the name of the purchaser and indicates the amount of tax
collected by the seller on the sale of the input to the purchaser. At
the end of a reporting period, a taxpayer may calculate its tax
liability by subtracting the cumulative amount of tax stated on its
purchase invoices from the cumulative amount of tax stated on its sales
invoices.
\1497\ EY, Worldwide VAT, GST and Sales Tax Guide 2015, p. 1021,
available at http://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-
GST-and-sales-tax-guide-2015/$FILE/
Worldwide%20VAT,%20GST%20and%20Sales%20Tax%20Guide%202015.pdf.
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With respect to cross-border transactions, the OECD has
recommended that the destination principle be adopted for all
indirect taxes, in part to conform to the treatment of such
transactions for purposes of customs duties. The OECD defines
the destination principle as ``the principle whereby, for
consumption tax purposes, internationally traded services and
intangibles should be taxed according to the rules of the
jurisdiction of consumption.'' \1498\ A jurisdiction may adopt
the convention that consumption occurs at the place of business
or residence of the customer. Such proxies are needed to
determine the location of consumption by persons other than
individuals, because such persons are more able to move the
location of use of goods, services, or intangibles in response
to imposition of tax.
---------------------------------------------------------------------------
\1498\ See OECD, ``Recommendation of the Council on the application
of value added tax/goods and services tax to the international trade in
services and intangibles as approved on September 27, 2016,''
[C(2016)120], appendix, page 3, reproduced in the appendix, OECD,
International VAT/GST Guidelines, OECD Publishing, 2017.
---------------------------------------------------------------------------
3. Resolving overlapping or conflicting jurisdiction to tax
Widely-accepted norms govern what constitutes a reasonable
regulatory action by a sovereign state that will be respected
by other sovereign states. General consensus on the limits of
state jurisdiction helps to reduce conflicts from
extraterritorial state action. In addition, jurisdictions have
developed mechanisms to resolve common conflicts. For example,
mechanisms to eliminate double taxation address situations in
which the source and residency determinations of two
jurisdictions result in duplicative assertion of taxing
authority over the same item.
When the same item is subject to tax under the rules of two
or more jurisdictions, double taxation is usually mitigated by
bilateral tax treaties or by laws permitting credit for taxes
paid to another jurisdiction. The United States is a partner in
numerous bilateral treaties that aim to avoid international
double taxation and prevent tax avoidance and evasion. Another
related objective of these treaties is the removal of barriers
to trade, capital flows, and commercial travel that may be
caused by overlapping tax jurisdictions and by the burdens of
complying with the tax laws of a jurisdiction when a person's
contacts with, and income derived from, that jurisdiction are
minimal. The current United States Model Income Tax Convention
(known as the U.S. model treaty), with its accompanying
preamble, reflects the most recent comprehensive statement of
the United States' negotiating position with respect to tax
treaties.\1499\ Bilateral agreements are also used to permit
limited mutual administrative assistance between
jurisdictions.\1500\
---------------------------------------------------------------------------
\1499\ The current U.S. model treaty is available at https://
www.treasury.gov/resource-center/tax-policy/treaties/Documents/Treaty-
US%20Model-2016.pdf; the preamble is available at https://
www.treasury.gov/resource-center/tax-policy/treaties/Documents/
Preamble-US%20Model-2016.pdf. Treasury periodically updates the U.S.
model treaty to reflect developments in the negotiating position of the
United States. Such changes include provisions that were successfully
included in bilateral treaties concluded by the United States, as well
as new proposed measures not yet included in any bilateral treaty.
Treasury published the current U.S. model treaty on February 17, 2016.
\1500\ Although U.S. courts extend comity to foreign judgments in
some instances, they are not required to recognize or assist in
enforcement of foreign judgments for collection of taxes, consistent
with the common law ``revenue rule'' in Holman v. Johnson, 1 Cowp. 341,
98 Eng. Rep. 1120 (K.B. 1775). American Law Institute, Restatement
(Third) of Foreign Relations Law of the United States, sec. 483 (1987).
The rule retains vitality in U.S. case law. See generally Pasquantino
v. United States, 544 U.S. 349 (2005) (a conviction for criminal wire
fraud arising from an intent to defraud Canadian tax authorities was
found not to conflict ``with any well-established revenue rule
principle[,]'' and thus was not in derogation of the revenue rule). To
the extent it is abrogated, it is done so in bilateral treaties, to
ensure reciprocity. At present, the United States has such agreements
in force with five jurisdictions: Canada, Denmark, France, the
Netherlands, and Sweden.
---------------------------------------------------------------------------
In addition to entering into bilateral treaties,
jurisdictions have worked in multilateral organizations to
develop common principles to alleviate double taxation. Those
principles are generally reflected in the provisions of the
Model Tax Convention on Income and on Capital of the
Organization for Economic Cooperation and Development (known as
the OECD model treaty),\1501\ a precursor of which was first
developed by a predecessor organization in 1958, which in turn
has antecedents from work by the League of Nations in the
1920s.\1502\ As a consensus document, the OECD model treaty is
intended to aid countries in constructing their own bilateral
treaties. The provisions have developed over time as practice
with actual bilateral treaties leads to unexpected results and
new issues are raised by parties to the treaties.\1503\
---------------------------------------------------------------------------
\1501\ OECD (2014), Model Tax Convention on Income and on Capital:
Condensed Version 2014, OECD Publishing, 2014, available at http://
dx.doi.org/10.1787//mtc_cond-2014-en. The multinational organization,
dedicated to global development, was first established in 1961 by the
United States, Canada, and 18 European countries, and has since
expanded to 35 members.
\1502\ See ``Report by the Experts on Double Taxation,'' League of
Nations Document E.F.S. 73/F19 (1923), which was a report commissioned
by the League at its second assembly; see also Lara Friedlander and
Scott Wilkie, ``Policy Forum: The History of Tax Treaty Provisions--And
Why It Is Important to Know About It,'' 54 Canadian Tax Journal No. 4
(2006).
\1503\ For example, the OECD initiated a multi-year study on base-
erosion and profit shifting in response to concerns of multiple
members. For an overview of that project, see Joint Committee on
Taxation, Background, Summary, and Implications of the OECD/G20 Base
Erosion and Profit Shifting Project (JCX-139-15), November 30, 2015.
This document can also be found on the Joint Committee on Taxation
website at www.jct.gov.
---------------------------------------------------------------------------
4. International principles as applied in the U.S. tax system
The United States imposes residence-based taxation on U.S.
persons, taxing them on their worldwide income, whether derived
in the United States or abroad, with limited deferral of
taxation of income earned by foreign corporations owned by U.S.
shareholders, and imposes source-based taxation on U.S.-source
income of nonresident alien individuals and other foreign
persons. Under this system (sometimes described as the U.S.
hybrid system), the application of the Code differs depending
on whether income arises from outbound investment (i.e.,
investment by U.S. persons outside the United States) or
inbound investment (i.e., investment by non-U.S. persons in the
United States).
B. Principles Common to Inbound and Outbound Taxation
While the United States taxes inbound and outbound
investment differently, certain rules are common to the
taxation of both, including residency rules, entity
classification rules, source determination rules, and transfer
pricing rules.
1. Residence
U.S. persons are subject to U.S. tax on their worldwide
income, while foreign persons are subject to U.S. tax only on
income that has sufficient connection with the United States.
The Code defines U.S. person to include all U.S. citizens and
residents as well as domestic entities such as partnerships and
corporations.\1504\ The term ``resident'' is defined only with
respect to individuals. Noncitizens who are lawfully admitted
as permanent residents of the United States in accordance with
immigration laws (colloquially referred to as green card
holders) are U.S. residents for tax purposes. In addition,
noncitizens who meet a substantial presence test and are not
otherwise exempt from U.S. taxation are also taxable as U.S.
residents.\1505\
---------------------------------------------------------------------------
\1504\ Sec. 7701(a)(30).
\1505\ Sec. 7701(b).
---------------------------------------------------------------------------
Domestic corporations are subject to U.S. tax on their
worldwide income, whereas partnerships (whether foreign or
domestic) generally are not subject to U.S. tax at the entity
level. Rather, partners generally are taxed based on the
activities of the partnership. Partnerships and corporations
are domestic if organized or created under the laws of the
United States, any State, or the District of Columbia, unless,
in the case of a partnership, the Secretary prescribes
otherwise by regulation.\1506\ All other partnerships and
corporations (i.e., those organized under the laws of foreign
countries) are foreign.\1507\ Other jurisdictions may use
factors such as situs or management and control to determine
residence. As a result, legal entities may have more than one
tax residence, or, in some cases, no residence. In such cases,
bilateral treaties may resolve conflicting claims of residence.
---------------------------------------------------------------------------
\1506\ Sec. 7701(a)(4).
\1507\ Sec. 7701(a)(5) and (9). Entities organized in a possession
or territory of the United States are not considered to have been
organized under the laws of the United States.
---------------------------------------------------------------------------
In certain cases, a foreign corporation that acquires a
domestic corporation or partnership may be treated as a
domestic corporation for Federal tax purposes.\1508\ That
result generally applies following a transaction in which,
pursuant to a plan or a series of related transactions: (1) a
domestic corporation becomes a subsidiary of a foreign-
incorporated entity or otherwise transfers substantially all of
its properties to such an entity; (2) the former shareholders
of the domestic corporation hold (by reason of the stock they
had held in the domestic corporation) at least 80 percent (by
vote or value) of the stock of the foreign-incorporated entity
after the transaction (often referred to as ``stock held by
reason of''); and (3) the foreign-incorporated entity,
considered together with all companies connected to it by a
chain of greater than 50-percent ownership (the ``expanded
affiliated group''), does not have substantial business
activities in the entity's country of organization, compared to
the total worldwide business activities of the expanded
affiliated group. If the above requirements are satisfied
except that the ``stock held by reason of'' the acquisition is
less than 80 percent but at least 60 percent of the stock of
the foreign corporation, the foreign corporation is not treated
as a domestic corporation but certain ``inversion gain'' of the
acquired entity must be recognized and other consequences may
apply to post-acquisition restructuring.\1509\
---------------------------------------------------------------------------
\1508\ Sec. 7874. The Treasury Department and the IRS have
promulgated detailed guidance, through both regulations and several
notices, addressing these requirements under section 7874 since the
section was enacted in 2004, and have sought to expand the reach of the
section or reduce the tax benefits of inversion transactions.
\1509\ In addition, an excise tax may be imposed on certain stock
compensation of executives of companies that undertake inversion
transactions. Sec. 4985.
---------------------------------------------------------------------------
2. Entity classification
Certain entities other than ``per se corporations'' are
eligible to elect their classification for Federal tax purposes
under the ``check-the-box'' regulations,\1510\ which affects
the determination of the source of the income, availability of
tax credits, and other tax attributes. Both foreign and
domestic entities may make the election. As a result, an entity
that operates in the United States and at least one other
jurisdiction may be treated as a hybrid entity (i.e., treated
as a partnership or disregarded entity for U.S. tax purposes
but as a corporation for foreign tax purposes) or a reverse
hybrid entity (i.e., treated as a corporation for U.S. tax
purposes but as a partnership or disregarded entity for foreign
tax purposes).
---------------------------------------------------------------------------
\1510\ Treas. Reg. sec. 301.7701-1, et seq.
---------------------------------------------------------------------------
3. Source of income rules
Various factors determine the source of income for U.S. tax
purposes, including the status or nationality of the payor or
recipient, and the location of the activities or assets that
generate the income.
Interest
Interest is from U.S. sources if paid by the United States
or any agency or instrumentality thereof, a State or any
political subdivision thereof, or the District of Columbia.
Interest is also from U.S. sources if paid by a U.S. resident
individual, a domestic corporation, or a partnership engaged in
a trade or business in the United States.\1511\ Interest paid
by the U.S. branch of a foreign corporation also is from U.S.
sources.\1512\
---------------------------------------------------------------------------
\1511\ Sec. 861(a)(1); Treas. Reg. sec. 1.861-2(a)(1). Certain
exceptions apply. For example, interest paid on deposits with foreign
branches of domestic corporations or domestic partnerships engaged in
commercial banking is foreign source, as is interest paid by foreign
branches of certain domestic financial institutions.
\1512\ Sec. 884(f)(1).
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Dividends
Dividend income is generally sourced by reference to the
payor's place of incorporation.\1513\ Thus, dividends paid by a
domestic corporation generally are U.S.-source income.
Similarly, dividends paid by a foreign corporation generally
are foreign-source income. Under a special rule, dividends from
a foreign corporation engaged in a trade or business in the
United States may be treated as partly U.S.-source and partly
foreign-source.\1514\
---------------------------------------------------------------------------
\1513\ Secs. 861(a)(2) and 862(a)(2).
\1514\ Sec. 861(a)(2)(B).
---------------------------------------------------------------------------
Rents and royalties
Rental and royalty income is sourced by reference to the
location or place of use of the property.\1515\ Rental income
from property located in the United States (or from any
interest in such property) is from U.S. sources. Royalty income
includes amounts paid for the use of or for the privilege of
using patents, copyrights, secret processes and formulas, good
will, trademarks, trade brands, franchises, and other like
property.
---------------------------------------------------------------------------
\1515\ Sec. 861(a)(4).
---------------------------------------------------------------------------
Income from sales of personal property
Subject to exceptions, income from the sale of personal
property is sourced according to the residence of the
seller.\1516\
---------------------------------------------------------------------------
\1516\ Sec. 865(a).
---------------------------------------------------------------------------
Several exceptions to that general rule apply. For example,
income from the sale of inventory property is generally sourced
to the place of sale, which is determined by where title to the
property passes.\1517\ If the sale is by a nonresident and is
attributable to an office or other fixed place of business in
the United States, however, the gain is income from U.S.
sources without regard to the place of sale, unless it is sold
for use, disposition, or consumption outside the United States
and a foreign office materially participates in the sale.\1518\
Income from the sale of inventory property that a taxpayer
produces (in whole or in part) in the United States and sells
outside the United States, or that a taxpayer produces (in
whole or in part) outside the United States and sells in the
United States, is partly U.S.-source and partly foreign-
source.\1519\
---------------------------------------------------------------------------
\1517\ Secs. 865(b), 861(a)(6), 862(a)(6); Treas. Reg. sec. 1.861-
7(c).
\1518\ Sec. 865(e)(2).
\1519\ Sec. 863(b). While sections 863(b) and 865(e)(2) may appear
to conflict when a nonresident produces outside the United States and
then sells through a U.S. office for use, disposition, or consumption
in the United States, in such cases the income generally is partly
U.S.-source and partly foreign-source.
---------------------------------------------------------------------------
Gain on the sale of depreciable property is divided between
U.S.-source and foreign-source in the same ratio that the
depreciation was previously deductible for U.S. tax
purposes.\1520\ Payments received on sales of intangible
property are sourced in the same manner as royalties to the
extent the payments are contingent on the productivity, use, or
disposition of the intangible property.\1521\
---------------------------------------------------------------------------
\1520\ Sec. 865(c).
\1521\ Sec. 865(d).
---------------------------------------------------------------------------
Personal services income
Compensation for labor or personal services is generally
sourced to the place of performance. Thus, compensation for
labor or personal services performed in the United States
generally is U.S.-source income, subject to an exception for
amounts that meet certain de minimis criteria.\1522\
---------------------------------------------------------------------------
\1522\ Sec. 861(a)(3).
---------------------------------------------------------------------------
Insurance income
Underwriting income from issuing insurance or annuity
contracts generally is U.S.-source income if the contract
involves property in, liability arising out of an activity in,
or the lives or health of residents of, the United
States.\1523\
---------------------------------------------------------------------------
\1523\ Sec. 861(a)(7).
---------------------------------------------------------------------------
Transportation income
Transportation income is any income derived from, or in
connection with, the use (or hiring or leasing for use) of a
vessel or aircraft (or a container used in connection
therewith) or the performance of services directly related to
such use.\1524\ That definition does not encompass land
transport except to the extent directly related to shipping by
vessel or aircraft, but regulations provide an analogous rule
for determining the source of income from transportation
services other than shipping or aviation. In general, income
from furnishing transportation that both begins and ends in the
United States is U.S.-source income, and 50 percent of income
attributable to transportation that either begins or ends in
the United States is U.S.-source income.
---------------------------------------------------------------------------
\1524\ Sec. 863(c)(3).
---------------------------------------------------------------------------
An exemption from U.S. tax is provided for transportation
income of foreign persons from countries that extend reciprocal
relief to U.S. persons. A nonresident alien individual with
income from the international operation of a ship may qualify,
provided that the foreign country in which such individual is
resident grants an equivalent exemption to individual residents
of the United States.\1525\ A similar exemption from U.S. tax
is provided for gross income derived by a foreign corporation
from the international operation of a ship or aircraft,
provided that the foreign country in which the corporation is
organized grants an equivalent exemption to corporations
organized in the United States.\1526\
---------------------------------------------------------------------------
\1525\ Sec. 872(b)(1).
\1526\ Sec. 883(a)(1) and (2).
---------------------------------------------------------------------------
Income from space or ocean activities or international
communications
For U.S. persons, all income from space or ocean activity
and 50 percent of income from international communications is
U.S.-source income. For foreign persons, generally no income
from a space or ocean activity or from international
communications is U.S.-source income.\1527\ International
communications income attributable to an office or other fixed
place of business in the United States, however, is U.S.-source
income.\1528\
---------------------------------------------------------------------------
\1527\ Sec. 863(d).
\1528\ Sec. 863(e).
---------------------------------------------------------------------------
Amounts received with respect to guarantees of indebtedness
Amounts received, directly or indirectly, from a
noncorporate resident or from a domestic corporation for the
provision of a guarantee of indebtedness of such person are
income from U.S. sources.\1529\ In addition, amounts received,
directly or indirectly, from a foreign person, for the
provision of a guarantee of indebtedness of that foreign person
are income from U.S. sources if the amounts received are
connected with income that is effectively connected with the
conduct of a trade or business in the United States.
---------------------------------------------------------------------------
\1529\ Sec. 861(a)(9).
---------------------------------------------------------------------------
4. Intercompany transfers
Transfer pricing
A basic U.S. tax principle applicable in dividing profits
from a transaction between related taxpayers is that the amount
of profit allocated to each related taxpayer must be measured
by reference to the amount of profit that a similarly situated
taxpayer would realize in a similar transaction with unrelated
parties bargaining at arm's length (the ``arm's-length
standard''). The transfer pricing rules of section 482 and the
accompanying Treasury regulations are intended to prevent
erosion of the U.S. tax base by taxpayers that improperly shift
income attributable to the United States to a related foreign
company.\1530\ Similarly, the domestic laws of most U.S.
trading partners include rules to limit income shifting through
transfer pricing. The arm's-length standard is difficult to
administer in situations in which no sufficiently comparable
transaction can be found to use to evaluate the appropriateness
of pricing in a transaction between related parties. When a
foreign person with U.S. activities has transactions with
related U.S. taxpayers, the amount of income attributable to
U.S. activities is determined in part by the same transfer
pricing rules of section 482 that apply when U.S. persons with
foreign activities transact with related foreign taxpayers.
---------------------------------------------------------------------------
\1530\ For a detailed description of the U.S. transfer pricing
rules, see Joint Committee on Taxation, Present Law and Background
Related to Possible Income Shifting and Transfer Pricing (JCX-37-10),
July 20, 2010, pp. 18-50.
---------------------------------------------------------------------------
Section 482 authorizes the Secretary to allocate income,
deductions, credits, or allowances among related business
entities \1531\ when necessary to clearly reflect income or
otherwise prevent tax avoidance. Comprehensive Treasury
regulations under that section generally adopt the arm's-length
standard as the method for determining whether a particular
allocation is appropriate.\1532\ The regulations generally
attempt to identify the income of each related party to a
transaction that would have resulted had the parties been
dealing at arm's length. For income from intangible property,
section 482 provides, ``in the case of any transfer (or
license) of intangible property (within the meaning of section
936(h)(3)(B)), the income with respect to such transfer or
license shall be commensurate with the income attributable to
the intangible.'' By requiring inclusion of amounts
commensurate with the income attributable to the intangible,
Congress was responding to concerns regarding the effectiveness
of the arm's-length standard with respect to intangible
property--including, in particular, high-profit-potential
intangibles.\1533\
---------------------------------------------------------------------------
\1531\ The term ``related'' as used herein refers to relationships
described in section 482, which refers to ``two or more organizations,
trades or businesses (whether or not incorporated, whether or not
organized in the United States, and whether or not affiliated) owned or
controlled directly or indirectly by the same interests.''
\1532\ Section 1059A buttresses section 482 by limiting the extent
to which costs used to determine custom valuation can also be used to
determine basis in property imported from a related party. A taxpayer
that imports property from a related party may not assign a value to
the property for cost purposes that exceeds its customs value.
\1533\ H.R. Rep. No. 99-426, p. 423.
---------------------------------------------------------------------------
Gain recognition on outbound transfers
If a transfer of intangible property to a foreign affiliate
occurs in connection with certain corporate transactions,
nonrecognition rules that may otherwise apply are suspended.
The transferor of intangible property must recognize gain from
the transfer as though the transferor had sold the intangible
(regardless of the stage of development of the intangible
property) in exchange for payments contingent on the use,
productivity, or disposition of the transferred property in
amounts that would have been received either annually over the
useful life of the property or upon disposition of the property
after the transfer.\1534\ The appropriate amounts of those
imputed payments are determined using transfer-pricing
principles. Final regulations issued in 2016 eliminated two
possible interpretations of existing law that taxpayers were
using to claim that outbound transfers of foreign goodwill and
going concern value in nonrecognition transactions were not
subject to taxation at all (i.e., neither immediately under
section 367(a) nor over the useful life of the property under
section 367(d)).\1535\ However, the Secretary subsequently
announced \1536\ that Treasury is considering reinstating an
exception for the outbound transfer of foreign goodwill and
going concern value used in the active conduct of a trade or
business in administratively simple cases with little potential
for abuse.\1537\
---------------------------------------------------------------------------
\1534\ Sec. 367(d).
\1535\ See T.D. 9803, 81 F.R. 91012 (December 17, 2016). Treas.
Reg. sec. 1.367(d)-1(b) now provides that the rules of section 367(d)
apply to transfers of intangible property as defined under Treas. Reg.
sec. 1.367(a)--1(d)(5) after September 14, 2015, and to any transfers
occurring before that date resulting from entity classification
elections filed on or after September 15, 2015.
\1536\ U.S. Treasury Department, Second Report to the President on
Identifying and Reducing Tax Regulatory Burdens, Executive Order 13789,
October 2, 2017.
\1537\ For the relevant legislative history, see H.R. Rep. No. 98-
432, 98th Cong., 2d Sess. 1318-1320 (March 5, 1984) and Conference
Report, H.R. Rep. No. 98-861, 98th Cong. 2d Sess. 951-957 (June 23,
1984).
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C. U.S. Tax Rules Applicable to Nonresident Aliens and Foreign
Corporations (Inbound)
Nonresident aliens and foreign corporations generally are
subject to U.S. tax only on their U.S.-source income. There are
two broad types of U.S.-source income of foreign taxpayers:
income that is ``fixed or determinable annual or periodical
gains, profits, and income'' (``FDAP income'') and income that
is ``effectively connected with the conduct of a trade or
business within the United States'' (``ECI''). FDAP income,
although nominally subject to a statutory 30-percent gross-
basis tax withheld at its source, in many cases is exempt or
subject to a reduced rate of tax under the Code or a bilateral
income tax treaty. ECI generally is subject to the same U.S.
tax rules and rates that apply to business income derived by
U.S. persons.
1. Gross-basis taxation of U.S.-source income
Certain income received by foreign persons from U.S.
sources is subject to a 30-percent gross-basis tax (i.e., a tax
on gross income without reduction for related expenses), which
is collected by withholding at the source of the payment. FDAP
income subject to the 30-percent tax includes interest,
dividends, rents, salaries, wages, premiums, annuities,
compensations, remunerations, and emoluments. The categories of
income subject to the 30-percent tax and the categories for
which withholding is required are generally coextensive.
FDAP income of nonresident aliens and foreign corporations
that is not ECI is subject to the 30-percent tax.\1538\ The
items enumerated in defining FDAP income are illustrative, and
the words ``annual or periodical'' are ``merely generally
descriptive'' of the payments within the purview of the
statute.\1539\
---------------------------------------------------------------------------
\1538\ Secs. 871(a) and 881. FDAP income that is ECI is taxed as
ECI.
\1539\ Commissioner v. Wodehouse, 337 U.S. 369, 393 (1949).
---------------------------------------------------------------------------
Exclusions from FDAP income
FDAP income encompasses a broad range of gross income, but
has important exceptions. Capital gains of nonresident aliens
are generally foreign source; however, capital gains of
nonresident aliens present in the United States for 183 days or
more \1540\ during the year are income from U.S. sources
subject to gross-basis taxation.\1541\ In addition, U.S-source
gains from the sale or exchange of intangibles are subject to
tax and withholding if they are contingent on the productivity
of the property sold.\1542\
---------------------------------------------------------------------------
\1540\ For purposes of this rule, whether a person is considered a
resident in the United States is determined by application of the rules
under section 7701(b).
\1541\ Sec. 871(a)(2). In addition, certain capital gains from
sales of U.S. real property interests are subject to tax as effectively
connected income under the Foreign Investment in Real Property Tax Act
of 1980 (``FIRPTA'').
\1542\ Secs. 871(a)(1)(D) and 881(a)(4).
---------------------------------------------------------------------------
Interest on bank deposits may qualify for exemption from
treatment as FDAP income on two grounds. First, interest on
deposits with domestic banks and savings and loan associations,
and certain amounts held by insurance companies, is U.S.-source
income but is exempt from the 30-percent tax when paid to a
foreign person.\1543\ Second, interest on deposits with foreign
branches of domestic banks and domestic savings and loan
associations is not U.S.-source income and thus is not subject
to U.S. tax.\1544\ Interest and original issue discount on
certain short-term obligations also is exempt from U.S. tax
when paid to a foreign person.\1545\ In addition, there is
generally no information reporting required with respect to
payments of such exempt amounts.\1546\
---------------------------------------------------------------------------
\1543\ Secs. 871(i)(2)(A) and 881(d); Treas. Reg. sec. 1.1441-
1(b)(4)(ii).
\1544\ Sec. 861(a)(1)(B); Treas. Reg. sec. 1.1441--1(b)(4)(iii).
\1545\ Secs. 871(g)(1)(B) and 881(a)(3); Treas. Reg. sec. 1.1441-
1(b)(4)(iv).
\1546\ Treas. Reg. sec. 1.1461-1(c)(2)(ii)(A) and (B). A bank must
report interest if the recipient is a nonresident alien who resides in
a country with which the United States has a satisfactory exchange of
information program under a bilateral agreement and the deposit is
maintained at an office in the United States. Treas. Reg. secs. 1.6049-
4(b)(5) and -8. The IRS publishes lists of the countries whose
residents are subject to the reporting requirements, and those
countries with respect to which the reported information is
automatically exchanged. See Rev. Proc. 2017-31, supplementing Rev.
Proc. 2014-64.
---------------------------------------------------------------------------
Although FDAP income includes U.S.-source portfolio
interest, such interest is specifically exempt from the 30-
percent gross-basis tax. Portfolio interest is any interest
(including original issue discount) that is paid on an
obligation that is in registered form and for which the
beneficial owner has provided to the U.S. withholding agent a
statement certifying that the beneficial owner is not a U.S.
person.\1547\ Portfolio interest, however, does not include
interest received by a 10-percent shareholder,\1548\ certain
contingent interest,\1549\ interest received by a controlled
foreign corporation from a related person,\1550\ or interest
received by a bank on an extension of credit made pursuant to a
loan agreement entered into in the ordinary course of its trade
or business.\1551\
---------------------------------------------------------------------------
\1547\ Sec. 871(h)(2).
\1548\ Sec. 871(h)(3).
\1549\ Sec. 871(h)(4).
\1550\ Sec. 881(c)(3)(C).
\1551\ Sec. 881(c)(3)(A).
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Withholding of 30-percent gross-basis tax
The 30-percent tax on FDAP income is generally collected by
means of withholding.\1552\ Withholding on FDAP payments to
foreign payees is required unless the withholding agent,\1553\
i.e., the person making the payment to the foreign person, can
establish that the beneficial owner of the amount is eligible
for an exemption from withholding or a reduced rate of
withholding under an income tax treaty.\1554\
---------------------------------------------------------------------------
\1052\ Secs. 1441 and 1442.
\1053\ A withholding agent includes any U.S. or foreign person that
has the control, receipt, custody, disposal, or payment of an item of
income of a foreign person subject to withholding. Treas. Reg. sec.
1.1441-7(a).
\1054\ Secs. 871, 881, 1441, and 1442; Treas. Reg. sec. 1.1441-
1(b).
---------------------------------------------------------------------------
Often the income subject to withholding is the only income
of the foreign person subject to any U.S. tax. As long as the
foreign person has no ECI and the withholding is sufficient to
satisfy the tax liability with respect to FDAP income, the
foreign person generally is not required to file a U.S. Federal
income tax return. Accordingly, the withholding of the 30-
percent gross-basis tax generally represents the collection of
the foreign person's final tax liability.
To the extent that a withholding agent withholds an amount,
the withheld tax is credited to the foreign recipient of the
income.\1555\ If the agent withholds more than is required, and
that results in an overpayment of tax, the foreign recipient
may file a claim for refund.
---------------------------------------------------------------------------
\1555\ Sec. 1462.
---------------------------------------------------------------------------
2. Net-basis taxation of U.S.-source income
The United States taxes ECI on a net basis.\1556\
---------------------------------------------------------------------------
\1556\ Secs. 871(b) and 882.
---------------------------------------------------------------------------
U.S. trade or business
A foreign person is subject to U.S. tax on a net basis if
the person is engaged in a U.S. trade or business. Partners in
a partnership and beneficiaries of an estate or trust are
treated as engaged in a U.S. trade or business if the
partnership, estate, or trust is so engaged.\1557\
---------------------------------------------------------------------------
\1557\ Sec. 875.
---------------------------------------------------------------------------
Whether a foreign person is engaged in a U.S. trade or
business is a factual question that has generated much case
law. Basic issues include whether the activity rises to the
level of a trade or business, whether a trade or business has
sufficient connections to the United States, and whether the
relationship between the foreign person and persons performing
activities in the United States for the foreign person is
sufficient to attribute those activities to the foreign person.
The trade or business rules differ from one activity to
another. The term ``trade or business within the United
States'' expressly includes the performance of personal
services within the United States.\1558\ If, however, a
nonresident alien individual performs personal services for a
foreign employer, and the individual's total compensation for
the services and period in the United States are minimal
($3,000 or less in total compensation and 90 days or fewer of
physical presence in a year), the individual is not considered
to be engaged in a U.S. trade or business.\1559\ Detailed rules
govern whether trading in stock or securities or commodities
constitutes the conduct of a U.S. trade or business.\1560\ A
foreign person who trades in stock or securities or commodities
in the United States through an independent agent generally is
not treated as engaged in a U.S. trade or business if the
foreign person does not have an office or other fixed place of
business in the United States through which trades are carried
out. A foreign person who trades stock or securities or
commodities for the person's own account also generally is not
considered to be engaged in a U.S. trade or business so long as
the foreign person is not a dealer in stock or securities or
commodities.
---------------------------------------------------------------------------
\1558\ Sec. 864(b).
\1559\ Sec. 864(b)(1).
\1560\ Sec. 864(b)(2) and Prop. Treas. Reg. sec. 1.864(b)-1.
---------------------------------------------------------------------------
For eligible foreign persons, U.S. bilateral income tax
treaties restrict the application of net-basis U.S. taxation.
Under each treaty, the United States is permitted to tax
business profits only to the extent those profits are
attributable to a U.S. permanent establishment of the foreign
person. The threshold level of activities that constitute a
permanent establishment is generally higher than the threshold
level of activities that constitute a U.S. trade or business.
For example, a permanent establishment typically requires the
maintenance of a fixed place of business over a significant
period of time.
Effectively connected income
A foreign person that is engaged in the conduct of a trade
or business within the United States is subject to U.S. net-
basis taxation on the income that is ``effectively connected''
with the business. Specific statutory rules govern whether
income is ECI.\1561\
---------------------------------------------------------------------------
\1561\ Sec. 864(c).
---------------------------------------------------------------------------
In the case of U.S.-source capital gain and U.S.-source
income of a type that would be subject to gross-basis U.S.
taxation, the factors taken into account in determining whether
the income is ECI include whether the income is derived from
assets used in or held for use in the conduct of the U.S. trade
or business and whether the activities of the U.S. trade or
business were a material factor in the realization of the
amount (the ``asset use'' and ``business activities''
tests).\1562\ Under the asset use and business activities
tests, due regard is given to whether such asset or such
income, gain, or loss was accounted for through the trade or
business. All other U.S.-source non-FDAP income is treated as
ECI.\1563\
---------------------------------------------------------------------------
\1562\ Sec. 864(c)(2).
\1563\ Sec. 864(c)(3).
---------------------------------------------------------------------------
A foreign person who is engaged in a U.S. trade or business
may have limited categories of foreign-source income that are
considered to be ECI.\1564\ Foreign-source income not included
in one of those categories generally is exempt from U.S. tax.
---------------------------------------------------------------------------
\1564\ This income is subject to net-basis U.S. taxation after
allowance of a credit for any foreign income tax imposed on the income.
See sec. 906.
---------------------------------------------------------------------------
A foreign person's income from foreign sources generally is
considered to be ECI only if the person has an office or other
fixed place of business within the United States to which the
income is attributable and the income is in one of the
following categories: (1) rents or royalties for the use of
patents, copyrights, secret processes or formulas, good will,
trademarks, trade brands, franchises, or other like intangible
properties derived in the active conduct of the trade or
business; (2) interest or dividends derived in the active
conduct of a banking, financing, or similar business within the
United States or received by a corporation the principal
business of which is trading in stocks or securities for its
own account; or (3) income derived from the sale or exchange
(outside the United States), through the U.S. office or fixed
place of business, of inventory or property held by the foreign
person primarily for sale to customers in the ordinary course
of the trade or business, unless the sale or exchange is for
use, consumption, or disposition outside the United States and
an office or other fixed place of business of the foreign
person in a foreign country participated materially in the sale
or exchange.\1565\ Foreign-source dividends, interest, and
royalties are not treated as ECI if the items are paid by a
foreign corporation more than 50 percent (by vote) of which is
owned directly, indirectly, or constructively by the recipient
of the income.\1566\
---------------------------------------------------------------------------
\1565\ Sec. 864(c)(4)(B).
\1566\ Sec. 864(c)(4)(D)(i).
---------------------------------------------------------------------------
In determining whether a foreign person has a U.S. office
or other fixed place of business, the office or other fixed
place of business of an agent generally is disregarded. The
place of business of an agent other than an independent agent
acting in the ordinary course of business is not disregarded,
however, if the agent either has the authority (regularly
exercised) to negotiate and conclude contracts in the name of
the foreign person or has a stock of merchandise from which he
regularly fills orders on behalf of the foreign person.\1567\
If a foreign person has a U.S. office or fixed place of
business, income, gain, deduction, or loss is not considered
attributable to the office unless the office was a material
factor in the production of the income, gain, deduction, or
loss and the office regularly carries on activities of the type
from which the income, gain, deduction, or loss was
derived.\1568\
---------------------------------------------------------------------------
\1567\ Sec. 864(c)(5)(A).
\1568\ Sec. 864(c)(5)(B).
---------------------------------------------------------------------------
Special rules apply in determining the ECI of an insurance
company. The foreign-source income of a foreign corporation
that is subject to tax under the insurance company provisions
of the Code is treated as ECI if the income is attributable to
its United States business.\1569\
---------------------------------------------------------------------------
\1569\ Sec. 864(c)(4)(C).
---------------------------------------------------------------------------
Income, gain, deduction, or loss for a particular year
generally is not treated as ECI if the foreign person is not
engaged in a U.S. trade or business in that year.\1570\ If,
however, income or gain taken into account for a taxable year
is attributable to the sale or exchange of property, the
performance of services, or any other transaction that occurred
in a prior taxable year, the income or gain is ECI if the
income or gain would have been ECI in the prior year.\1571\ If
any property ceases to be used or held for use in connection
with the conduct of a U.S. trade or business and the property
is disposed of within 10 years after the cessation, the income
or gain attributable to the disposition of the property is ECI
if the income or gain would have been ECI had the disposition
occurred immediately before the property ceased to be used or
held for use in connection with the conduct of a U.S. trade or
business.\1572\
---------------------------------------------------------------------------
\1570\ Sec. 864(c)(1)(B).
\1571\ Sec. 864(c)(6).
\1572\ Sec. 864(c)(7).
---------------------------------------------------------------------------
Transportation income from U.S. sources is treated as
effectively connected with a foreign person's conduct of a U.S.
trade or business only if the foreign person has a fixed place
of business in the United States that is involved in the
earning of such income and substantially all of such income of
the foreign person is attributable to regularly scheduled
transportation.\1573\ If the transportation income is
effectively connected with conduct of a U.S. trade or business,
the transportation income, along with transportation income
that is from U.S. sources because the transportation both
begins and ends in the United States, may be subject to net-
basis taxation. Income of certain foreign persons from the
international operation of a ship or aircraft may be eligible
for an exemption, provided that the jurisdiction in which the
foreign person is organized provides an equivalent exemption
for U.S. persons.\1574\
---------------------------------------------------------------------------
\1573\ Sec. 887(b)(4).
\1574\ See sec. 883(a)(1), (2), and (c). The most recent
compilation of countries that the United States recognizes as providing
exemptions lists countries in three groups: 27 countries are eligible
for exemption on the basis of a review of the law of the foreign
jurisdiction; 39 countries exchanged diplomatic notes with the United
States that grant exemption to some extent; and more than 50 countries
are parties with the United States to bilateral income tax treaties
that include a shipping article. Rev. Rul. 2008-17, 2008-1 C.B. 626,
modified by Ann. 2008-57, 2008-C.B. 1192, 2008.
---------------------------------------------------------------------------
Allowance of deductions
Taxable ECI is computed by taking into account deductions
associated with gross ECI. Regulations address the allocation
and apportionment of deductions between ECI and other income.
Certain deductions may be allocated and apportioned on the
basis of units sold, gross sales or receipts, costs of goods
sold, profits contributed, expenses incurred, assets used,
salaries paid, space used, time spent, or gross income
received. Specific rules provide for the allocation and
apportionment of research and experimental expenditures, legal
and accounting fees, income taxes, losses on dispositions of
property, and net operating losses. In general, interest is
allocated and apportioned based on assets rather than income.
3. Special rules
FIRPTA
A foreign person's gain or loss from the disposition of a
U.S. real property interest (``USRPI'') is treated as
ECI.\1575\ Thus, a foreign person subject to tax on such a
disposition is required to file a U.S. tax return. In the case
of a foreign corporation, the gain from the disposition of a
USRPI may also be subject to the branch profits tax at a 30-
percent rate (or lower treaty rate).
---------------------------------------------------------------------------
\1575\ Sec. 897(a).
---------------------------------------------------------------------------
The payor of income that FIRPTA treats as ECI is generally
required to withhold U.S. tax from the payment.\1576\ The
foreign person can request a refund with its U.S. tax return,
if appropriate, based on that person's overall tax liability
for the taxable year.
---------------------------------------------------------------------------
\1576\ Sec. 1445 and regulations thereunder.
---------------------------------------------------------------------------
Branch profits taxes
A domestic corporation is subject to U.S. income tax on its
net income. The earnings of the domestic corporation may be
subject to a second tax, this time at the shareholder level,
when dividends are paid. When the shareholders are foreign, the
second-level tax may be collected by withholding. Unless the
portfolio interest exemption or another exemption applies,
interest payments made by a domestic corporation to foreign
creditors are likewise subject to withholding tax. To
approximate those second-level withholding taxes imposed on
payments made by domestic subsidiaries to their foreign
shareholders, the United States taxes a foreign corporation
that is engaged in a U.S. trade or business through a U.S.
branch on amounts of U.S. earnings and profits that are shifted
(to the head office) out of, or amounts of interest that are
deducted by, the U.S. branch of the foreign corporation. Those
branch taxes may be reduced or eliminated under an applicable
income tax treaty.\1577\
---------------------------------------------------------------------------
\1577\ See Treas. Reg. secs. 1.884-1(g) and -5.
---------------------------------------------------------------------------
Under the branch profits tax, the United States imposes a
tax of 30 percent on a foreign corporation's ``dividend
equivalent amount.'' \1578\ The dividend equivalent amount
generally is the earnings and profits of a U.S. branch of a
foreign corporation attributable to its ECI.\1579\ Limited
categories of earnings and profits attributable to a foreign
corporation's ECI are excluded in calculating the dividend
equivalent amount.\1580\
---------------------------------------------------------------------------
\1578\ Sec. 884(a).
\1579\ Sec. 884(b).
\1580\ See sec. 884(d)(2) (excluding, e.g., earnings and profits
attributable to gain from the sale of domestic corporation stock that
constitutes a USRPI subject to FIRPTA).
---------------------------------------------------------------------------
In arriving at the dividend equivalent amount, a branch's
effectively connected earnings and profits are adjusted to
reflect changes in a branch's U.S. net equity (i.e., the excess
of the branch's assets over its liabilities, taking into
account only amounts treated as connected with its U.S. trade
or business).\1581\ The first adjustment reduces the dividend
equivalent amount to the extent the branch's earnings are
reinvested in trade or business assets in the United States (or
reduce U.S. trade or business liabilities). The second
adjustment increases the dividend equivalent amount to the
extent prior reinvested earnings are considered remitted to the
home office of the foreign corporation.
---------------------------------------------------------------------------
\1581\ Sec. 884(b).
---------------------------------------------------------------------------
Interest paid by a U.S. trade or business of a foreign
corporation generally is treated as if paid by a domestic
corporation and therefore generally is subject to 30-percent
withholding tax if paid to a foreign person.\1582\ Certain
``excess interest'' of a U.S. trade or business of a foreign
corporation is treated as if paid by a U.S. corporation to a
foreign parent and, therefore, also may be subject to 30-
percent withholding tax.\1583\ For this purpose, excess
interest is the excess of the interest expense of the foreign
corporation apportioned to the U.S. trade or business over the
amount of interest paid by the trade or business.
---------------------------------------------------------------------------
\1582\ Sec. 884(f)(1)(A).
\1583\ Sec. 884(f)(1)(B).
---------------------------------------------------------------------------
Earnings stripping
Earnings stripping generally refers to the process whereby
a taxpayer reduces its U.S. taxable income by making deductible
payments to a related foreign person. Taxpayers are limited in
their ability to engage in certain earnings stripping
transactions that involve interest payments. If the payor's
debt-to-equity ratio exceeds 1.5 to 1 (a debt-to-equity ratio
of 1.5 to 1 or less is considered a ``safe harbor''), a
deduction for disqualified interest paid or accrued by the
payor in a taxable year is generally disallowed to the extent
of the payor's excess interest expense.\1584\ Disqualified
interest includes interest paid or accrued to related parties
when no Federal income tax is imposed with respect to such
interest,\1585\ to unrelated parties in certain cases in which
a related party guarantees the debt, or to a REIT by a taxable
REIT subsidiary of that REIT. Excess interest expense is the
amount by which the payor's net interest expense (i.e., the
excess of interest paid or accrued over interest income)
exceeds 50 percent of its adjusted taxable income (generally
taxable income computed without regard to deductions for net
interest expense, net operating losses, domestic production
activities under section 199, depreciation, amortization, and
depletion). Interest disallowed under these rules can be
carried forward indefinitely and is allowed as a deduction to
the extent of excess limitation in a subsequent tax year. Any
excess limitation (i.e., the excess, if any, of 50 percent of
the adjusted taxable income of the payor over the payor's net
interest expense) can be carried forward three years.
---------------------------------------------------------------------------
\1584\ Sec. 163(j).
\1585\ If a treaty reduces the tax rate on interest paid or accrued
by the taxpayer, the interest is treated as interest on which no
Federal income tax is imposed to the extent of the same proportion of
such interest as the tax rate imposed without regard to the treaty,
reduced by the tax rate imposed under the treaty, bears to the tax rate
imposed without regard to the treaty. Sec. 163(j)(5)(B).
---------------------------------------------------------------------------
D. U.S. Tax Rules Applicable to Foreign Activities of U.S. Persons
(Outbound)
1. In general
In general, income earned directly by a U.S. person from
the conduct of a foreign business is taxed currently,\1586\ but
income earned indirectly by a separate foreign legal entity
operating the foreign business is not, provided that the entity
is treated as a corporation for U.S. tax purposes. Instead,
active foreign business income earned by a U.S. person
indirectly through an interest in a foreign corporation
generally is not subject to U.S. tax until the income is
distributed as a dividend to the U.S. person. Certain anti-
deferral regimes may cause the U.S. owner to be taxed currently
in the United States on certain categories of passive or highly
mobile income earned by the foreign corporation regardless of
whether the income has been distributed as a dividend to the
U.S. owner. The main anti-deferral regimes that provide such
exceptions are the controlled foreign corporation (``CFC'')
rules of subpart F \1587\ and the passive foreign investment
company (``PFIC'') rules.\1588\ A foreign tax credit generally
is available to offset, in whole or in part, the U.S. tax owed
on foreign-source income, whether the income is earned directly
by the domestic corporation, repatriated as an actual dividend,
or included in the domestic parent corporation's income under
one of the anti-deferral regimes.\1589\
---------------------------------------------------------------------------
\1586\ A U.S. citizen or resident living abroad may be eligible to
exclude from U.S. taxable income certain foreign earned income and
foreign housing costs under section 911. For a description of this
exclusion, see Present Law and Issues in U.S. Taxation of Cross-Border
Income (JCX-42-11), September 6, 2011, p. 52.
\1587\ Secs. 951-964.
\1588\ Secs. 1291-1298.
\1589\ Secs. 901, 902, 960, and 1293(f).
---------------------------------------------------------------------------
2. Anti-deferral regimes
Subpart F
Subpart F,\1590\ applicable to CFCs and their shareholders,
is the main anti-deferral regime of relevance to a U.S.-based
multinational corporate group. A CFC generally is defined as
any foreign corporation if U.S. persons own (directly,
indirectly, or constructively) more than 50 percent of the
corporation's stock (measured by vote or value), taking into
account only those U.S. persons that are within the meaning of
the term ``United States shareholder,'' which refers only to
those U.S. persons who own at least 10 percent of the stock
(measured by vote only).\1591\
---------------------------------------------------------------------------
\1590\ Secs. 951-964.
\1591\ Secs. 951(b), 957, and 958. The term ``United States
shareholder'' is used interchangeably herein with ``U.S. shareholder.''
---------------------------------------------------------------------------
Subpart F income
Under the subpart F rules, the United States generally
taxes the 10-percent U.S. shareholders of a CFC on their pro
rata shares of certain income of the CFC (``subpart F
income''), without regard to whether the income is distributed
to the shareholders.\1592\ In effect, the United States treats
the 10-percent U.S. shareholders of a CFC as having received a
current distribution of the CFC's subpart F income. With
exceptions described below, subpart F income generally includes
passive income and other income that is readily movable from
one jurisdiction to another. Subpart F income consists of
foreign base company income,\1593\ insurance income,\1594\ and
certain income relating to international boycotts and other
violations of public policy.\1595\
---------------------------------------------------------------------------
\1592\ Sec. 951(a).
\1593\ Sec. 954.
\1594\ Sec. 953.
\1595\ Sec. 952(a)(3)-(5).
---------------------------------------------------------------------------
Foreign base company income consists of foreign personal
holding company income, which includes passive income such as
dividends, interest, rents, and royalties, and a number of
categories of income from business operations, including
foreign base company sales income, foreign base company
services income, and foreign base company oil-related income.
\1596\
---------------------------------------------------------------------------
\1596\ Sec. 954.
---------------------------------------------------------------------------
Insurance income subject to current inclusion under the
subpart F rules includes any income of a CFC attributable to
the issuing or reinsuring of any insurance or annuity contract
in connection with risks located in a country other than the
CFC's country of organization. Subpart F insurance income also
includes income attributable to an insurance contract in
connection with risks located within the CFC's country of
organization as the result of an arrangement under which
another corporation receives a substantially equal amount of
consideration for insurance of other country risks. Finally,
special rules under subpart F with respect to related person
insurance income \1597\ address captive insurance
companies.\1598\ Under these rules, the threshold for
determining control is reduced to 25 percent, and any level of
stock ownership by a U.S. person in such corporation is
sufficient for the person to be treated as a U.S. shareholder.
---------------------------------------------------------------------------
\1597\ Sec. 953(c). Related person insurance income is defined to
mean any insurance income attributable to a policy of insurance or
reinsurance with respect to which the primary insured is either a U.S.
shareholder (within the meaning of the provision) in the foreign
corporation receiving the income or a person related to such a
shareholder.
\1598\ See Joint Committee on Taxation, General Explanation of the
Tax Reform Act of 1986 (JCS-10-87), May 4, 1987, p. 968.
---------------------------------------------------------------------------
Investments in U.S. property
The 10-percent U.S. shareholders of a CFC also are required
to include in income currently their pro rata shares of the
corporation's untaxed earnings invested in certain items of
U.S. property.\1599\ This U.S. property generally includes
tangible property located in the United States, stock of a U.S.
corporation, an obligation of a U.S. person, and certain
intangible assets, such as patents and copyrights, acquired or
developed by the CFC for use in the United States.\1600\ There
are specific exceptions to the general definition of U.S.
property, including for bank deposits, certain export property,
and certain trade or business obligations.\1601\ The inclusion
rule for investment of earnings in U.S. property is intended to
prevent taxpayers from avoiding U.S. tax on dividend
repatriations by repatriating CFC earnings through non-dividend
payments, such as loans to U.S. persons.
---------------------------------------------------------------------------
\1599\ Secs. 951(a)(1)(B) and 956.
\1600\ Sec. 956(c)(1).
\1601\ Sec. 956(c)(2).
---------------------------------------------------------------------------
Subpart F exceptions
Several exceptions to the broad definition of subpart F
income permit continued deferral for income from certain
transactions, dividends, interest, and certain rents and
royalties received by a CFC from a related corporation
organized and operating in the same foreign country in which
the CFC is organized.\1602\ The same-country exception is not
available to the extent that the payments reduce the subpart F
income of the payor. A second exception from foreign base
company income and insurance income is available for any item
of income received by a CFC if the taxpayer establishes that
the income was subject to an effective foreign income tax rate
greater than 90 percent of the maximum U.S. corporate income
tax rate (i.e., more than 90 percent of 35 percent, or 31.5
percent).\1603\
---------------------------------------------------------------------------
\1602\ Sec. 954(c)(3).
\1603\ Sec. 954(b)(4).
---------------------------------------------------------------------------
A provision colloquially referred to as the ``CFC look-
through'' rule excludes from foreign personal holding company
income dividends, interest, rents, and royalties received or
accrued by one CFC from a related CFC to the extent
attributable or properly allocable to non-subpart-F income of
the payor.\1604\ The look-through rule applies to taxable years
of foreign corporations beginning before January 1, 2020, and
to taxable years of U.S. shareholders with or within which such
taxable years of foreign corporations end.
---------------------------------------------------------------------------
\1604\ Sec. 954(c)(6).
---------------------------------------------------------------------------
There is also an exclusion from subpart F income for
certain income of a CFC that is derived in the active conduct
of banking or financing business (``active financing
income'').\1605\ With respect to income derived in the active
conduct of a banking, financing, or similar business, a CFC is
required to be predominantly engaged in such business and to
conduct substantial activity with respect to such business to
qualify for the exclusion. In addition, certain nexus
requirements apply, which provide that income derived by a CFC
or a qualified business unit (``QBU'') of a CFC from
transactions with customers is eligible for the exclusion if,
among other things, substantially all of the activities in
connection with such transactions are conducted directly by the
CFC or QBU in its home country and such income is treated as
earned by the CFC or QBU in its home country for purposes of
such country's tax laws. Moreover, the exclusion applies to
certain income derived from certain cross border transactions.
---------------------------------------------------------------------------
\1605\ Sec. 954(h).
---------------------------------------------------------------------------
For a securities dealer, foreign personal holding company
income excludes any interest or dividend (or certain equivalent
amounts) from any transaction, including a hedging transaction
or a transaction consisting of a deposit of collateral or
margin, entered into in the ordinary course of the dealer's
trade or business as a dealer in securities within the meaning
of section 475.\1606\ In the case of a QBU of the dealer, the
income is required to be attributable to activities of the QBU
in the country of incorporation, or to a QBU in the country in
which the QBU both maintains its principal office and conducts
substantial business activity. A coordination rule provides
that, for securities dealers, this exception generally takes
precedence over the exception for active financing income.
---------------------------------------------------------------------------
\1606\ Sec. 954(c)(2)(C).
---------------------------------------------------------------------------
Certain income of a qualifying insurance company (or a
qualifying branch of a qualifying insurance company) with
respect to risks located within the home country of the branch
or within the CFC's country of organization are also excluded
from foreign personal holding company income. Further,
additional exclusions apply for certain income of certain CFCs
or branches with respect to risks located in a country other
than the United States, provided that certain requirements,
including reserve requirements, are met.\1607\
---------------------------------------------------------------------------
\1607\ Subject to approval by the IRS, a taxpayer may establish
that the reserve of a life insurance company for life insurance and
annuity contracts is the amount taken into account in determining the
foreign statement reserve for the contract (reduced by catastrophe,
equalization, or deficiency reserve or any similar reserve). IRS
approval is to be based on whether the method, the interest rate, the
mortality and morbidity assumptions, and any other factors taken into
account in determining foreign statement reserves (taken together or
separately) provide an appropriate means of measuring income for
Federal income tax purposes.
---------------------------------------------------------------------------
Exclusion of previously taxed earnings and profits
A 10-percent U.S. shareholder of a CFC may exclude from its
income actual distributions of earnings and profits from the
CFC that were previously included in the 10-percent U.S.
shareholder's income under subpart F.\1608\ Any income
inclusion (under section 956) resulting from investments in
U.S. property may also be excluded from the 10-percent U.S.
shareholder's income when such earnings are ultimately
distributed.\1609\ Ordering rules provide that distributions
from a CFC are treated as coming first out earnings and profits
of the CFC that have been previously taxed under 956, then
subpart F income, then other earnings and profits.\1610\
---------------------------------------------------------------------------
\1608\ Sec. 959(a)(1).
\1609\ Sec. 959(a)(2).
\1610\ Sec. 959(c).
---------------------------------------------------------------------------
Basis adjustments
In general, a 10-percent U.S. shareholder of a CFC
increases the basis in its CFC stock by the amount of any
subpart F inclusions.\1611\ Similarly, a 10-percent U.S.
shareholder of a CFC generally reduces its basis in its CFC
stock by the amount of any distributions that the 10-percent
U.S. shareholder receives from the CFC that are excluded from
its income as previously taxed under subpart F.\1612\
---------------------------------------------------------------------------
\1611\ Sec. 961(a).
\1612\ Sec. 961(b).
---------------------------------------------------------------------------
Passive foreign investment companies
The Tax Reform Act of 1986 \1613\ established the PFIC
anti-deferral regime. A PFIC is generally defined as any
foreign corporation if 75 percent or more of its gross income
for the taxable year consists of passive income, or 50 percent
or more of its assets consists of assets that produce, or are
held for the production of, passive income.\1614\ Alternative
sets of income inclusion rules apply to U.S. persons that are
shareholders in a PFIC, regardless of their percentage
ownership in the company. Under one set of rules, U.S.
shareholders pay tax on certain income or gain realized through
the company, plus an interest charge that is attributable to
the value of deferral.\1615\ Under another set of rules for
PFICs that are qualified electing funds, electing U.S.
shareholders currently include in gross income their respective
shares of the company's earnings, with a separate election to
defer payment of tax, subject to an interest charge, on income
not currently received.\1616\ A third set of rules applies to
PFIC stock that is marketable, under which electing U.S.
shareholders currently take into account as income (or loss)
the difference between the fair market value of the stock as of
the close of the taxable year and their adjusted basis in such
stock (subject to certain limitations), often referred to as
``marking to market.'' \1617\
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\1613\ Pub. L. No. 99-514.
\1614\ Sec. 1297.
\1615\ Sec. 1291.
\1616\ Secs. 1293-1295.
\1617\ Sec. 1296.
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Under the PFIC regime, passive income is any income of a
kind that would be foreign personal holding company income,
including dividends, interest, royalties, rents, and certain
gains on the sale or exchange of property, commodities, or
foreign currency. However, among other exceptions, passive
income does not include any income derived in the active
conduct of an insurance business by a corporation that is
predominantly engaged in an insurance business and that would
be subject to tax under subchapter L if it were a domestic
corporation.\1618\ In applying the insurance exception, the IRS
analyzes whether risks assumed under contracts issued by a
foreign company organized as an insurer are truly insurance
risks, whether the risks are limited under the terms of the
contracts, and the status of the company as an insurance
company.\1619\
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\1618\ Sec. 1297(b)(2)(B).
\1619\ Notice 2003-34, 2003-C.B. 1 990, June 9, 2003. See also
Prop. Treas. Reg. sec. 1.1297-4.
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Other anti-deferral regimes and coordination rules
The subpart F and PFIC rules are not the only anti-deferral
regimes. Other rules that impose current U.S. taxation on
income earned through corporations include the accumulated
earnings tax rules \1620\ and the personal holding company
rules.
---------------------------------------------------------------------------
\1620\ Secs. 531-537.
---------------------------------------------------------------------------
Rules for coordination among the anti-deferral regimes are
provided to prevent U.S. persons from being subject to U.S. tax
on the same item of income under multiple regimes. For example,
a corporation generally is not treated as a PFIC with respect
to a particular shareholder if the corporation is also a CFC
and the shareholder is a 10-percent U.S. shareholder. That is,
subpart F trumps the PFIC rules.
3. Foreign tax credit
Subject to certain limitations, U.S. citizens, resident
individuals, and domestic corporations are allowed to claim
credit for foreign income taxes they pay. A domestic
corporation that owns at least 10 percent of the voting stock
of a foreign corporation is allowed a ``deemed-paid'' credit
for foreign income taxes paid by the foreign corporation that
the domestic corporation is deemed to have paid when the
related income is distributed as a dividend or is included in
the domestic corporation's income under the anti-deferral
rules.\1621\
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\1621\ Secs. 901, 902, 960, and 1291(g).
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The foreign tax credit generally is limited to a taxpayer's
U.S. tax liability on its foreign-source taxable income (as
determined under U.S. tax accounting principles). This limit is
intended to ensure that the credit serves its purpose of
mitigating double taxation of foreign-source income without
offsetting U.S. tax on U.S.-source income. \1622\ The limit is
computed by multiplying a taxpayer's total pre-credit U.S. tax
liability for the year by the ratio of the taxpayer's foreign-
source taxable income for the year to the taxpayer's total
taxable income for the year. If the total amount of foreign
income taxes paid and deemed paid for the year exceeds the
taxpayer's foreign tax credit limitation for the year, the
taxpayer may carry back the excess foreign taxes to the
previous year or carry forward the excess taxes to one of the
succeeding 10 years.\1623\
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\1622\ Secs. 901 and 904.
\1623\ Sec. 904(c).
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The computation of the foreign tax credit limitation
requires a taxpayer to determine the amount of its taxable
income from foreign sources in each limitation category by
allocating and apportioning deductions between U.S.-source
gross income, on the one hand, and foreign-source gross income
in each limitation category, on the other. In general,
deductions are allocated and apportioned to the gross income to
which the deductions factually relate.\1624\ However, subject
to certain exceptions, deductions for interest expense and
research and experimental expenses are apportioned based on
certain ratios.\1625\ Interest expense is apportioned based on
the ratio of the corporation's foreign or domestic (as
applicable) assets to its worldwide assets. In the case of
research and experimental expenses, the ratio is based on
either sales or gross income. All members of an affiliated
group of corporations generally are treated as a single
corporation for purposes of determining the apportionment
ratios.\1626\
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\1624\ Treas. Reg. sec. 1.861-8(b) and Temp. Treas. Reg. sec.
1.861-8T(c).
\1625\ Temp. Treas. Reg. sec. 1.861-9T and Treas. Reg. sec. 1.861-
17.
\1626\ Sec. 864(e)(1) and (6); Temp. Treas. Reg. sec. 1.861-
14T(e)(2).
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The term ``affiliated group'' is determined by reference to
the rules for determining whether corporations are eligible to
file consolidated returns, with certain modifications.\1627\
These rules generally exclude foreign corporations from an
affiliated group.\1628\ Interest expense allocation rules
permitting a U.S. affiliated group to elect to apportion the
interest expense of the members of the U.S. affiliated group on
a worldwide basis were modified in 2004, and initially
effective for taxable years beginning after December 31,
2008.\1629\ The effective date of the modified rules has been
delayed to January 1, 2021.\1630\ A result of this rule is that
interest expense of foreign members of a U.S. affiliated group
is taken into account in determining whether a portion of the
interest expense of the domestic members of the group must be
allocated to foreign-source income. An allocation to foreign-
source income generally is required only if, in broad terms,
the domestic members of the group are more highly leveraged
than is the entire worldwide group.
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\1627\ Secs. 864(e)(5) and 1504.
\1628\ Sec. 1504(b)(3).
\1629\ Sec. 864(f).
\1630\ See Hiring Incentives to Restore Employment Act, Pub. L. No.
111-147, sec. 551(a).
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The foreign tax credit limitation is applied separately to
passive category income and to general category income.\1631\
Passive category income includes passive income, such as
portfolio interest and dividend income, and certain specified
types of income. All other income is in the general category.
Passive income is treated as general category income if earned
by a qualifying financial services entity or if highly taxed
(i.e., if the foreign tax rate is determined to exceed the
highest tax rate specified in section 1 or 11, as applicable).
Dividends (and subpart F inclusions), interest, rents, and
royalties received by a 10-percent U.S. shareholder from a CFC
are assigned to the passive category to the extent the payments
or inclusions are allocable to passive category income of the
CFC.\1632\ Dividends received by a 10-percent corporate
shareholder of a foreign corporation that is not a CFC are also
categorized on a look-through basis.\1633\
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\1631\ Sec. 904(d). The foreign tax credit limitation is also
applied separately to certain additional separate categories. See
Treas. Reg. sec. 1.904-4(m).
\1632\ Sec. 904(d)(3).
\1633\ Sec. 904(d)(4).
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Special rules apply to the allocation of income and losses
from foreign and U.S. sources within each category of
income.\1634\ Foreign losses from one category first offset
foreign-source income from other categories. Any remaining
overall foreign loss offsets U.S.-source income. The same
principle applies to losses from U.S. sources. In subsequent
years, any losses deducted against another category or source
of income are recaptured. That is, an equal amount of income
from the same category or source that generated a loss in a
prior year is recharacterized as income from the other category
or source against which the loss was deducted. Foreign-source
income in a particular category may be fully recharacterized as
income in another category, whereas only up to 50 percent of
income from one source in any subsequent year may be
recharacterized as income from the other source.
---------------------------------------------------------------------------
\1634\ Sec. 904(f) and (g).
---------------------------------------------------------------------------
A taxpayer's ability to claim a foreign tax credit may be
further limited by a matching rule that prevents the separation
of creditable foreign taxes from the associated foreign income.
Under this rule, a foreign tax generally is not taken into
account for U.S. tax purposes, and thus no foreign tax credit
is available with respect to that foreign tax, until the
taxable year in which the related income is taken into account
for U.S. tax purposes.\1635\
---------------------------------------------------------------------------
\1635\ Sec. 909.
---------------------------------------------------------------------------
4. Special rules
Dual consolidated loss rules
A dual consolidated loss (``DCL'') is any net operating
loss of a domestic corporation if the corporation is subject to
an income tax of a foreign country without regard to whether
such income is from sources in or outside such foreign country,
or if the corporation is subject to such a tax on a residence
basis (a ``dual resident corporation'').\1636\ A DCL generally
cannot be used to reduce the taxable income of any member of
the corporation's affiliated group. Losses of a separate unit
of a domestic corporation (a foreign branch or an interest in a
hybrid entity owned by the corporation) are subject to this
limitation in the same manner as if the unit were a wholly-
owned subsidiary of such corporation. An exemption applies to a
DCL with respect to which the corporation makes a domestic use
election (i.e., an election to use the loss only for domestic,
and not foreign, tax purposes).\1637\ Recapture is required,
however, upon the occurrence of certain triggering events,
including the conversion of a separate unit to a foreign
corporation and the transfer of 50 percent or more of the
assets of a separate unit within a 12-month period.\1638\
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\1636\ Sec. 1503(d). The DCL rules presuppose the loss was used for
foreign tax purposes.
\1637\ Treas. Reg. sec. 1.1503(d)-6(d).
\1638\ See Treas. Reg. sec. 1.1503(d)-6(e)(1).
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Temporary dividends-received deduction for repatriated foreign earnings
In 2004, Congress enacted section 965, a temporary
provision intended to encourage U.S. multinational companies to
repatriate foreign earnings.\1639\ Under that provision, for
one taxable year certain dividends received by a U.S.
corporation from its CFCs were eligible for an 85-percent
dividends-received deduction. At the taxpayer's election, this
deduction was available for dividends received either during
the taxpayer's first taxable year beginning on or after October
22, 2004, or during the taxpayer's last taxable year beginning
before such date.
---------------------------------------------------------------------------
\1639\ American Jobs Creation Act of 2004, Pub. L. 108-357, sec.
421.
---------------------------------------------------------------------------
The temporary deduction was subject to a number of general
limitations. First, the deduction applied only to cash
repatriations generally in excess of the taxpayer's average
repatriation level calculated for a three-year base period
preceding the year of the deduction. Second, the amount
eligible for the deduction was generally limited to the amount
of earnings shown as permanently invested outside the United
States on the taxpayer's recent audited financial statements.
Third, to qualify for the deduction, dividends were required to
be invested in the United States according to a domestic
reinvestment plan approved by the taxpayer's senior management
and board of directors.\1640\
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\1640\ Section 965(b)(4). The plan was required to provide for the
reinvestment of the repatriated dividends in the United States,
including as a source for the funding of worker hiring and training,
infrastructure, research and development, capital investments, and the
financial stabilization of the corporation for the purposes of job
retention or creation.
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No foreign tax credit (or deduction) was allowed for
foreign taxes attributable to the deductible portion of any
dividend.\1641\ For this purpose, the taxpayer was permitted to
specifically identify which dividends were treated as carrying
the deduction and which dividends were not. In other words, the
taxpayer was allowed to choose which of its dividends were
treated as meeting the base-period repatriation level (and thus
carry foreign tax credits, to the extent otherwise allowable),
and which of its dividends were treated as part of the excess
eligible for the deduction (and thus subject to proportional
disallowance of any associated foreign tax credits).\1642\
Deductions were disallowed for expenses that were directly
allocable to the deductible portion of any dividend.\1643\
---------------------------------------------------------------------------
\1641\ Sec. 965(d)(1).
\1642\ Accordingly, taxpayers generally were expected to pay
regular dividends out of high-taxed CFC earnings (thereby generating
deemed-paid credits available to offset foreign-source income) and
section 965 dividends out of low-taxed CFC earnings (thereby availing
themselves of the 85-percent deduction).
\1643\ Sec. 965(d)(2).
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Domestic international sales corporations
A domestic international sales corporation (``DISC'') is a
domestic corporation that satisfies the following conditions:
95 percent of its gross receipts must be qualified export
receipts; 95 percent of the sum of the adjusted bases of all
its assets must be attributable to the sum of the adjusted
bases of qualified export assets; the corporation must have no
more than one class of stock; the par or stated value of the
outstanding stock must be at least $2,500 on each day of the
taxable year; and an election must be in effect to be taxed as
a DISC.\1644\ In general, a DISC is not subject to corporate-
level tax and offers limited deferral of tax liability to its
shareholders.\1645\ DISC income attributable to a maximum of
$10 million annually of qualified export receipts is generally
exempt from income tax at both the corporate and shareholder
level. Shareholders must pay interest to account for the
benefit of deferring the tax liability on undistributed DISC
income related to this $10 million maximum annual amount.\1646\
Such entities are also referred to as interest charge DISCs, or
IC-DISCs. Shareholders of a DISC are deemed to receive a
dividend out of current earnings and profits from qualified
export receipts in excess of $10 million.\1647\ Gain on the
sale of DISC stock is treated as a dividend to the extent of
accumulated DISC income.\1648\ The shareholders of a
corporation which is not a DISC, but was a DISC in a previous
taxable year, and which has previously taxed income or
accumulated DISC income, are also required to pay interest on
the deferral benefit, and gain on the sale or exchange of stock
in such corporation is treated as a dividend.
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\1644\ Sec. 992(a) and (b). A corporation that fails to satisfy
either or both of the 95-percent tests is deemed to satisfy such tests
if it makes a pro rata distribution of its gross receipts that are not
qualified export receipts and the fair market value of its assets that
are not qualified export assets. Sec. 992(c).
\1645\ Sec. 991. Prior to the 1984 Revenue Act (Pub. L. 98-369),
DISCs were eligible for more generous tax benefits that were eliminated
in favor of the since-repealed foreign sales corporation regime
(``FSC''). An overview of the history of the DISCs and FSCs regimes is
provided in Joseph Isenbergh, Vol. 3 U.S. Taxation of Foreign Persons
and Foreign Income, Para. 81. (Fourth Ed. 2016).
\1646\ The rate is the average of one-year constant maturity
Treasury yields. The deferral benefit is the excess of the amount of
tax for which the shareholder would be liable if deferred DISC income
were included as ordinary income over the actual tax liability of such
shareholder. Sec. 995(f).
\1647\ The amount of the deemed distribution is the sum of several
items, including qualified export receipts in excess of $10 million.
See sec. 955(b).
\1648\ Sec. 995(c).
PART I--OUTBOUND TRANSACTIONS
SUBPART A--ESTABLISHMENT OF PARTICIPATION EXEMPTION SYSTEM FOR TAXATION
OF FOREIGN INCOME
A. Deduction for Foreign-Source Portion of Dividends Received by
Domestic Corporations from Specified 10-Percent Owned Foreign
Corporations (sec. 14101 of the Act and sec. 904(b) and new sec. 245A
of the Code)
Explanation of Provision
Background on prior law
To limit multiple levels of corporate tax in the case of
tiered corporate structures, corporations are allowed a
dividends received deduction (``DRD''). U.S. corporations are
permitted a deduction for qualifying dividends received from
other U.S. corporations. The amount of the DRD is calculated as
a percentage of the dividend received. The DRD percentage is
based on the amount of stock that the recipient U.S.
corporation owns in the paying U.S. corporation, as follows:
(1) 50 percent if the ownership is less than 20 percent; (2) 65
percent if the ownership is at least 20 percent and less than
80 percent; and (3) 100 percent if the ownership is at least 80
percent.\1649\ A U.S. corporation may also be eligible for a
DRD for dividends received from a qualified 10-percent owned
foreign corporation with respect to the U.S.-source portion of
the dividends.\1650\
---------------------------------------------------------------------------
\1649\ Sec. 243. The Act changed the DRD percentages. The changes
to section 243 are discussed in greater detail in the explanation of
section 13002 of the Act.
\1650\ Sec. 245. The DRD on the eligible portion of the dividend is
based on the percentage of stock ownership of the foreign corporation,
as described in section 243.
---------------------------------------------------------------------------
In general
The provision exempts certain foreign income of certain
domestic corporations by means of a 100-percent DRD for the
foreign-source portion of dividends received from a specified
10-percent owned foreign corporation. A specified 10-percent
owned foreign corporation is any foreign corporation (other
than a PFIC that is not also a CFC) with respect to which any
domestic corporation is a U.S. shareholder.\1651\ A corporate
U.S. shareholder of a CFC receiving a dividend from a 10-
percent owned foreign corporation shall be allowed a DRD with
respect to the subpart F inclusion attributable to such
dividend in the same manner as a dividend would be allowable
under section 245A.\1652\ However, certain dividends that
qualify for the DRD may result in an inclusion under section
951(a) (subpart F) or section 951A (``GILTI'') in cases in
which any such inclusion is reduced under section 951(a)(2)(B)
by reason of a dividend or in certain cases in which the CFC
ceases to have a U.S. shareholder with section 958(a)
ownership.\1653\
---------------------------------------------------------------------------
\1651\ Sec. 245A(b). Under section 951(b) as revised by section
14214 of the Act, a domestic corporation is a U.S. shareholder of a
foreign corporation if it owns, within the meaning of section 958(a),
or is considered as owning by applying the rules of section 958(b), 10
percent or more of the vote or value of the foreign corporation.
\1652\ A technical correction may be necessary to reflect this
intent.
\1653\ Technical corrections may be necessary to reflect this
intent.
---------------------------------------------------------------------------
The term ``dividend received'' is intended to be
interpreted broadly, consistently with the meaning of the
phrases ``amount received as dividends''' and ``dividends
received'' under sections 243 and 245, respectively. For
example, if a domestic corporation indirectly owns stock of a
foreign corporation through a partnership and the domestic
corporation would qualify for the DRD with respect to dividends
from the foreign corporation if the domestic corporation owned
such stock directly, the domestic corporation would be allowed
the DRD with respect to its distributive share of the
partnership's dividend from the foreign corporation. However,
the provisions of section 245A are intended to apply only to
amounts that are treated as dividends for Federal income tax
purposes. Furthermore, the dividend cannot be a CFC-PFIC's
section 1291(d)(2)(B) ``purging'' dividend.\1654\ Under section
245A(g), the Secretary shall prescribe such regulations or
other guidance as may be necessary or appropriate to carry out
the provisions of this section, including regulations for the
treatment of U.S. shareholders owning stock of a specified 10-
percent owned foreign corporation through a partnership.
---------------------------------------------------------------------------
\1654\ Sec. 245A(f).
---------------------------------------------------------------------------
The DRD is available only to C corporations that are
neither RICs nor REITs.\1655\
---------------------------------------------------------------------------
\1655\ An S corporation's taxable income is computed in the same
manner as an individual (sec. 1363(b)) so that deductions allowable
only to corporations, including the section 245A deduction, do not
apply. See Report by the House Committee on Ways and Means to accompany
H.R. 6055, Subchapter S Revision Act of 1982, H. Rep. No. 97-826, p.
14; and Report by the Senate Committee on Finance to accompany H.R.
6055, Subchapter S Revision Act of 1982, S. Rep. 97-640, p. 15. The
Code provides that deductions for corporations provided in part VIII of
subchapter B, which include the DRD under section 245A, do not apply in
computing RIC taxable income (sec. 852(b)(2)(C)) or REIT taxable income
(sec. 857(b)(2)(A)). Therefore, the DRD under section 245A is not
available for RICs or REITs.
---------------------------------------------------------------------------
Foreign-source portion of a dividend
The foreign-source portion of any dividend equals the
amount of the dividend multiplied by the percentage of
undistributed earnings that are attributable neither to ECI nor
to certain dividends received from domestic corporations.\1656\
Undistributed earnings are the amount of the earnings and
profits of a specified 10-percent owned foreign corporation
\1657\ as of the close of the taxable year of the specified 10-
percent owned foreign corporation in which the dividend is
distributed and not reduced by dividends \1658\ distributed
during that taxable year.
---------------------------------------------------------------------------
\1656\ Sec. 245A(c). Such dividends include any dividend received
(directly or through a wholly owned foreign corporation) from a
domestic corporation at least 80 percent of the stock of which is owned
(directly or through such wholly owned foreign corporation) by the
specified 10-percent owned foreign corporation.
\1657\ Computed in accordance with sections 964(a) and 986.
\1658\ Note that pursuant to section 959(d), a distribution of
previously taxed income (``PTI'') does not constitute a dividend.
---------------------------------------------------------------------------
For example, assume a domestic corporation (``U.S.
Parent'') wholly owns a specified 10-percent owned foreign
corporation (``SFC''). At the beginning of year 1, SFC has no
accumulated earnings and profits. SFC has $1,000 of current-
year earnings and profits for year 1, of which $250 is
attributable to ECI. SFC makes a single distribution of $1,500
to U.S. Parent in year 1. The amount of the $1,500 distribution
that is a dividend is $1,000 because SFC has only $1,000 of E&P
in year 1.\1659\ Of that amount, $750 is the foreign-source
portion and eligible for the 100-percent DRD under section 245A
(the $1,000 dividend * ($750 of E&P that is not ECI / $1,000 of
total E&P)).
---------------------------------------------------------------------------
\1659\ Secs. 301(c)(1) and 316.
---------------------------------------------------------------------------
Holding period requirement
A domestic corporation is not permitted a DRD in respect of
any dividend on any share of stock that is held by the domestic
corporation for 365 days or less during the 731-day period
beginning on the date that is 365 days before the date on which
the share becomes ex-dividend with respect to the dividend. For
this purpose, the holding period requirement is satisfied only
if the specified 10-percent owned foreign corporation is a
specified 10-percent owned foreign corporation at all times
during the period and the taxpayer is a U.S. shareholder with
respect to such specified 10-percent owned foreign corporation
at all times during the period.\1660\
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\1660\ Sec. 246(c)(5).
---------------------------------------------------------------------------
Foreign tax credit disallowance
No foreign tax credit or deduction is allowed for any taxes
paid or accrued with respect to any dividend that qualifies for
the DRD. For example, assume $100 of foreign income taxes are
withheld from a $1,000 dividend from a specified 10-percent
owned foreign corporation to a domestic corporation. The
foreign-source portion of the dividend is $800, and an $800 DRD
is allowed. No foreign tax credit or deduction will be allowed
for $80 of the foreign income taxes pursuant to section
245A(d), and no foreign tax credit or deduction will be allowed
for the remaining $20 of foreign income taxes pursuant to
section 245(a)(8).
For purposes of computing the foreign tax credit
limitation, a domestic corporation that is a U.S. shareholder
of a specified 10-percent owned foreign corporation must
determine its foreign-source taxable income (and entire taxable
income) by disregarding any dividend for which the DRD is
taken, and any deductions properly allocable or apportioned to
income (other than amounts includible under section 951(a)(1)
or 951A(a)) with respect to stock of such foreign corporation,
or the stock to the extent income with respect to the stock is
other than amounts includible under section 951(a)(1) or
951A(a).\1661\
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\1661\ Sec. 904(b)(4).
---------------------------------------------------------------------------
Hybrid dividends
The DRD is not available for any hybrid dividend. A hybrid
dividend is an amount received from a CFC for which section
245A(a) would allow a DRD and for which the CFC received a
deduction (or other tax benefit) with respect to any income,
war profits, or excess profits taxes imposed by any foreign
country or possession of the United States. Furthermore, no
foreign tax credit or deduction is allowed for any taxes paid
or accrued with respect to any hybrid dividend.
If a CFC for which a domestic corporation is a U.S.
shareholder receives a hybrid dividend from any other CFC for
which that domestic corporation is a U.S. shareholder, the
hybrid dividend will be treated as subpart F income, and,
notwithstanding any other provision of the Code, the U.S.
shareholder will include in income its pro rata share of the
income under section 951(a).\1662\ This tiered hybrid dividend
rule applies to an amount treated as a dividend in the hands of
the recipient CFC (as opposed to amounts allowed the DRD) and
for which the distributing CFC received a deduction or other
tax benefit.\1663\
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\1662\ This is the result even if, for example, the dividend would
normally be entitled to look-through treatment under section 954(c)(6),
the subpart F income would normally be reduced by deductions pursuant
to section 954(b)(5), or the subpart F income would normally be limited
by current earnings and profits under section 952(c).
\1663\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
Effective Date
The provision applies to distributions made after (and for
purposes of determining a taxpayer's foreign tax credit
limitation under section 904, deductions with respect to
taxable years ending after) December 31, 2017.\1664\
---------------------------------------------------------------------------
\1664\ A technical correction may be necessary to reflect the
intent that the DRD be excluded from adjusted current earnings
(``ACE'') adjustments for purposes of the corporate alternative minimum
tax (``AMT'') as applicable to certain fiscal-year taxpayers for their
2017 taxable year.
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B. Special Rules Relating to Sales or Transfers Involving Specified 10-
Percent Owned Foreign Corporations (sec. 14102 of the Act and secs.
367(a)(3), 961, 964(e), and 1248 and new sec. 91 of the Code)
Explanation of Provision
Background on prior law
Gain recognized by a U.S. person on the sale or exchange of
the stock of a foreign corporation may be recharacterized as a
dividend to the extent of the E&P attributable to that stock if
the U.S. person owned, directly, indirectly or constructively,
10 percent or more (by vote) of the stock of the foreign
corporation while the foreign corporation was a CFC at any time
during the preceding five-year period.\1665\ Similarly, section
964(e) requires a CFC to include in income as a dividend gain
recognized on the sale or exchange of the stock of another
foreign corporation to the same extent that it would have been
so included under section 1248(a) if the CFC were a U.S.
person.
---------------------------------------------------------------------------
\1665\ Sec. 1248(a).
---------------------------------------------------------------------------
Certain branch loss recapture rules prevent a taxpayer from
deducting losses incurred by a foreign branch against U.S.
taxable income and then incorporate the branch when it is
profitable. Prior law required a U.S. corporation to recapture
the loss deduction to the extent of built-in gain in the branch
assets that are transferred outside the U.S. tax jurisdiction
to a foreign corporation in an otherwise tax-free
transaction.\1666\ Under prior law, the recapture amount was
limited to unrealized asset appreciation and treated as
foreign-source income.
---------------------------------------------------------------------------
\1666\ Sec. 367(a)(3)(C) as in effect before the enactment of the
Act. Section 367(a)(3)(C) was enacted to prevent a U.S. corporation
from using losses of a foreign branch to offset its taxable income
without having to pay U.S. tax on the associated future income after
the branch's incorporation.
---------------------------------------------------------------------------
Section 367 generally requires gain recognition on many
types of otherwise tax-free transfers by U.S. persons to
foreign corporations, unless a specific exception applies. One
such exception under prior law provided that property
transferred to a foreign corporation for use by the transferee
in the active conduct of a trade or business outside of the
United States is not subject to tax.\1667\
---------------------------------------------------------------------------
\1667\ Sec. 367(a)(3)(A) as in effect before the enactment of the
Act.
---------------------------------------------------------------------------
In general
The provision establishes limitations on the ability to
obtain duplicative tax benefits from losses in specified 10-
percent foreign corporations and transfers of certain foreign
branch losses to such foreign corporations, as described below.
It provides a new coordination rule under section 1248 to
ensure that gain upon the sale or exchange of stock in the
specified 10-percent foreign corporation that is
recharacterized as a dividend under section 1248 is treated as
a ``dividend received'' for purposes of applying section 245A,
and further prescribes basis adjustments with respect to loss
from such sales or exchanges. The ability to transfer foreign
branch losses is limited by new section 91. Finally, the
aforementioned active trade or business exception is repealed.
Sales by United States persons of CFC stock
If a domestic corporation sells or exchanges stock in a
foreign corporation that it has held for one year or more, any
amount received by the domestic corporation which is treated as
a dividend for purposes of section 1248, is treated as a
dividend for purposes of applying the rules of new section 245A
with respect to the new 100-percent DRD. Thus, to the extent
section 1248 treats an amount received as a dividend, such
dividend may qualify for a DRD under section 245A if the
requirements of section 245A are satisfied.\1668\
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\1668\ Sec. 1248(j).
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Sale of stock in a lower-tier CFC
If for any taxable year of a CFC beginning after December
31, 2017, an amount is treated as a dividend because of a sale
or exchange by the CFC of stock in another foreign corporation
held for a year or more,\1669\ then: (i) the foreign-source
portion of the dividend is treated as subpart F income of the
selling CFC,\1670\ (ii) a U.S. shareholder with respect to the
selling CFC includes in gross income for the taxable year of
the shareholder with or within which the taxable year of the
CFC ends, an amount equal to the shareholder's pro rata share
of the amount treated as subpart F income under (i), and (iii)
the amount includible in the gross income of the United States
shareholder under clause (ii) shall be treated as a divided
from a specified 10-percent owned foreign corporation for
purposes of applying section 245A.\1671\
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\1669\ See sec. 964(e)(1).
\1670\ See generally sec. 954(c)(1)(B).
\1671\ A technical correction may be necessary to reflect this
intent.
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To the extent a dividend arising under section 964(e)(1) is
a hybrid dividend, the tiered hybrid rules of section
245A(e)(2), rather than the rules of section 964(e)(4)(A),
apply to the dividend.\1672\
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\1672\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
Reduction in basis of certain foreign stock
A distribution from a foreign corporation eligible for a
DRD could reduce the value of the foreign corporation, reducing
built-in gain or increasing built-in loss in the stock of the
foreign corporation. Therefore, solely for the purpose of
determining a loss, a domestic corporate shareholder's adjusted
basis in the stock of a specified 10-percent owned foreign
corporation (as defined in section 245A) is reduced by an
amount equal to the portion of any dividend received with
respect to such stock from such foreign corporation that was
not taxed by reason of the DRD allowable under section 245A in
any taxable year of such domestic corporation.\1673\ This rule
applies in coordination with section 1059, such that any
reduction in basis required pursuant to this provision will be
disregarded to the extent the basis in the specified 10-percent
owned foreign corporation's stock has already been reduced
under section 1059.
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\1673\ Sec. 961(d).
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In the case of a sale or exchange by a CFC of stock in
another corporation in a taxable year of the selling CFC
beginning after December 31, 2017, to which this provision
applies if gain were recognized, rules similar to the rules of
section 961(d) apply.\1674\
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\1674\ Sec. 964(e)(4)(B).
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Inclusion of transferred loss amount in certain asset transfers
If a domestic corporation transfers substantially all of
the assets of a foreign branch (within the meaning of section
367(a)(3)(C)) as in effect before the Act) to a specified 10-
percent owned foreign corporation with respect to which it is a
U.S. shareholder after the transfer, the domestic corporation
includes in gross income an amount equal to the transferred
loss amount, subject to certain limitations.\1675\
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\1675\ Sec. 91(a).
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The transferred loss amount is, with respect to any
transfer of substantially all of the assets of a foreign
branch, the excess (if any) of: (1) the sum of the losses
incurred by the foreign branch after December 31, 2017, and
before the transfer, for which a deduction was allowed to the
domestic corporation, over (2) the sum of any taxable income
earned by the foreign branch after the loss incurred and any
amount recognized under section 904(f)(3) on account of the
transfer.\1676\ The transferred loss amount is reduced (but not
below zero) by the amount of gain recognized by the taxpayer
(other than gain recognized by reason of an overall foreign
loss recapture) on account of the transfer.\1677\
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\1676\ Sec. 91(b).
\1677\ Sec. 91(c). Sec. 14102(d)(4) of the Act, relating to
transition rules, provides:``(4) Transition rule. The amount of gain
taken into account under section 91(c) of the Internal Revenue Code of
1986, as added by this subsection, shall be reduced by the amount of
gain which would be recognized under section 367(a)(3)(C) (determined
without regard to the amendments made by subsection (e)) with respect
to losses incurred before January 1, 2018.''
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Amounts included in gross income by reason of the provision
are treated as derived from sources within the United
States.\1678\ Consistent with regulations or guidance that the
Secretary of the Treasury shall prescribe, proper adjustments
are made in the adjusted basis of the taxpayer's stock in the
specified 10-percent owned foreign corporation to which the
transfer is made, and in the transferee's adjusted basis in the
property transferred, to reflect the amounts included in gross
income under the provision.\1679\
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\1678\ Sec. 91(d).
\1679\ Sec. 91(e).
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The amount of gain taken into account under this provision
is reduced by the amount of gain which would be recognized
under section 367(a)(3)(C) as in effect before the date of the
Act \1680\ with respect to losses incurred before January 1,
2018.
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\1680\ Determined without regard to the rule providing for proper
adjustment of basis in the stock in the specified 10-percent owned
foreign corporation to which the transfer is made.
---------------------------------------------------------------------------
To illustrate this provision assume that a U.S.
multinational corporation (``U.S. Parent''), a calendar year
taxpayer, incorporates its branch located in country X
(``Incorporated Country X Branch'') on December 31, 2018.
Incorporated Country X Branch recognized $150 of losses during
calendar year 2018 for which U.S. Parent took a deduction.
On December 31, 2018, Incorporated Country X Branch has
tangible assets with built-in gain of $100, and U.S. Parent
recognizes that $100 of gain under section 367(a)(1). Under
section 91(a), U.S. Parent includes $50 in gross income ($150
of losses, reduced by $100 section 91(c) reduction amount,
which in this case is the amount of gain recognized under
section 367(a)(1)). However, if, for example, Incorporated
Country X Branch also had $75 of pre-2018 branch losses, the
$100 section 91(c) reduction amount would be reduced by $75 to
$25. In this case, U.S. Parent would include $125 in gross
income ($150 of losses, reduced by the $25 section 91(c)
reduction amount).
Repeal of active trade or business exception under section 367
Section 367(a) is amended to provide that in connection
with any exchange described in sections 332, 351, 354, 356, or
361, if a U.S. person transfers property used in the active
conduct of a trade or business outside of the United States to
a foreign corporation, such foreign corporation shall not, for
purposes of determining the extent to which gain shall be
recognized on such transfer, be considered to be a corporation.
That is, a transfer of property used in the active conduct of a
trade or business outside of the United States by a U.S.
corporation to a foreign corporation does not qualify for non-
recognition of gain, notwithstanding that the transfer may
quality for non-recognition of gain, in whole or part, under
other provisions of the Code.
Effective Date
The provisions relating to sales or exchanges of CFC stock
apply to sales or exchanges after December 31, 2017.
The provision relating to reduction of basis in certain
foreign stock for the purposes of determining a loss is
effective for distributions made after December 31, 2017.
The provisions relating to transfer of loss amounts from
foreign branches to certain foreign corporations and to the
repeal of the active trade or business exception under section
367 apply to transfers after December 31, 2017.
C. Treatment of Deferred Foreign Income Upon Transition to
Participation Exemption System of Taxation and Deemed Repatriation at
Two-Tier Rate (sec. 14103 of the Act and secs. 78, 904, 907, and 965 of
the Code)
Explanation of Provision
In general
As part of the transition from a deferral system with
limitations to a system under which companies are eligible for
a 100-percent dividends received deduction with respect to
distributions of foreign earnings, the provision requires
certain foreign corporations to include as subpart F income the
untaxed and undistributed foreign earnings that were
accumulated by those corporations in taxable years since 1986.
The U.S. shareholders of those corporations are subject to tax
(``transition tax'') with respect to the shareholders' pro rata
shares of such subpart F income. The transition tax ensures
that undistributed foreign earnings that accrued before the
effective date of the participation exemption system are
subject to tax by the United States, allowing uniform
applicability of the participation exemption with respect to
post-enactment foreign earnings and profits of foreign
subsidiaries.
The provision generally requires that, for the last taxable
year beginning before January 1, 2018, any U.S. shareholder of
a specified foreign corporation \1681\ must include in income
its pro rata share of the accumulated post-1986 deferred
foreign income of the corporation. However, a portion of that
pro rata share of foreign earnings is deductible. The
deductible amount depends on the proportion of the deferred
earnings that are held in cash or other assets, resulting in a
reduced rate of tax applicable to the income includible under
this provision. A corresponding portion of the credit for
foreign taxes paid with respect to such income is disallowed,
thus limiting the credit to the taxable portion of the included
income. The separate foreign tax credit limitation rules of
section 904 continue to apply, with coordinating rules. The
transition tax generally may be paid over an eight-year period.
Special rules are provided for S corporations and REITs.
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\1681\ For purposes of this provision, a specified foreign
corporation is any CFC and any foreign corporation that has at least
one domestic corporation that is a U.S. shareholder. The term excludes
PFICs that are not also CFCs.
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Subpart F inclusion of deferred foreign income
The provision requires that certain pre-effective date
foreign earnings be treated as subpart F income of a deferred
foreign income corporation (``DFIC'') in the last taxable year
that begins before January 1, 2018. The increase in subpart F
income of the DFIC required by this provision (``the section
965 inclusion'') is the greater of two measurements of the
accumulated post-1986 deferred foreign income of the
corporation, i.e., the amount determined either as of November
2, 2017,\1682\ or as of December 31, 2017 (the ``measurement
date(s)'').
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\1682\ H.R. 1, Tax Cuts and Jobs Act, 115th Cong., was introduced
in the House of Representatives on November 2, 2017.
---------------------------------------------------------------------------
The transition tax applies to all U.S. shareholders of a
DFIC, which is any specified foreign corporation with
accumulated post-1986 deferred income that is greater than
zero. Consistent with the operation of subpart F in general and
of section 951 in particular, each U.S. shareholder of a DFIC
must include in income the shareholder's pro rata share of the
section 965 inclusion of the DFIC.
In determining whether a foreign corporation is a specified
foreign corporation with respect to a U.S. shareholder, the
shareholder must take into account the contemporaneous change
in the operation of the constructive ownership rules,\1683\
which are effective for the year of the transition tax.
Taxpayers must determine whether they have constructive
ownership in entities with respect to which they may not have
previously had a reporting or tax obligation under the Code.
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\1683\ Prior to enactment of the Act, Section 958(b)(4) provided
that the attribution rules of section 318 that would otherwise apply
are inapplicable if the result would attribute stock held by a foreign
person to a U.S. person. See, section 14213 of the Act and the
description thereof, at subpart I.B.
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Scope of accumulated post-1986 deferred foreign income
To determine whether a specified foreign corporation is a
DFIC, the U.S. shareholder must determine whether the
corporation has accumulated post-1986 deferred foreign income
greater than zero, based on the accumulated post-1986 deferred
foreign income as of the measurement date. The earnings and
profits taken into account for that measurement date include
all post-1986 earnings and profits that are (1) not
attributable to income that is effectively connected with the
conduct of a trade or business in the United States and thus
subject to current U.S. income tax, or (2) when distributed,
not excludible from the gross income of a U.S. shareholder when
distributed as previously taxed income under section 959.
Post-1986 earnings and profits are those earnings that
accumulated in taxable years beginning after 1986 (including
previously taxed earnings and profits), computed in accordance
with sections 964(a) and 986, for all periods during which the
corporation was a specified foreign corporation. Post-1986
earnings and profits are not reduced by distributions during
the taxable year to which the transition tax applies. The post-
1986 earnings and profits include earnings and profits
described in sections 959(c)(1) and (2), but do not include
earnings and profits that were accumulated by a foreign company
prior to attaining its status as a specified foreign
corporation.
The Secretary shall prescribe appropriate rules regarding
the treatment of accumulated post-1986 foreign deferred income
of specified foreign corporations that have shareholders who
are not U.S. shareholders. Such rules may also include rules
that are appropriate to implement the intent of the transition
tax and the use of November 2, 2017, the date of introduction,
as one of the measurement dates in order to establish a floor
for determining the post-1986 deferred foreign earnings and
profits. For example, guidance may address the extent to which
retroactive effective dates selected in entity classification
elections filed after introduction of the Act will be
permitted.\1684\
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\1684\ See, Treas. Reg. sec. 301.7701-3(c), under which an election
may specify an effective date up to 75 days prior to the date on which
the election is filed.
---------------------------------------------------------------------------
Deficits netted against accumulated post-1986 earnings and
profits
A U.S. shareholder may reduce (but not below zero) its
share of accumulated post-1986 earnings and profits from
specified foreign corporations by the shareholder's share of
deficits from other specified foreign corporations, including
netting against deficits of another U.S. shareholder in a
different U.S. ownership chain within the same U.S. affiliated
group. The income inclusion required of a U.S. shareholder from
DFICs under this transition rule is reduced by the portion of
the aggregate foreign earnings and profits deficit allocated to
that person by reason of that person's interest in an earnings
and profits deficit foreign corporation (``E&P deficit foreign
corporation''). An E&P deficit foreign corporation is any
foreign corporation that is a specified foreign corporation
with respect to the U.S. shareholder as of the date on which
accumulated earnings and profits are measured for that
corporation (November 2, 2017, or December 31, 2017, as the
case may be) and which has a deficit in post-1986 earnings and
profits as of that date.\1685\ Accordingly, deficits that a
foreign corporation accumulated prior to the U.S. shareholder
acquisition of its interest in that corporation may be taken
into account in determining the aggregate foreign earnings and
profits deficit of a U.S. shareholder. The netting permitted by
this rule is applied to the total earnings and profits of the
specified foreign corporation, without regard to whether the
earnings and profits and deficits were accumulated in the same
income category for foreign tax credit limitation purposes.
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\1685\ It is possible that a specified foreign corporation is
neither a DFIC nor an earnings and profits deficit foreign corporation,
despite having post-1986 earnings and profits greater than zero or a
deficit in accumulated post-1986 deferred foreign income.
---------------------------------------------------------------------------
For example, assume that a foreign corporation organized
after December 31, 1986 has $100 of accumulated earnings and
profits as of November 2, 2017, and December 31, 2017
(determined without diminution by reason of dividends
distributed during the taxable year, other than dividends
distributed to other specified foreign corporations), which
consist of $120 general limitation earnings and profits and a
$20 passive limitation deficit. Under generally applicable
rules, if the $20 passive limitation deficit was a hovering
deficit described in regulations, the foreign corporation's
post-1986 earnings and profits would be $100, but foreign tax
credits related to the hovering deficit would not be deemed
paid by the U.S. shareholder, because the deemed paid credits
are limited to the amount that is in proportion to the
absorption of the deficit by current earnings in the same
income category that gave rise to the deficit.\1686\ Solely for
purposes of calculating the amount of foreign income taxes
deemed paid by the U.S. shareholder with respect to an
inclusion under section 965, Congress intends that a hovering
deficit may be absorbed by current year earnings and profits
and the foreign income taxes related to the hovering deficit
may be added to the specified foreign corporation's post-1986
foreign income taxes in that separate category on a pro rata
basis in the year of inclusion.
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\1686\ See, Treas. Reg. sec. 1.367(b)-7(d)(2)(ii) (hovering deficit
offset rule) and (iii) (foreign income taxes related to a hovering
deficit).
---------------------------------------------------------------------------
The U.S. shareholder aggregates its pro rata share of the
foreign earnings and profits deficits of each E&P deficit
foreign corporation and allocates such aggregate amount among
the remaining specified foreign corporations. The aggregate
foreign earnings and profits deficit is allocable to a
specified foreign corporation in the same ratio as the U.S.
shareholder's pro rata share of post-1986 deferred income of
that corporation bears to the U.S. shareholder's pro rata share
of accumulated post-1986 deferred foreign income from all
deferred foreign income companies of such shareholder. The
earnings and profits of the E&P deficit foreign corporation
that are taken into account by a U.S. shareholder are increased
at the foreign corporation level by the amount of the specified
E&P deficit of such corporation that was used. Such increase
does not apply for purposes of determining post-1986
undistributed earnings under section 902.\1687\
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\1687\ See section 965(b)(4)(B). A technical correction may be
required to reflect this intent.
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Example 1
To illustrate the ratio, assume that Z, a domestic
corporation, is a U.S. shareholder with respect to each of four
specified foreign corporations, two of which are earnings and
profits deficit foreign corporations. Assume further the
foreign companies have the following accumulated post-1986
deferred foreign income or foreign earnings and profits
deficits as of November 2, 2017, and December 31, 2017:
----------------------------------------------------------------------------------------------------------------
Post-1986
Percentage Earnings and
Specified Foreign Corp. Owned Profits Pro rata Share
(Deficit) USD
----------------------------------------------------------------------------------------------------------------
A............................................................... 60% ($1,000) ($600)
B............................................................... 10% ($200) ($20)
C............................................................... 70% $2,000 $1,400
D............................................................... 100% $1,000 $1,000
----------------------------------------------------------------------------------------------------------------
The aggregate foreign earnings and profits deficit of the
U.S. shareholder is ($620), and the aggregate share of
accumulated post-1986 deferred foreign income is $2,400. Thus,
the portion of the aggregate foreign earnings and profits
deficit allocable to foreign corporation C is ($362), that is,
($620) 1400/2400. The remainder of the aggregate
foreign earnings and profits deficit is allocable to foreign
Corporation D. The U.S. shareholder has a net surplus of
earnings and profits in the amount of $1,780.
Example 2
The intragroup netting among U.S. shareholders in an
affiliated group in which there is at least one U.S.
shareholder with a net earnings and profits surplus and another
with a net earnings and profits deficit permits the net
earnings and profits surplus shareholder to reduce its net
surplus by the shareholder's applicable share of aggregate
unused earnings and profits deficit, based on the group's
ownership percentage of the members. For example, a U.S.
corporation may have two domestic subsidiaries, X and Y, in
which it owns 100 percent and 80 percent, respectively. If X
has a $1,000 net earnings and profits surplus, and Y has $1,000
net earnings and profits deficit, X is an earnings and profits
net surplus shareholder, and Y is an earnings and profits net
deficit shareholder. The net earnings and profits surplus of X
may be reduced by the net earnings and profits deficit of Y to
the extent of the group's ownership percentage in Y, which is
80 percent. The remaining net earnings and profits deficit of Y
is unused. If the U.S. shareholder Z from Example 1 is also a
wholly owned subsidiary of the same U.S. parent as X and Y, the
group ownership percentage of Y is unchanged, and the surpluses
of X and Z are reduced ratably by $800 of the net earnings and
profits deficit of Y.
In taxable years beginning after 2017, amounts by which a
U.S. shareholder's section 951 inclusion is reduced by
aggregate earnings and profits deficits are considered as
amounts included in the gross income of the U.S. shareholder.
The shareholder's pro rata share of the earnings and profits of
an E&P deficit foreign corporation that used qualified deficits
to reduce its section 965 inclusion is increased by the amount
of such deficit and attributed to the same activity to which
the income was attributed.
Partial participation exemption deduction
A U.S. shareholder is allowed a deduction under section
965(c) of a portion of its pro rata share of the section 965
inclusion from all DFICs. The deductible portion is a sum of an
amount equal to the 15.5-percent rate equivalent percentage of
the portion of the shareholder's pro rata share of the
inclusion amount that is the shareholder's aggregate cash
position plus the eight-percent rate equivalent percentage of
the portion of the inclusion that exceeds the aggregate cash
position. By stating the permitted deduction in the form of a
tax rate equivalent percentage rather than a flat rate of
deduction, the provision ensures that all pre-effective date
accumulated post-1986 deferred foreign income is subject to
corporate tax at either an 8-percent rate or a 15.5-percent
rate, without regard to the corporate tax rate that may be in
effect at the time the shareholder is required to report the
inclusion. For example, corporate U.S shareholders that use a
fiscal year as their taxable year may not be required to
include their pro rata share of the section 965 inclusions
until a taxable year for which a corporate tax rate lower than
that in effect for calendar year taxpayers for 2017 would
apply. The structure of the allowable deduction ensures that
amounts required to be included under sections 965 and 951 are
generally subject to U.S. tax at either an 8-percent or 15.5
percent rate.
Aggregate cash position
The aggregate cash position of a U.S. shareholder is the
shareholder's pro rata share of the earnings and profits
attributable to cash assets of specified foreign corporations.
It is the greater of the pro rata share of the cash position of
all specified foreign corporations of the U.S. shareholder as
of the last day of the last taxable year beginning before
January 1, 2018, or the pro rata share of the average of the
cash position of such corporations determined on the last day
of each of the two taxable years ending immediately before
November 9, 2017. If a specified foreign corporation does not
exist on any particular cash measurement date, its cash
position would be zero with respect to that date. For purposes
of this computation, the cash position of certain noncorporate
entities that would be treated as specified foreign
corporations if they were foreign corporations is also
included.
The cash position of a specified foreign corporation (or of
an entity treated as such) consists of all cash, net accounts
receivables, and the fair market value of the following
enumerated categories of assets: personal property of a type
that is actively traded on an established financial market
(other than stock in the specified foreign corporation),
government securities, certificates of deposit, commercial
paper, foreign currency, and short-term obligations with a term
of less than one year. In addition, the Secretary may identify
other assets to be treated as cash assets if the Secretary
determines that they are economically equivalent to the types
of property enumerated in the statute.
Certain exclusions from aggregate cash position of a U.S.
shareholder are specified in the provision. First, in limited
circumstances, the aggregate cash position does not include net
accounts receivable, short-term obligations, or property of a
type actively traded on an established financial market (e.g.,
publicly traded stock held by a specified foreign corporation.)
This exception from inclusion in the aggregate cash position is
limited to instances in which a U.S. shareholder can
demonstrate that the value of such asset was taken into account
as cash or cash equivalent by another specified foreign
corporation with respect to which such shareholder is a U.S.
shareholder.
Second, the aggregate cash position of a U.S. shareholder
does not generally include the cash attributable to a direct
ownership interest in a partnership. However, cash positions of
certain noncorporate foreign entities are taken into account if
such entities would be specified foreign corporations with
respect to the U.S. shareholder if the entity were a foreign
corporation. For example, if a U.S. shareholder owns a five-
percent interest in a partnership, the balance of which is held
by specified foreign corporations with respect to which such
shareholder is a U.S. shareholder, the partnership is treated
as a specified foreign corporation with respect to the U.S.
shareholder, and the portion of its earnings held in cash or
cash equivalent is includible in the aggregate cash position of
the U.S. shareholder on a look-through basis. The Secretary may
provide guidance for taking into account only the specified
foreign corporations' share of the partnership's cash position,
and not the five-percent interest directly owned by the U.S.
shareholder.
The provision grants the Secretary authority to disregard
transactions that the Secretary determines had the principal
purpose of reducing the aggregate foreign cash position.
Special rules
The rate equivalent percentages are intended to ensure that
deferred foreign income of U.S. shareholders is generally
subject to comparable rates of tax, without regard to the type
of U.S. person who is the shareholder or the different rates of
income tax to which a taxpayer may be subject. Individuals who
are U.S. shareholders, as well as the individual investors in
U.S. shareholders that are pass-through entities, may achieve
rate parity with corporate shareholders by electing application
of corporate rates for the year under inclusion, under section
962. That section allows such individual U.S. shareholders to
make the election for a specific taxable year, subject to
regulations provided by the Secretary. Consistent with the goal
of rate parity where possible, and to avoid duplicative tax on
the amounts included in income under this provision, the entire
amount of such inclusion, without reduction for the partial
participation exemption deduction, is considered previously
taxed income of the DFIC for purposes of subpart F.
Special rules complement the rules that generally govern
basis adjustments for U.S. shareholders that are not entities
organized under subchapter C.\1688\ First, for partners in a
partnership that is a U.S. shareholder of the DFIC, the
increase in partnership income that is not taxed by reason of
the partial dividends-received deduction available to the
partner is treated as income not exempt from tax for purposes
of determining the basis in an interest in a partnership.\1689\
As a result, the partner's section 951 inclusion requires an
adjustment to basis for the partner's distributive share of the
inclusion. Upon actual distribution, basis is decreased by the
amount of the distribution.
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\1688\ Sec. 965(f)(2)(A).
\1689\ Sec. 705(a)(1)(B).
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Similar rules apply to the determination of basis in stock
of an S corporation.\1690\ The general rules governing
adjustments to basis and the accumulated adjustment account
(``AAA'') of such corporations require an increase in basis,
with adjustments to the AAA in a manner similar to basis, with
several exceptions.\1691\ Among the exceptions is a rule that
the AAA is not adjusted for tax-exempt income. The general
rules require that both basis and the AAA increase by the
taxable portion of the section 951 inclusion, i.e., the
inclusion less the partial participation exemption deduction.
The special rule in section 965(f)(2) treats an amount equal to
the partial participation exemption deduction as income that is
tax-exempt and requires an increase in shareholder basis for
this amount, but as income that is not tax-exempt for purposes
of the AAA adjustment.\1692\ Thus, the entire section 951
inclusion increases both basis and the AAA. When subsequently
distributed to the shareholder in the S corporation, a decrease
in basis in the same amount is required.
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\1690\ Section 1361 defines an S corporation as a domestic small
business corporation that has an election in effect for status as an S
corporation, with fewer than 100 shareholders, none of whom are
nonresident aliens, and all of whom are individuals, estates, trusts or
certain exempt organizations.
\1691\ Secs. 1367 and 1368. Under section 1367(a)(1), a
shareholder's basis in an S corporation is increased by the amount
included in income by the shareholder, including by reason of section
965. This amount will also increase the S corporation's AAA pursuant to
section 1368(e)(1)(A). Under section 1367(a)(2), a shareholder's basis
in an S corporation is reduced by deductions, including the partial
participation exemption deduction. This amount also reduces the S
corporation's AAA pursuant to section 1368(e)(1)(A). Thus, both
shareholder basis and the S corporation's AAA are increased by the net
amount of the inclusion under section 965 (i.e., the amount included in
income under Section 965(a)(1) less the amount allowed as a deduction
under Section 965(c)).
\1692\ Secs. 1367(a)(1)(A) and 1368(e)(1)(A).
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Individual U.S. shareholders of a DFIC who do not make an
election under section 962 may claim the partial participation
exemption deduction in computing adjusted gross income, without
regard to limitations that may apply to itemized deductions.
The section 965(c) deduction is not treated as an itemized
deduction for any purpose.\1693\
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\1693\ A technical correction may be needed to reflect this intent.
Filing instructions published for the 2018 filing season reflect this
intent. See, Internal Revenue Service, ``Questions and Answers about
Reporting Related to Section 965 on 2017 Tax Returns,'' Appendix: Q&A2,
available at https://www.irs.gov/newsroom/questions-and-answers-about-
reporting-related-to-section-965-on-2017-tax-returns. See also, sec. 6,
Notice 2018-26.
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Foreign tax credits and the section 965(c) deduction
A portion of foreign income taxes deemed paid under section
960(a)(1) with respect to a U.S. shareholder's pro rata share
of section 965 inclusions is creditable against the Federal
income tax attributable to the inclusion. The portion that is
attributable to the nontaxed portion of the deferred foreign
income is neither creditable nor deductible. The disallowed
portion of foreign taxes deemed paid is 55.7 percent of the
foreign taxes deemed paid with respect to the inclusion
attributable to the aggregate cash position plus 77.1 percent
of the foreign taxes deemed paid with respect to the remaining
portion of the section 965 inclusion.\1694\ A similar portion
of foreign taxes paid, accrued or deemed paid with respect to
distributions of previously taxed earnings and profits that
result from an inclusion under section 965(a) (including taxes
imposed on distributions of previously taxed earnings and
profits that are the result of section 965(a)) is neither
creditable nor deductible. In addition, it is intended that no
deduction or credit is allowed for taxes associated with
earnings and profits that, by reason of section 965(b), are not
included in income.\1695\
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\1694\ Other foreign tax credits used by a taxpayer against tax
liability resulting from the deemed inclusion apply in full.
\1695\ A technical correction may be needed to reflect this intent.
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The provision coordinates the disallowance of foreign tax
credits described above with the requirement \1696\ that a
domestic corporate shareholder is deemed to receive a dividend
in an amount equal to foreign taxes it is deemed to have paid
and for which it claimed a credit. Under the coordination rule,
the foreign taxes deemed paid by a domestic corporation as a
result of the inclusion are limited to the portion of those
taxes in proportion to the taxable portion of the section 965
inclusion. The gross-up amount equals the total foreign income
taxes multiplied by a fraction, the numerator of which is the
taxable portion of the increased subpart F income under this
provision and the denominator of which is the total increase in
subpart F income under this provision.
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\1696\ Sec. 78.
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A U.S. shareholder may elect,\1697\ no later than with a
timely filed return for the taxable year, not to apply net
operating loss carryovers to reduce taxable income in that year
below the amount of the deemed repatriation. Depending on a
taxpayer's circumstances, a possible effect of this election
may be that the taxpayer offsets its U.S. tax in the transition
tax year with a foreign tax credit that, had net operating
losses reduced taxable income below the amount of the
inclusion, would have been carried forward to future tax years
to which the participation exemption regime applies. If the
election is made, neither the pro rata share of the section 965
inclusion (as reduced by the section 965(c) deduction), nor the
section 78 gross-up in the amount of any related deemed paid
foreign tax credits is taken into account in computing the
amount of the net operating loss incurred in, or the amount of
the net operating loss deduction allowed in that year.
Deductions, whether for current year expenses or for a net
operating loss carryover, taken into account in the election
year may not exceed gross income determined without regard to
the transition inclusion and related section 78 gross-up.\1698\
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\1697\ Sec. 965(n).
\1698\ A technical correction may be needed to reflect the intent.
The reference in section 965(n)(1)(A) to ``a net operating loss
deduction under section 172'' may be read to limit the election to a
taxpayer's net operating loss carryforwards and carrybacks, but not
allow losses in the year for which the election is made. However, any
deductions that are deferred to preserve a net operating loss for the
year may not also be deducted in the election year, so that the
taxpayer's taxable income for the year cannot be less than the amount
described in section 965(n)(2).
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Installment payments and special elections
Election to pay transition tax over eight years
A U.S. shareholder may elect to pay the net tax liability
that results from the inclusion of a pro rata share of the
section 965 inclusions in eight annual installments.\1699\ The
net tax liability eligible to be paid in installments is the
excess of the U.S. shareholder's net income tax for the taxable
year in which the section 965 inclusions are included in income
over the taxpayer's net income tax for that year determined
without regard to the inclusion of such earnings or any
dividend received by a U.S. shareholder from a DFIC. Net income
tax is defined as the regular tax liability less certain
nonrefundable credits.\1700\ Regular tax liability means
regular tax as defined in section 26, which includes neither
the minimum tax under section 59 nor the base erosion and anti-
abuse tax of section 59A. As a result, neither the alternative
minimum tax (if applicable in computing the tax liability
without regard to the section 965 inclusions) nor the base
erosion and anti-abuse tax is considered in determining the
portion of the tax liability that is eligible to be paid over
eight installments.\1701\
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\1699\ The amount due with each installment is a prescribed
percentage of the net tax liability, as follows: Each of installments
one through five equals eight percent of the net tax liability. The
sixth and seventh installments increase to 15 percent and 20 percent,
respectively. The eighth installment equals 25 percent.
\1700\ The credits taken into account for purposes of determining
the net tax liability are those described in sections 21 through 26
(nonrefundable personal credits), section 27 (taxes of foreign
countries or territories of the United States), section 30A (Puerto
Rican economic activity credit) sections 30B through 30D (related to
fuel or motor vehicle), and sections 38 through 45S (certain business
credits).
\1701\ A technical correction may be needed to reflect the
legislative intent.
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An election to pay tax in installments must be made by the
due date for the tax return for the taxable year in which the
pre-effective date undistributed CFC earnings are included in
income. The Secretary has authority to prescribe the manner of
making the election. The first installment must be paid on the
due date (determined without regard to extensions) for the tax
return for the taxable year of the income inclusion. Succeeding
annual installments are due no later than the due dates
(without extensions) for the income tax return of each
succeeding year. If a deficiency is later determined with
respect to the net tax liability, the additional tax due may be
prorated among all installment payments in most circumstances.
The portions of the deficiency prorated to an installment that
was due before the deficiency was assessed must be paid upon
notice and demand. The portion prorated to any remaining
installment is payable with the timely payment of that
installment payment, unless the deficiency is attributable to
negligence, intentional disregard of rules or regulations, or
fraud with intent to evade tax, in which case the entire
deficiency is payable upon notice and demand.
The timely payment of an installment does not incur
interest. If a deficiency is determined that is attributable to
an understatement of the net tax liability due under this
provision, the deficiency is payable with underpayment interest
for the period beginning on the date on which the net tax
liability would have been due, without regard to an election to
pay in installments, and ending with the payment of the
deficiency. Furthermore, any amount of deficiency prorated to a
remaining installment also bears interest on the deficiency,
but not on the original installment amount.
The provision also includes an acceleration rule. If (1)
there is a failure to pay timely any required installment, (2)
there is a liquidation or sale of substantially all of the U.S.
shareholder's assets (including in a bankruptcy case), (3) the
U.S. shareholder ceases business, or (4) another similar
circumstance arises, the unpaid portion of all remaining
installments is due on the date of the event (or, in a title 11
bankruptcy case or similar proceeding, the day before the
petition is filed).
Special rule for S corporations
A special rule permits deferral of the transition net tax
liability for shareholders of a U.S. shareholder that is itself
an S corporation and not subject to tax at the entity level.
The S corporation is required to report on its income tax
return for its last taxable year that begins before January 1,
2018, the amount that is includible in gross income by reason
of this provision, as well as the amount of deduction that
would be allowable, and provide a copy of such information to
each shareholder. Any shareholder of the S corporation may
elect to defer his or her portion of the net tax liability
until the shareholder's taxable year in which a triggering
event occurs. The election to defer the net tax liability is
due not later than the due date for the shareholder's tax
return for the taxable year that includes the close of the
taxable year in which the S corporation reports the inclusion
required by this provision.
Three types of events may trigger an end to deferral of the
net tax liability. The first type of triggering event is a
change in the status of the corporation as an S corporation.
The second category includes liquidation or sale of
substantially all corporate assets (including by reason of
reorganization in bankruptcy or similar proceeding),
termination of the company or end of business, or similar
event. The third type of triggering event is a transfer of
shares of stock in the S corporation by the electing taxpayer,
whether by sale, death, or otherwise, unless the transferee of
the stock agrees with the Secretary to be liable for net tax
liability in the same manner as the transferor. Partial
transfers trigger the end of deferral only with respect to the
portion of tax properly allocable to the portion of stock sold.
If a shareholder of an S corporation has elected deferral
under the special rule for S corporation shareholders and a
triggering event occurs, the S corporation and the electing
shareholder are jointly and severally liable for any net tax
liability and related interest or penalties. The period within
which the IRS may collect such liability does not begin before
the date of an event that triggers the end of the deferral. If
an election to defer payment of the net tax liability is in
effect for a shareholder, that shareholder must report the
amount of the deferred net tax liability on each income tax
return due during the period that the election is in effect.
Failure to include that information with each income tax return
will result in a penalty equal to five percent of the amount
that should have been reported.
After a triggering event occurs, a shareholder of the S
corporation may elect to pay the net tax liability in eight
installments, subject to rules similar to those generally
applicable to all U.S. shareholders, with certain exceptions.
If the triggering event is a liquidation, sale of substantially
all corporate assets, termination of the company or end of
business, or similar event, the installment payment election is
not available. Instead, the entire net tax liability is due
upon notice and demand. The installment election is due with
the timely return for the year in which the triggering event
occurs. The first installment payment is required by the due
date of the same return, determined without regard to
extensions of time to file.
Special rules for REITs
Special rules are also provided to address instances in
which the U.S. shareholder is a EIT. First, although the REIT
must determine its pro rata share of the increase in subpart F
income in accordance with the rules described above, the REIT
is not required to take into account the section 951 inclusion
for purposes of determining the REIT's amount of qualified REIT
gross income.\1702\ The section 951 inclusion is, however,
taken into account for purposes of determining the income
potentially required to be included in taxable income under
section 857(b).
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\1702\ To qualify as a REIT, an entity must meet certain income
requirements. A REIT is restricted to earning certain types of
generally passive income. Among other requirements, at least 75 percent
of the gross income of a REIT in each taxable year must consist of real
estate-related income. Sec. 856. In addition, a REIT is required to
distribute at least 90 percent of REIT income (other than net capital
gain) annually. Sec. 857. Even if a REIT meets the 90-percent income
distribution requirement for REIT qualification, more stringent
distribution requirements must be met to avoid an excise tax under
section 4981.
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A REIT is generally permitted to deduct the portion of its
income that is distributed to its shareholders as a dividend or
qualifying liquidating distribution each year.\1703\ The
distributed income of the REIT is not taxed at the entity
level; instead, it is taxed once, at the investor level.
Requiring inclusion under this section could trigger a
requirement that the REIT distribute an amount equal to 90
percent of that inclusion despite the fact that the REIT
received no distribution from the DFIC.
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\1703\ Liquidating distributions are covered to the extent of
earnings and profits, and are defined to include redemptions of stock
that are treated by shareholders as a sale of stock under section 302.
Secs. 857(b)(2)(B), 561, and 562(b).
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To avoid requiring that any distribution requirement be
satisfied in one year, a REIT may elect to defer a portion of
the section 951 inclusion. Under a timely election, a REIT may
instead take the amounts into income over a period of eight
years. It must include eight percent in each of the five years
beginning with the initial year in which the section 951
inclusion is determined, 15 percent in the sixth year, 20
percent in the seventh year and 25 percent in the eighth year.
In each of those years, it may claim a partial dividends-
received deduction in the applicable percentages in proportion
to the amount included in each of the eight years. If a timely
election is made by the REIT to defer inclusion, neither the
REIT nor its investors may invoke the installment payment
election.\1704\
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\1704\ Under section 965(m)(2)(B)(i)(III), a rule barring an
electing trust from making an election to pay in installments refers to
subsection (g), which deals with foreign tax credits, rather than
subsection (h). A technical correction may be needed to reflect the
correct cross-reference.
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In the event that a REIT liquidates, ceases to operate its
business, or distributes substantially all its assets (or any
other similar event occurs), any portion of the required
inclusion not yet taken into income is accelerated and required
to be included as gross income as of the day before the event.
Limitations on assessment extended
The provision establishes a minimum period of six years for
assessment of the transition tax, or underpayments with respect
to the transition tax, measured from the date on which the
return initially reflecting the section 951 inclusion was
filed. To the extent that such return was filed by a U.S.
shareholder that is a domestic partnership, a commensurate
extension of the period for making adjustments to a partnership
return is intended.\1705\ The provision does not operate to
shorten any otherwise applicable limitations period that would
provide a greater period for such adjustments or assessments.
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\1705\ A technical correction may be needed to reflect the intent.
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Recapture from expatriated entities
The partial participation exemption deduction is subject to
recapture if the U.S. shareholder that claimed the deduction
becomes an expatriated entity at any point during the 10 years
beginning on the date of enactment of the Act (December 22,
2017). An entity is subject to the recapture rule if it becomes
an expatriated entity with respect to which a foreign
corporation becomes a surrogate foreign corporation for the
first time during the same 10-year period. For purposes of this
rule, the terms expatriated entity and surrogate foreign
corporation are given the same meaning as those terms are
defined in section 7874(a)(2), except that a surrogate foreign
corporation that is treated as a domestic corporation under
section 7874(b) is not within the scope of this recapture
provision.
The recapture rule operates by increasing the tax in the
year of expatriation. The income tax otherwise due in the year
of expatriation is increased by an amount equal to 35 percent
of the claimed partial participation exemption deduction.
Although the amount due is computed by reference to the year in
which the deemed subpart F income was originally reported and
the deduction claimed, the additional tax arises and is
assessed for the taxable year in which the U.S. shareholder
becomes an expatriated entity. No credits are permitted to
offset the additional tax due as a result of the recapture
rule.
Regulatory authority
The provision specifies several areas for which regulatory
action is expected to carry out the intent of the provision and
to deter tax avoidance. With respect to the determination of
cash position, the provision specifically authorizes the
Secretary to identify other assets that are economically
equivalent to the enumerated assets that are treated as cash.
The provision also authorizes the Secretary to disregard
transactions that are determined to have the principal purpose
of reducing the aggregate foreign cash position. The specific
grants of regulatory authority complement the Secretary's
authority under the consolidated return provisions and allow
him to determine proper application of this section on a
consolidated basis for affiliated groups filing a consolidated
return.
To avoid double-counting of earnings (or double
noncounting) that may occur due to different measurement dates
applicable to specified foreign corporations within an
affiliated group or the timing of intragroup distributions, the
Secretary is required to provide guidance to adjust the amount
of post-1986 earnings and profits of a specified foreign
corporation to ensure that a single item of a specified foreign
corporation is taken into account only once in determining the
income of a U.S. shareholder subject to this provision. For
example, the Secretary may identify instances in which it is
appropriate to adjust the amount of post-1986 earnings and
profits of a specified foreign corporation to ensure that the
earnings and profits of the specified foreign corporation are
taken into account once. Such an adjustment may be necessary,
for example, when there is a deductible payment (e.g., interest
or royalties) from one specified foreign corporation to another
specified foreign corporation between measurement dates.
The grant of regulatory authority in the provision includes
a nonexhaustive list of examples of areas in which the
Secretary shall prescribe rules or guidance that are consistent
with the intent of the statute and deter tax avoidance through
use of entity classification elections and accounting method
changes, among other possible strategies (e.g., intragroup
transactions such as distributions or liquidations).
The Secretary has proposed regulations pursuant to this
provision.\1706\
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\1706\ See, Prop. Treas. Reg. sec. 1.965-1 et seq. Notice of
Proposed Rulemaking, 83 FR 39514, August 9, 2018.
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Effective Date
The provision is effective for the last taxable year of a
foreign corporation that begins before January 1, 2018, and
with respect to U.S. shareholders, for the taxable years in
which or with which such taxable year of the foreign
corporation ends.
SUBPART B--RULES RELATED TO PASSIVE AND MOBILE INCOME
A. Current Year Inclusion of Global Intangible Low-Taxed Income by U.S.
Shareholders (sec. 14201 of the Act and sec. 78 and new secs. 951A and
960(d) of the Code)
Explanation of Provision
In general
Under the provision, a U.S. shareholder \1707\ of any CFC
must include in gross income for a taxable year its global
intangible low-taxed income (``GILTI'') in a manner generally
similar to inclusions of subpart F income. GILTI means, with
respect to any U.S. shareholder for the shareholder's taxable
year, the excess (if any) of the shareholder's net CFC tested
income over the shareholder's net deemed tangible income
return. The shareholder's net deemed tangible income return
equals the excess (if any) of 10 percent of the aggregate of
its pro rata share of the qualified business asset investment
(``QBAI'') of each CFC with respect to which it is a U.S.
shareholder over certain interest expense. The interest expense
that reduces a U.S. shareholder's net deemed tangible income
return is the amount of interest expense taken into account in
determining its net CFC tested income for the taxable year to
the extent that the interest income attributable to such
interest expense is not taken into account in determining the
shareholder's net CFC tested income.
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\1707\ As determined under section 951A(e)(2), described below.
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The formula for GILTI, which is calculated at the U.S.
shareholder level, is:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
where Interest Expense is defined and limited in the manner
described above.\1708\
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\1708\ As the net deemed tangible income return cannot be less than
zero, the formula assumes that interest expense does not exceed 10
percent of QBAI. Otherwise, GILTI equals net CFC tested income.
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Although a GILTI inclusion is generally treated as a
subpart F inclusion, GILTI is not subpart F income. Unlike
subpart F income, GILTI is computed at the U.S.-shareholder
level rather than the CFC level, with a U.S. shareholder
allowed to offset tested income of its CFCs with tested loss of
other CFCs in computing net CFC tested income. U.S.
shareholders are not allowed certain other tax attributes of
CFCs with tested loss--such as foreign tax credits and QBAI--
when computing tax liability associated with GILTI. In
addition, the foreign tax credit limitation is applied
separately with respect to GILTI, and, in contrast with the
general rules allowing carryovers and carrybacks of excess
foreign tax credits, no carryovers and carrybacks of excess
foreign tax credits are allowed in the GILTI foreign tax credit
limitation category.
Net CFC tested income
Net CFC tested income means, with respect to any U.S.
shareholder, the excess of the aggregate of the shareholder's
pro rata share of the tested income of each CFC with respect to
which it is a U.S. shareholder over the aggregate of its pro
rata share of the tested loss of each CFC with respect to which
it is a U.S. shareholder.\1709\ Pro rata shares are determined
under subpart F principles (i.e., the rules of section
951(a)(2) and the regulations thereunder).
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\1709\ Sec. 951A(c)(1).
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The formula for net CFC tested income of the U.S.
shareholder is:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The tested income of a CFC is the excess (if any) of the
gross income of the CFC determined without regard to certain
amounts that are exceptions to tested income (referred to in
this document as ``gross tested income'') over deductions
(including taxes) properly allocable to such gross income. The
exceptions to a CFC's tested income are: (1) any effectively
connected income described in section 952(b); (2) any gross
income taken into account in determining the CFC's subpart F
income; (3) any gross income excluded from foreign base company
income or insurance income by reason of the high-tax exception
under section 954(b)(4); (4) any dividend received from a
related person (as defined in section 954(d)(3)); and (5) any
foreign oil and gas extraction income (as defined in section
907(c)(1)).
The tested loss of a CFC means the excess (if any) of
deductions (including taxes) properly allocable to the CFC's
gross tested income over the amount of such gross income.
For purposes of computing deductions (including taxes)
properly allocable to gross tested income, the deductions are
allocated to such gross income following rules similar to the
rules of section 954(b)(5) (or to which such deductions would
be allocable if there were such gross income).
Qualified business asset investment
QBAI means, with respect to any CFC for a taxable year, the
average of the aggregate of its adjusted bases, determined as
of the close of each quarter of the taxable year, in specified
tangible property used in its trade or business and of a type
with respect to which a deduction is generally allowable under
section 167.\1710\ The adjusted basis in any property is
determined by allocating the depreciation deduction with
respect to the property ratably to each day during the period
in the taxable year to which the depreciation relates, with
depreciation deductions calculated using the alternative
depreciation system under section 168(g) as in effect on the
date of enactment of the Act, unless a later enacted law
specifically and directly amends the definition of QBAI under
section 951A.
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\1710\ Sec. 951A(d)(1).
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Specified tangible property means any property used in the
production of tested income.\1711\ If such property was used in
the production of both gross tested income and gross income
that is not gross tested income (i.e., dual-use property), the
property is treated as specified tangible property in the same
proportion that the amount of gross tested income produced with
respect to the property bears to the total amount of gross
income produced with respect to the property.\1712\
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\1711\ Sec. 951A(d)(2). Specified tangible property does not
include property used in the production of tested loss, so that a CFC
that has a tested loss in a taxable year does not have QBAI for such
taxable year.
\1712\ A technical correction may be needed to reflect this intent.
For example, if a building produces $1,000 of gross tested income and
$250 of gross subpart F income for a taxable year, then 80 percent
($1,000/$1,250) of a CFC's average adjusted basis in the building is
included in QBAI for that taxable year.
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If a CFC holds an interest in a partnership at the close of
the CFC's taxable year, the CFC takes into account its
distributive share of the aggregate of the partnership's
adjusted basis (determined as of such date in the hands of the
partnership) in tangible property held by the partnership to
the extent that the property is used in the trade or business
of the partnership, is of a type with respect to which a
deduction is allowable under section 167, and is used in the
production of tested income (determined with respect to the
CFC's distributive share of income with respect to the
property). The CFC's distributive share of the adjusted basis
of any property is the CFC's distributive share of income with
respect to the property.
Coordination with subpart F
In contrast with subpart F income, which is a CFC amount,
GILTI is a U.S.-shareholder amount. Nonetheless, GILTI
inclusions are generally treated as subpart F inclusions.\1713\
In particular, GILTI inclusions are treated in the same manner
as amounts included as subpart F income for purposes of
applying sections 168(h)(2)(B), 535(b)(10), 904(h)(1), 959,
961, 962, 993(a)(1)(E), 996(f)(1), 1248(b)(1), 1248(d)(1),
6501(e)(1)(C), 6654(d)(2)(D), and 6655(e)(4).\1714\ The
Secretary may provide rules for treating GILTI inclusions as
amounts included as subpart F income for other provisions of
the Code in which the determination of subpart F income is
required to be made at the CFC level.
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\1713\ Under Rev. Proc. 2018-48, amounts included in gross income
by a REIT under sections 951(a)(1) (except by reason of section 965)
and 951A(a), among other provisions in the Code, are treated as
qualifying income for purposes of the gross income test under section
856(c)(2).
\1714\ Sec. 951A(f)(1).
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The provision requires that the total amount of GILTI
included by a U.S. shareholder be allocated across all CFCs
with respect to which it is a U.S. shareholder. The portion of
GILTI treated as being allocable to a CFC is zero for a CFC
with no tested income and is, for a CFC with tested income, the
portion of GILTI which bears the same ratio to the total amount
of GILTI as the U.S. shareholder's pro rata amount of the
tested income of the CFC bears to the aggregate amount of the
U.S. shareholder's pro rata amount of the tested income of each
CFC with respect to which it is a U.S. shareholder. For a CFC
with tested income, the following formula expresses how to
determine the portion of GILTI treated as being allocable to
the CFC:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
where Share of CFC's Tested Income is the U.S. shareholder's
pro rata amount of the tested income of a CFC, Share of Agg.
CFC Tested Income is the aggregate amount of the U.S.
shareholder's pro rata amount of the tested income of each CFC
with respect to which it is a U.S. shareholder, and GILTI is
the total amount of GILTI included by the U.S. shareholder.
For purposes of the provision, a person is treated as a
U.S. shareholder of a CFC for any taxable year of such person
only if the person owns (within the meaning of section 958(a))
stock in the foreign corporation on the last day in the taxable
year of the foreign corporation on which the foreign
corporation is a CFC.\1715\ A corporation is generally treated
as a CFC for any taxable year if the corporation is a CFC at
any time during the taxable year.
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\1715\ Sec. 951A(e)(2).
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Deemed-paid credit for taxes properly attributable to tested income
For any amount of GILTI included in the gross income of a
domestic corporation, the corporation is allowed a deemed-paid
credit equal to 80 percent of the corporation's inclusion
percentage multiplied by the aggregate (i.e., sum of) tested
foreign income taxes paid or accrued, with respect to tested
income (but not tested loss), by each CFC with respect to which
the domestic corporation is a U.S. shareholder.\1716\ The
inclusion percentage means, with respect to any domestic
corporation, the ratio (expressed as a percentage) of such
corporation's GILTI amount divided by the aggregate amount of
its pro rata share of the tested income (but not tested loss)
of each CFC with respect to which it is a U.S. shareholder
(referred to as ``aggregate tested income'' in the formulas
below). Tested foreign income taxes means, with respect to any
domestic corporation that is a U.S. shareholder of a CFC, the
foreign income taxes paid or accrued by the CFC that are
properly attributable to the CFC's tested income (but not
tested loss).\1717\
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\1716\ Sec. 960(d)(1). In addition, only 80 percent of foreign
income taxes paid or accrued (or treated as paid or accrued) with
respect to distributions out of income that was previously taxed as
GILTI are creditable under section 901, and the amount not creditable
is not deductible under section 901. A technical correction may be
needed to reflect this intent.
\1717\ Tested foreign income taxes do not include any foreign
income tax paid or accrued by a CFC that is properly attributable to
the CFC's tested loss (if any).
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The deemed-paid credit with respect to a U.S. shareholder's
GILTI inclusion can be expressed in the following formula:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The provision creates a separate foreign tax credit
limitation for GILTI, with no carryforward or carryback
available for excess credits.\1718\ For purposes of determining
the foreign tax credit limitation, GILTI is not general
category income, and income that is both GILTI and passive
category income is considered passive category income. As
provided in section 14301 of the Act and amended section 78,
the taxes deemed to have been paid are treated as a dividend
under section 78, determined by taking into account 100 percent
of the product of the inclusion percentage and aggregate tested
foreign income taxes (instead of 80 percent in the
determination of the deemed-paid credit). For foreign tax
credit limitation purposes, the section 78 gross-up amount
attributable to a GILTI inclusion is assigned to the basket to
which the related foreign taxes deemed paid were
allocated.\1719\
---------------------------------------------------------------------------
\1718\ Financial services income (sec. 904(d)(2)(C)(i)) is not
treated as passive category income for foreign tax credit limitation
purposes. A technical correction may be needed to reflect this intent.
In addition, the carryback and carryover rules for foreign oil and gas
taxes under section 907(f)(1) do not apply to taxes paid or accrued
with respect to GILTI. A technical correction may be needed to reflect
this intent.
\1719\ A technical correction may be needed to reflect this intent.
---------------------------------------------------------------------------
The section 78 gross-up amount can be expressed in the
following formula:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Regulatory authority to address abuse
Congress intends that non-economic transactions intended to
affect tax attributes of CFCs and their U.S. shareholders
(including amounts of tested income and tested loss, tested
foreign income taxes, net deemed tangible income return, and
QBAI) to minimize tax under this provision be disregarded. One
area of concern for Congress is certain planning related to
QBAI and the transition to the participation exemption system
created by the Act. The Secretary is expected to prescribe
regulations to address transactions undertaken to increase a
CFC's QBAI that occur after the measurement date of post-1986
earnings and profits under amended section 965, but before the
first taxable year for which new section 951A applies.
The Secretary has proposed regulations pursuant to this
provision.\1720\
---------------------------------------------------------------------------
\1720\ See Prop. Treas. Reg. sec. 1.951-1 et seq. Notice of
Proposed Rulemaking, 83 FR 51072, October 10, 2018.
---------------------------------------------------------------------------
Examples
The following examples illustrate how GILTI is calculated
for domestic corporations and allocated across CFCs. The
examples are highly stylized and are not meant to represent
actual taxpayer scenarios. These examples account for the 50-
percent deduction for GILTI available to domestic corporations
under new section 250 (described in section 14202 of the Act)
for taxable years beginning after December 31, 2017, and before
January 1, 2026.\1721\
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\1721\ For taxable years after December 31, 2025, the deduction for
GILTI and the GILTI-attributable section 78 gross-up amount is reduced
to 37.5 percent. The examples assume that the deduction is 50 percent
and therefore assume that the calculations are being performed with
respect to a taxable year of a domestic corporation beginning after
December 31, 2017, and before January 1, 2026.
---------------------------------------------------------------------------
Example 1: Two Wholly Owned CFCs, Each with Tested Income
Assume a domestic corporation, USCo, wholly owns two CFCs,
CFC1 and CFC2, and has no expenses or other sources of income.
These are the only CFCs with respect to which USCo is a U.S.
shareholder. The following table includes more information
about CFC1 and CFC2. Assume that their foreign sales income are
items of gross income included in the computation of tested
income, and that CFC1 and CFC2 each allocate all of their
expenses to their foreign sales income. Also assume that CFC1
and CFC2 each face a uniform tax rate across all their sources
of income.
FACTS FOR EXAMPLE 1
------------------------------------------------------------------------
CFC1 CFC2
------------------------------------------------------------------------
Gross Income:
Foreign Sales Income........ $300.............. $2,000
Subpart F Income............ $100.............. $0
Oil Extraction Income....... $600.............. $0
Expenses:
Operating Expenses.......... $200.............. $300
Net Income...................... $800.............. $1,700
Foreign Tax Rate................ 20 percent........ 5 percent
QBAI............................ $500.............. $0
------------------------------------------------------------------------
CFC-level calculations of tested income
CFC1 earns foreign sales income of $300 and has deductions
of $220 ($20 of taxes plus $200 of operating expenses)
allocable to its foreign sales income. The subpart F income and
oil extraction income are not included in tested income.
Therefore, it has tested income of $80 ($300-$220) and tested
foreign income tax of $20 (20 percent * [$300-$200]). CFC1 has
QBAI of $500.
CFC2 earns foreign sales income of $2,000 and has
deductions of $385 ($85 of taxes plus $300 of operating
expenses) allocable to its foreign sales income. Therefore, it
has tested income of $1,615 ($2,000-$385) and tested foreign
income tax of $85 (5 percent * [$2,000-$300]). CFC2 has QBAI of
$0.
U.S.-shareholder-level calculation of GILTI and U.S. tax
liability
USCo has net CFC tested income of $1,695, which is the sum
of CFC1's tested income of $80 and CFC2's tested income of
$1,615. Its pro rata share of QBAI is $500 ([100 percent *
$500] + [100 percent * $0]). Therefore, USCo's GILTI =
$1,695-(10 percent * $500) = $1,645.
USCo is allowed a deemed-paid credit equal to 80 percent of
its inclusion percentage multiplied by the aggregate tested
foreign income taxes paid or accrued by CFC1 and CFC2. Its
inclusion percentage is 97.05 percent (GILTI/Aggregate Tested
Income = $1,645/$1,695). With respect to USCo, the aggregate
tested foreign income taxes paid or accrued by CFC1 and CFC2 is
$105 ($20 + $85). Therefore, USCo's deemed-paid credit is 80
percent * 97.05 percent * $105 = $81.52.
USCo includes 100 percent of its GILTI and section 78
gross-up amount in gross income, or $1,746.90 ($1,645 +
$101.90).\1722\ It is allowed a deduction for 50 percent of
this amount, or $873.45, resulting in U.S. taxable income of
$873.45. The tentative U.S. tax owed on this income is the U.S.
corporate tax rate of 21 percent applied to USCo's taxable
income amount of $873.45, or $183.42.
---------------------------------------------------------------------------
\1722\ The section 78 gross-up amount = 100 percent * 97.05 percent
* $105 = $101.90.
---------------------------------------------------------------------------
The residual U.S. tax paid by USCo on its GILTI is its
tentative U.S. tax of $183.42 less its deemed-paid credit of
$81.52, or $101.90.
Allocation of GILTI across CFCs
USCo's GILTI amount is allocated across each CFC with
respect to which it is a U.S. shareholder based on the
percentage of its pro rata share of the tested income of all
CFCs that is accounted for by each CFC. The portion of USCo's
GILTI amount of $1,645 treated as being with respect to CFC1
equals $77.64 ($1,645 * [$80/$1,695]). The portion of USCo's
GILTI amount that is treated as being with respect to CFC2 is
the remainder, or $1,567.36 ($1,645 * [$1,615/$1,695]).
Example 2: Variant of Example 1, With Tested Loss
Example 2 generally has the same facts as Example 1, except
that CFC2 has foreign sales income of $360. Assume that CFC2
still pays foreign taxes of $85 with respect to its foreign
sales income. Thus, CFC2 has foreign sales income of $360 and
deductions of $385 ($85 of taxes plus $300 of operating
expenses) allocable to its foreign sales income. Therefore, it
has tested loss of $25 ($360-$385). Because CFC2 has a tested
loss, the foreign income taxes paid by CFC2 are not tested
foreign income taxes.
As in Example 1, CFC1 has tested income of $80 and tested
foreign income tax of $20.
U.S.-shareholder-level calculation of GILTI and U.S.
liability
USCo has net CFC tested income of $55, which is CFC1's
tested income of $80 less CFC2's tested loss of $25. Its pro
rata share of QBAI is $500 ([100 percent * $500] + [100 percent
* $0]).\1723\ Therefore, USCo's GILTI = $55-(10 percent * $500)
= $5.
---------------------------------------------------------------------------
\1723\ Note that a CFC that has a tested loss in a taxable year
(such as CFC2 in Example 2) does not have QBAI for such taxable year.
---------------------------------------------------------------------------
USCo is allowed a deemed-paid credit equal to 80 percent of
its inclusion percentage multiplied by the aggregate tested
foreign income taxes paid or accrued by CFC1 and CFC2. Its
inclusion percentage is 6.25 percent (GILTI/Aggregate Tested
Income = $5/$80). With respect to USCo, the aggregate tested
foreign income taxes paid or accrued by CFC1 and CFC2 is $20.
Therefore, USCo's deemed-paid credit is 80 percent * 6.25
percent * $20 = $1.
USCo includes 100 percent of its GILTI and section 78
gross-up amount in gross income, or $6.25 ($5 + $1.25).\1724\
It is allowed a deduction for 50 percent of this amount, or
$3.13, resulting in U.S. taxable income of $3.12 ($6.25-$3.13).
The tentative U.S. tax owed on this income is the U.S.
corporate tax rate of 21 percent applied to USCo's taxable
income amount, or $0.66.
---------------------------------------------------------------------------
\1724\ The section 78 gross-up amount = 100 percent * 6.25 percent
* $20 = $1.25.
---------------------------------------------------------------------------
The residual U.S. tax paid by USCo on its GILTI is its
tentative U.S. tax of $0.66 less its deemed-paid credit of $1,
or $0. The amount of USCo's deemed-paid credit that is unused,
$0.34, may not be carried back or carried forward.
Allocation of GILTI across CFCs
Because only CFC1 has tested income among each CFC with
respect to which USCo is a U.S. shareholder, all of USCo's
GILTI of $5 is allocated to CFC1.
Example 3: Multiple U.S. Shareholders and CFCs
Example 3 illustrates how GILTI is calculated when there
are multiple U.S. shareholders of one CFC, and each U.S.
shareholder wholly owns another CFC.
Consider two domestic corporations, US1 and US2. US1 wholly
owns CFC1 and owns 75 percent of the shares in CFC2. US2 wholly
owns CFC3 and owns 25 percent of the shares in CFC2. Neither
US1 nor US2 have expenses or other sources of income or own
shares in other CFCs besides the ones described.
Additional facts for Example 3 are described below. Assume
that gross income from foreign sales is included in the
computation of tested income for each CFC.
FACTS FOR EXAMPLE 3
----------------------------------------------------------------------------------------------------------------
CFC1 CFC2 CFC3
----------------------------------------------------------------------------------------------------------------
Gross Income:
Foreign Sales Income............. $1,500................. $2,000................. $700
Expenses:
Operating Expenses............... $200................... $300................... $800
Net Income........................... $1,300................. $1,700................. -$100
Foreign Tax Rate..................... 10 percent............. 5 percent.............. 15 percent
QBAI................................. $500................... $1,000................. $0
----------------------------------------------------------------------------------------------------------------
CFC-level calculations of tested income
CFC1 earns foreign sales income of $1,500, pays foreign
income tax of $130 (10 percent * $1,300), and has deductions of
$330 ($130 of taxes plus $200 of expenses) allocable to its
foreign sales income. Therefore, it has tested income of $1,170
($1,500-$330) and tested foreign income tax of $130. CFC1 has
QBAI of $500.
CFC2 earns foreign sales income of $2,000, pays foreign
income tax of $85 (5 percent * $1,700), and has deductions of
$385 ($85 of taxes plus $300 of expenses) allocable to its
foreign sales income. Therefore, it has tested income of $1,615
($2,000-$385) and tested foreign income tax of $85. CFC2 has
QBAI of $1,000.
CFC3 earns foreign sales income of $700, pays no foreign
income tax, and has deductions of $800 allocable to its foreign
sales income. Therefore, it has tested loss of $100. Because
CFC3 has tested loss, it has no QBAI.
U.S.-shareholder-level calculation of GILTI and U.S.
tax liability
US1's GILTI and U.S. tax liability
US1 has net CFC tested income of $2,381.25, which is the
sum of CFC1's tested income of $1,170 and US1's pro rata share
(75 percent) of CFC2's tested income of $1,615 (or $1,211.25).
US1 has aggregate tested foreign income tax of $193.75, which
is the sum of CFC1's tested foreign income tax of $130 and
US1's pro rata share of CFC2's tested foreign income tax of $85
(or $63.75). Its pro rata share of QBAI is $1,250 ([100 percent
* $500] + [75 percent * $1,000]). Therefore, US1's GILTI =
$2,381.25-(10 percent * $1,250) = $2,256.25.
US1 is allowed a deemed-paid credit equal to 80 percent of
its inclusion percentage multiplied by the aggregate tested
foreign income taxes paid or accrued by CFC1 and CFC2. Its
inclusion percentage is 94.8 percent (GILTI/Aggregate Tested
Income = $2,256.25/$2,381.25). The aggregate tested foreign
income taxes paid or accrued by CFC1 and CFC2 with respect to
US1 is $193.75. Therefore, US1's deemed-paid credit is 80
percent * 94.8 percent * $193.75 = $146.94.
US1 includes 100 percent of its GILTI and section 78 gross-
up amount in gross income, or $2,439.93 ($2,256.25 +
$183.68).\1725\
It is allowed a deduction of 50 percent of this amount, or
$1,219.97, resulting in U.S. taxable income of $1,219.96
($2,439.93-$1,219.97). The tentative U.S. tax owed on this
income is the U.S. corporate tax rate of 21 percent applied to
US1's taxable income of $1,219.96, or $256.19.
---------------------------------------------------------------------------
\1725\ The section 78 gross-up amount = 100 percent * 94.8 percent
* $193.75 = $183.68.
---------------------------------------------------------------------------
The residual U.S. tax paid by US1 on its GILTI is its
tentative U.S. tax of $256.19 less its deemed-paid credit of
$146.94, or $109.25.
US2's GILTI and U.S. tax liability
US2 has net CFC tested income of $303.75, which is its pro
rata share of CFC2's tested income ($403.75 = 25 percent *
$1,615) less the $100 in tested loss of CFC3. US2 has aggregate
tested foreign income tax of $21.25, which is 25 percent of
CFC2's tested foreign income tax of $85. Because CFC3 has a
tested loss, it has no tested foreign income tax and no QBAI.
US2's pro rata share of QBAI is $250 ([25 percent * $1,000] +
[100 percent * $0]). Therefore, US2's GILTI = $303.75-(10
percent * $250) = $278.75.
US2 is allowed a deemed-paid credit equal to 80 percent of
its inclusion percentage multiplied by its aggregate tested
foreign income taxes. Its inclusion percentage is 69 percent
(GILTI/Aggregate Tested Income = $278.75/$403.75). US2's pro
rata share of CFC2's tested foreign income tax is $21.25 (25
percent * $85). Therefore, US2's deemed-paid credit is 80
percent * 69 percent * $21.25 = $11.73.
US2 includes 100 percent of its GILTI and section 78 gross-
up amount in gross income, or $293.41 ($278.75 + $14.66).\1726\
It is allowed a deduction for 50 percent of this amount, or
$146.71, resulting in U.S. taxable income of $146.70
($293.41-$146.71). The tentative U.S. tax owed on this income
is the U.S. corporate tax rate of 21 percent applied to US2's
taxable income of $146.70, or $30.81.
---------------------------------------------------------------------------
\1726\ The section 78 gross-up amount = 100 percent * 69 percent *
$21.25 = $14.66.
---------------------------------------------------------------------------
The residual U.S. tax paid by US2 on its GILTI is its
tentative U.S. tax of $30.81 less its deemed-paid credit of
$11.73, or $19.08.
Allocation of GILTI across CFCs
US1 has $2,256.25 of GILTI to be allocated across each of
its CFCs with tested income. Its pro rata share of the
aggregate tested income of each CFC with respect to which it is
a U.S. shareholder is $2,381.25, with its pro rata share of
CFC1's tested income accounting for 49.1 percent ($1,170/
$2,381.25) and its pro rata share of CFC2's tested income
accounting for the remaining 50.9 percent. Therefore, the
amount of US1's GILTI allocated to CFC1 is $1,107.82 (49.1
percent * $2,256.25), while the remainder of $1,148.43 is
allocated to CFC2.
US2 has $278.75 of GILTI to allocate across each CFC with
tested income with respect to which it is a U.S. shareholder.
Since CFC3 has a tested loss, all of US2's GILTI of $278.25 is
allocated to CFC2.
As a result, the amount of GILTI allocated to each CFC by
both US1 and US2 is as follows: $1,107.82 for CFC1, $1,426.68
for CFC2, and $0 for CFC3.
Effective Date
The provision is effective for taxable years of foreign
corporations beginning after December 31, 2017, and for taxable
years of U.S. shareholders in which or with which such taxable
years of foreign corporations end.
B. Deduction for Foreign-Derived Intangible Income and Global
Intangible Low-Taxed Income (sec. 14202 of the Act and new sec. 250 of
the Code)
Explanation of Provision
In general
New section 250 allows a domestic corporation a 37.5-
percent deduction for its foreign-derived intangible income
(``FDII'') and a 50-percent deduction on the sum of its GILTI
and the amount treated as a dividend received by the
corporation under section 78 that is attributable to its GILTI
(referred to in this document as the ``GILTI-attributable
section 78 gross-up amount'').\1727\ FDII is a corporation's
deemed intangible income multiplied by the percentage of its
deduction eligible income that is derived from serving foreign
markets. A corporation's deemed intangible income equals the
excess (if any) of its deduction eligible income over a 10-
percent return on its qualified business asset investment
(``QBAI''). The formula for FDII can be expressed as the
following:
---------------------------------------------------------------------------
\1727\ The section 250 deduction is only available to C
corporations that are neither RICs nor REITs.
An S corporation's taxable income is computed in the same manner as
an individual (sec. 1363(b)) so that deductions allowable only to
corporations, including the section 250 deduction, do not apply. See
Report by the House Committee on Ways and Means to accompany H.R. 6055,
Subchapter S Revision Act of 1982, H. Rep. No. 97-826, p. 14; and
Report by the Senate Committee on Finance to accompany H.R. 6055,
Subchapter S Revision Act of 1982, S. Rep. 97-640, p. 15.
The Code provides that deductions for corporations provided in part
VIII of subchapter B, which include the section 250 deduction, do not
apply in computing RIC taxable income (sec. 852(b)(2)(C)) or REIT
taxable income (sec. 857(b)(2)(A)). Therefore, the section 250
deduction is not available for RICs or REITs.
In general, it is intended that the Secretary may provide that the
section 250 deduction be treated as exempting the deducted income from
tax. However, the section 250 deduction would not give rise to an
increase in a domestic corporate partner's basis in a domestic
partnership under section 705(a)(1)(B) because the deduction is allowed
at the domestic corporate partner level.
In addition, the section 250 deduction is computed after applying
the limitation on the deduction for business interest (sec. 163(j)) and
the limitation on the deduction for NOLs (sec. 172).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Note that, for purposes of determining FDII, deemed
intangible income is calculated on a formulaic basis and not on
an item-of-income basis. Although a factual inquiry is made to
determine which components of a corporation's overall income
are derived from serving foreign markets, no factual inquiry is
made to determine whether deemed intangible income is derived
from serving foreign markets.
Deduction for FDII and GILTI
In the case of domestic corporations for taxable years
beginning after December 31, 2017, and before January 1, 2026,
the provision generally allows as a deduction an amount equal
to the sum of 37.5 percent of the corporation's FDII plus 50
percent of the sum of its GILTI (if any) and GILTI-attributable
section 78 gross-up amount. For taxable years beginning after
December 31, 2025, the deduction for FDII is reduced to 21.875
percent and the deduction for GILTI is reduced to 37.5
percent.\1728\ As a result, for taxable years beginning after
December 31, 2017, and before January 1, 2026, the effective
U.S. tax rate (i.e., taking into account the effect of the
deduction) on FDII is 13.125 percent and the effective U.S. tax
rate on GILTI is 10.5 percent.\1729\ For taxable years
beginning after December 31, 2025, the effective U.S. tax rate
on FDII rises to 16.406 percent and the effective U.S. tax rate
on GILTI rises to 13.125 percent.
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\1728\ Sec. 250(a)(2)(B)(3).
\1729\ Due to the reduction in the effective U.S. tax rate
resulting from the deduction for FDII and GILTI, the Secretary is
expected to provide, as appropriate, regulations or other guidance
similar to that under amended section 965 with respect to the
determination of gain or loss under section 986(c).
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The Secretary is authorized to prescribe regulations or
other guidance as may be necessary or appropriate to carry out
this provision.\1730\
---------------------------------------------------------------------------
\1730\ Sec. 250(c).
---------------------------------------------------------------------------
Deduction eligible income
A domestic corporation's FDII is its deemed intangible
income multiplied by the percentage of its deduction eligible
income that is foreign-derived.\1731\ While deemed intangible
income and foreign-derived deduction eligible income are
calculated separately, the starting point for each calculation
is a corporation's deduction eligible income.
---------------------------------------------------------------------------
\1731\ Sec. 250(b)(1).
---------------------------------------------------------------------------
Deduction eligible income means, with respect to any
domestic corporation, the excess (if any) of the gross income
of the corporation determined without regard to certain amounts
that exceptions to deduction eligible income (referred to in
this document as ``gross deduction eligible income'') over
deductions (including taxes) properly allocable to such gross
income.\1732\ The exceptions to deduction eligible income are:
(1) any subpart F income included in the gross income of the
corporation under 951(a)(1); (2) any GILTI of the corporation;
(3) any financial services income (as defined in section
904(d)(2)(D)) of the corporation; (4) any dividend received
from a CFC with respect to which the corporation is a U.S.
shareholder; (5) any domestic oil and gas extraction income of
the corporation; (6) any foreign branch income (as defined in
new section 904(d)(2)(J)) of the corporation; (7) any income
received or accrued that is of a kind that would be foreign
personal holding company income (as defined in section
954(c));\1733\ and any amount included in gross income of the
corporation under section 1293.\1734\
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\1732\ Sec. 250(b)(3)(A).
\1733\ A technical correction may be needed to reflect this intent.
\1734\ A technical correction may be needed to reflect this intent.
---------------------------------------------------------------------------
Deemed intangible income
The domestic corporation's deemed intangible income means
the excess (if any) of its deduction eligible income over its
deemed tangible income return.\1735\ The deemed tangible income
return means, with respect to any corporation, an amount equal
to 10 percent of the corporation's QBAI. Deemed intangible
income can be calculated as follows:\1736\
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\1735\ Sec. 250(b)(2).
\1736\ If the quantity in this formula is negative, deemed
intangible income is zero.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Qualified business asset investment
For purposes of computing its FDII, a domestic
corporation's QBAI is the average of the aggregate of its
adjusted bases, determined as of the close of each quarter of
the taxable year, in specified tangible property used in its
trade or business and of a type with respect to which a
deduction is allowable under section 167.\1737\ The adjusted
basis in any property must be determined using the alternative
depreciation system under section 168(g) as in effect on the
date of enactment of the Act, unless a later enacted law
specifically and directly amends the definition of QBAI for
purposes of computing FDII.
---------------------------------------------------------------------------
\1737\ The definition of QBAI for purposes of computing FDII relies
on the definition of QBAI for purposes of computing GILTI under section
951A(d), determined by substituting ``deduction eligible income'' for
``tested income'' in section 951A(d)(2) and without regard to whether
the corporation is a controlled foreign corporation. Sec. 250(b)(2)(B).
---------------------------------------------------------------------------
Specified tangible property means any tangible property
used in the production of deduction eligible income.\1738\ If
such property was used in the production of gross deduction
eligible income and income that is not gross deduction eligible
income (i.e., dual-use property), the property is treated as
specified tangible property in the same proportion that the
amount of gross deduction eligible income produced with respect
to the property bears to the total amount of gross income
produced with respect to the property.\1739\ In other words,
the percentage of a domestic corporation's adjusted basis in
dual-use property that is included in QBAI equals the gross
deduction eligible income produced with respect to the property
divided by the total gross income produced with respect to the
property.
---------------------------------------------------------------------------
\1738\ The adjusted basis in any tangible depreciable property held
by a foreign branch is generally not included in QBAI for purposes of
computing FDII because foreign branch income is excluded from gross
deduction eligible income.
\1739\ A technical correction may be needed to reflect this intent.
For example, if a building is used in the production of $1,000 of total
gross income for a taxable year, $250 of which was gross domestic oil
and gas extraction income and the remaining $750 of which was gross
deduction eligible income, then 75 percent of a domestic corporation's
average adjusted basis in the building is included in QBAI for that
taxable year.
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Foreign-derived deduction eligible income
Foreign-derived deduction eligible income means, with
respect to a taxpayer for its taxable year, any deduction
eligible income of the taxpayer that is derived in connection
with (1) property that is sold by the taxpayer to any person
who is not a U.S. person \1740\ and that the taxpayer
establishes to the satisfaction of the Secretary is for a
foreign use \1741\ or (2) services provided by the taxpayer
that the taxpayer establishes to the satisfaction of the
Secretary are provided to any person, or with respect to
property, not located within the United States.\1742\
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\1740\ If property is sold by the taxpayer to a person who is not a
U.S. person, but the Federal government facilitates the transaction
purely as an intermediary (e.g., for certain foreign military sales),
income derived from the sale of such property may be treated as
foreign-derived deduction eligible income if the other requirements are
met. A technical correction may be needed to reflect this intent.
\1741\ If property is sold by a taxpayer to a person who is not a
U.S. person, and after such sale the property is subject to
manufacture, assembly, or other processing (including the incorporation
of such property, as a component, into a second product by means of
production, manufacture, or assembly) outside the United States by such
person, then the property is for a foreign use.
\1742\ Sec. 250(b)(4).
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Foreign use means any use, consumption, or disposition that
is not within the United States.\1743\ Special rules for
determining foreign use apply to transactions that involve
property or services provided to domestic intermediaries or to
certain related parties.\1744\
---------------------------------------------------------------------------
\1743\ Sec. 250(b)(5)(A).
\1744\ Secs. 250(b)(5)(B) and (C).
---------------------------------------------------------------------------
For purposes of determining foreign-derived intangible
income, the terms ``sold,'' ``sells''', and ``sale'' include
any lease, license, exchange, or other disposition.\1745\
---------------------------------------------------------------------------
\1745\ Sec. 250(b)(5)(E).
---------------------------------------------------------------------------
Property or services provided to domestic intermediaries
\1746\
---------------------------------------------------------------------------
\1746\ Sec. 250(b)(5)(B).
---------------------------------------------------------------------------
If a taxpayer sells property to another person (other than
a related party) for further manufacture or modification within
the United States, the property is generally not treated as
sold for a foreign use even if such other person subsequently
utilizes such property for foreign use.\1747\ Deduction
eligible income derived in connection with services provided to
another person (other than a related party) located within the
United States is not treated as foreign-derived deduction
eligible income, even if the other person uses the services in
providing services the income from which is considered foreign-
derived deduction eligible income.
---------------------------------------------------------------------------
\1747\ In other words, the fact that a component is included in
property that is eventually sold for a foreign use is insufficient for
the sale of the component to be considered for a foreign use.
---------------------------------------------------------------------------
Special rules with respect to certain related party
transactions \1748\
---------------------------------------------------------------------------
\1748\ Sec. 250(b)(5)(C).
---------------------------------------------------------------------------
If property is sold to a related foreign party, the sale is
not treated as for a foreign use unless (1) the property is
ultimately sold by a related party to (or used by a related
party in connection with property that is sold to or in
connection with the provision of services to) another person
who is an unrelated party who is not a U.S. person and (2) the
taxpayer establishes to the satisfaction of the Secretary that
such property is for a foreign use. Income derived in
connection with services provided to a related party who is not
located in the United States is not treated as foreign-derived
deduction eligible income unless the taxpayer establishes to
the satisfaction of the Secretary that such service is not
substantially similar to services provided by the related party
to persons located within the United States.\1749\
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\1749\ A clerical correction may be needed to reflect this intent.
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Related party
For purposes of determining foreign use, a related party
means any member of an affiliated group as defined in section
1504(a) determined by substituting ``more than 50 percent'' for
``at least 80 percent'' each place it appears and without
regard to sections 1504(b)(2) and 1504(b)(3).\1750\ Any person
(other than a corporation) is treated as a member of the
affiliated group if the person is controlled by members of the
group (including any entity treated as a member of the group by
reason of this sentence) or controls any member, with control
being determined under the rules of section 954(d)(3).
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\1750\ Sec. 250(b)(5)(D).
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Taxable income limitation
If the sum of a domestic corporation's FDII, GILTI, and
GILTI-attributable section 78 gross-up amounts exceeds its
taxable income determined without regard to this provision,
then the amount of FDII, GILTI, and GILTI-attributable section
78 gross-up for which a deduction is allowed is reduced (but
not below zero) by an amount determined by such excess.\1751\
The reduction in the amount of FDII for which a deduction is
allowed equals such excess multiplied by a percentage equal to
the corporation's FDII divided by the sum of its FDII, GILTI,
and GILTI-attributable section 78 gross-up amounts. The
reduction in the sum of the corporation's GILTI and GILTI-
attributable section 78 gross-up amounts for which a deduction
is allowed equals the remainder of such excess.\1752\
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\1751\ Technical corrections may be needed to reflect this intent.
\1752\ For example, consider a domestic corporation with $1,250 of
FDII, $650 of GILTI, and $100 of GILTI-attributable section 78 gross-
up, and taxable income (determined without regard to this provision) of
$1,500. The sum of the corporation's FDII, GILTI, and GILTI-
attributable section 78 gross-up amounts is $2,000, which exceeds
$1,500 by $500. For purposes of this provision, the amount of FDII for
which a deduction is allowed is reduced by $500 multiplied by $1,250/
$2,000, or $312.50. The sum of the amount of GILTI and GILTI-
attributable section 78 gross-up amounts for which a deduction is
allowed is reduced by the remainder of the excess, or $187.50 ($500 *
$750/$2,000).
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Illustration of effective tax rates on FDII and GILTI
This section provides an algebraic illustration of
effective tax rates on FDII and GILTI and shows how the
effective tax rates on FDII and GILTI may align. For
simplicity, the illustration assumes, among other things, that
the taxable income limitation is not binding, that the CFCs
relevant to the calculations each have tested income, and that
the domestic corporation has no expenses.\1753\ If these
assumptions do not hold, the effective tax rates on FDII and
GILTI may not align and the results below may change.
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\1753\ As under the law prior to enactment of the Act, U.S.
shareholders are required to allocate expenses to foreign-source income
for foreign tax credit limitation purposes based on principles
applicable prior to the enactment of the Act.
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As a result of the deduction, and with respect to domestic
corporations, the effective tax rate on FDII is 13.125 percent
and the effective U.S. tax rate on GILTI is 10.5 percent for
taxable years beginning after December 31, 2017, and before
January 1, 2026. Since only a portion (80 percent) of foreign
tax credits are allowed to offset U.S. tax on GILTI, the
minimum foreign tax rate, with respect to GILTI, at which no
U.S. residual tax is owed by a domestic corporation is 13.125
percent.\1754\ If the foreign tax rate on GILTI is zero
percent, then the U.S. residual tax rate on GILTI is 10.5
percent. Therefore, as foreign tax rates on GILTI range between
zero percent and 13.125 percent, the total combined foreign and
U.S. tax rate on GILTI ranges between 10.5 percent and 13.125
percent. At foreign tax rates greater than or equal to 13.125
percent, there is no residual U.S. tax owed on GILTI, so that
the combined foreign and U.S. tax rate on GILTI equals the
foreign tax rate.
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\1754\ The effective GILTI rate of 10.5 percent divided by 80
percent equals 13.125 percent. If the foreign tax rate on a particular
amount of GILTI is 13.125 percent, and domestic corporations are
allowed a credit equal to 80 percent of foreign taxes paid, then the
foreign tax rate, after accounting for the 80-percent haircut, on this
amount of GILTI equals 10.5 percent (13.125 percent * 80 percent),
which equals the effective GILTI rate of 10.5 percent. Therefore, no
U.S. residual tax is owed.
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For domestic corporations in taxable years beginning after
December 31, 2025, the effective tax rate on FDII rises to
16.406 percent and the effective U.S. tax rate on GILTI rises
to 13.125 percent. The minimum foreign tax rate, with respect
to GILTI, at which no U.S. residual tax is owed by a domestic
corporation rises to 16.406 percent.\1755\
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\1755\ Under the assumptions in this illustration of effective tax
rates, if the foreign tax rate on GILTI is zero percent, then the U.S.
residual tax rate on GILTI is 13.125 percent. Therefore, as foreign tax
rates on GILTI range between zero percent and 16.406 percent, the total
combined foreign and U.S. tax rate on GILTI ranges between 13.125
percent and 16.406 percent. At foreign tax rates greater than or equal
to 16.406 percent, there is no residual U.S. tax on GILTI, and the
combined foreign and U.S. tax rate on GILTI equals the foreign tax
rate.
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Example of FDII calculation
This example illustrates how the deduction for FDII is
calculated. Calculations related to GILTI can be found in the
explanation of section 14201 of the Act.
Consider USCo, a domestic corporation which has $5,000 of
gross deduction eligible income and $2,000 of deductions
allocable to that gross income. These are USCo's only items of
income and deductions, so that all its gross income is gross
deduction eligible income and all of its deductions are
allocable to its gross deduction eligible income.
USCo's deduction eligible income is its gross deduction
eligible income less deductions allocable to that income, or
$5,000 - $2,000 = $3,000. In this particular example, USCo's
deduction eligible income equals its taxable income. Assume
that USCo has established to the satisfaction of the Secretary
that $1,200 of its deduction eligible income is foreign-
derived, and that USCo has $10,000 of QBAI.
USCo's deemed intangible income equals its deduction
eligible income minus a 10 percent return on its QBAI, or
$3,000 - (10 percent * $10,000) = $2,000.
USCo's FDII is its deemed intangible income multiplied by
the percentage of its deduction eligible income that is
foreign-derived, or $2,000 * ($1,200/$3,000) = $800. USCo is
allowed a deduction of 37.5 percent on its FDII of $800, or
$300.
USCo's taxable income, less the deduction for FDII, is
$3,000 -- $300 = $2,700. Under a 21-percent corporate tax rate,
USCo's tax liability is $567 (21 percent * $2,700). Therefore,
the deduction for FDII has reduced the effective tax rate on
USCo's pre-deduction taxable income of $3,000 from 21 percent
to 18.9 percent ($567/$3,000).\1756\
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\1756\ USCo's effective tax rate is not reduced by the full amount
of the deduction (i.e., from 21 percent to 13.125 percent, or 7.875
percentage points). This is because only a portion (66.7 percent) of
USCo's deduction eligible income is deemed intangible income, and only
a portion (40 percent) of USCo's deduction eligible income is foreign-
derived. In this particular example, the rate reduction of 2.1
percentage points equals 7.875 percentage points * 66.7 percent * 40
percent.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
C. Repeal of Treatment of Foreign Base Company Oil Related Income as
Subpart F Income (sec. 14211 of the Act and sec. 954(a) of the Code)
Explanation of Provision
The provision eliminates foreign base company oil related
income as a category of foreign base company income.
Effective Date
The provision is effective for taxable years of foreign
corporations beginning after December 31, 2017, and for taxable
years of U.S. shareholders in which or with which such taxable
years of foreign corporations end.
D. Repeal of Inclusion Based on Withdrawal of Previously Excluded
Subpart F Income from Qualified Investment (sec. 14212 of the Act and
sec. 955 of the Code)
Explanation of Provision
Background on prior law
In 1975, foreign base company shipping income was added as
a category of subpart F income for taxable years beginning
after 1975. Foreign base company shipping income was income
derived from the use of an aircraft or vessel in foreign
commerce, the performance of services directly related to the
use of any such aircraft or vessel, the sale or other
disposition of any such aircraft or vessel, and certain space
or ocean activities (e.g., leasing of satellites for use in
space). A reinvestment exception permitted a CFC to defer
inclusion of foreign base company shipping income to the extent
that it was reinvested during the taxable year in certain
qualified shipping investments.\1757\ Subsequent net decreases
in qualified shipping investments were considered subpart F
income, to the extent of previously excluded subpart F income.
In the Tax Reform Act of 1986,\1758\ the reinvestment exception
was repealed, but foreign base company shipping income that was
previously deferred by reason of the reinvestment exception
remained deferred until a net decrease in such qualified
investments triggered an inclusion required by section 955. For
taxable years beginning after 2004, foreign base company
shipping income is no longer subpart F income. However, to the
extent that foreign base company shipping income deferred
before 1987 was withdrawn from qualified investments, it
remained subject to inclusion under section 955.
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\1757\ The qualified shipping investments were described in former
section 954(b)(2).
\1758\ Pub. L. No. 99-514 (October 22, 1986).
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Repeal of section 955
The provision repeals section 955. As a result, a U.S.
shareholder in a CFC that invested its previously excluded
subpart F income in qualified foreign base company shipping
operations is no longer required to include in income a pro
rata share of the previously excluded subpart F income when the
CFC decreases such investments.
Effective Date
The provision is effective for taxable years of foreign
corporations beginning after December 31, 2017, and to taxable
years of U.S. shareholders within which or with which such
taxable years of foreign corporations end.
E. Modification of Stock Attribution Rules for Determining Status as a
Controlled Foreign Corporation (sec. 14213 of the Act and secs. 318 and
958 of the Code)
Explanation of Provision
Background on prior law
The ownership attribution rules for determining
constructive ownership of corporate stock are modified for
purposes of determining U.S. shareholder status. Prior to the
Act, stock owned by a foreign person, regardless of the
ownership threshold, was not attributed to U.S. persons,
including domestic corporations, through so-called downward
attribution from a parent to its subsidiary.\1759\ As a result,
a wholly-owned domestic subsidiary of a foreign corporation was
not treated as owning stock in other foreign corporations owned
by the foreign parent.\1760\ In a common example, a new foreign
parent, or another non-CFC foreign affiliate, could transfer
property to a CFC in exchange for stock representing at least
50 percent of the voting power and value of the CFC. Such
transactions ``de-control'' the CFC, thus converting former
CFCs to non-CFCs, despite continuous ownership by the U.S.
shareholders, and avoiding the application of subpart F
provisions.
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\1759\ Secs. 318 and former 958(b)(4). Specifically, section
958(b)(4) provided that section 318(a)(3) did not apply to treat a U.S.
person as owning stock owned by a foreign person.
\1760\ Sec. 958(b)(4); Treas. Reg. sec. 1.958-2(d)(1)(iii).
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Change to the modification of stock attribution rules
The provision amends the ownership attribution rules by
repealing the paragraph that precluded downward attribution of
stock owned by a foreign person to a U.S. person. As a result,
certain stock of a foreign corporation owned by a foreign
person is attributed to a related U.S. person owned by the
foreign person for purposes of determining whether the related
U.S. person is a U.S. shareholder of the foreign corporation
and, therefore, whether the foreign corporation is a CFC. In
other words, the provision requires ``downward attribution''
from a foreign person to a related U.S. person in circumstances
in which prior law did not. Congress intended to render
ineffective certain transactions among related persons that are
used as a means of avoiding the subpart F provisions, including
the ``de-control'' transactions described above.\1761\ The pro
rata share of a CFC's subpart F income that a U.S. shareholder
is required to include in gross income, however, continues to
be determined based on direct or indirect ownership of the CFC,
without application of the new downward attribution rule.
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\1761\ A technical correction may be necessary to reflect the
intent expressed by Congress. See, Committee Report, Reconciliation
Recommendations Pursuant to H. Con. Res. 71, S. Prt. 115-20, December
2017, p. 378, as reprinted on the website of the Senate Budget
Committee, available at https://www.budget.senate.gov/taxreform, (the
Committee did not intend ``to cause a foreign corporation to be treated
as a controlled foreign corporation with respect to a U.S. shareholder
as a result of attribution of ownership under section 318(a)(3) to a
U.S. person that is a related person (within the meaning of section
954(d)(3)) to such U.S. shareholder as a result of the repeal of
section 958(b)(4)'') and Conference Report to accompany H.R. 1, H.R.
Report 115-466, December 15, 2017, pp. 633-634.
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Effective Date
The provision is effective for the last taxable year of
foreign corporations beginning before January 1, 2018, and each
subsequent year of such foreign corporations and for the
taxable years of U.S. shareholders in which or with which such
taxable years of foreign corporations end.
F. Modification of Definition of United States Shareholder (sec. 14214
of the Act and sec. 951 of the Code)
Explanation of Provision
U.S. shareholders of a CFC must include in their gross
income certain types of income and investments of the CFC that
otherwise would not be currently taxable to them under general
tax rules. The Act expands the definition of a U.S. shareholder
under section 951(b) to include not only (as under prior law) a
U.S. person who owns 10 percent of the voting stock of a
foreign corporation, but also any U.S. person who owns 10
percent or more of the total value of shares of all classes of
stock of a foreign corporation. This expanded definition of a
U.S. shareholder applies for all purposes of the Code.\1762\
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\1762\ For purposes of determining U.S. shareholder status, stock
owned directly, indirectly and constructively is taken into account.
See sec. 958. However, U.S. shareholders are subject to taxation under
subpart F only to the extent of their direct and indirect ownership.
Sec. 951(a).
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Section 1248 provides special rules for taxing U.S.
shareholders (and certain former U.S. shareholders) of a CFC
upon the disposition of stock in the CFC. These rules are
designed to insure that any gain recognized on the disposition
of CFC stock is taxed as ordinary income (rather than as
capital gain) to the U.S. shareholders to the extent of
earnings and profits of the CFC that had not previously been
subject to U.S. taxation under subpart F.\1763\ Accordingly,
section 1248(a)(2) should require ownership of at least 10
percent of the value or voting stock of the CFC during periods
in which the expanded definition of U.S. shareholder under
section 951(b) applies.\1764\
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\1763\ See S. Rep. No. 1881, 87th Cong., 2d Sess. 107 (1962).
\1764\ A technical correction may be necessary to reflect this
intent.
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Effective Date
The provision is effective for taxable years of foreign
corporations beginning after December 31, 2017, and for taxable
years of U.S. shareholders in which or with which such taxable
years of foreign corporations end.
G. Elimination of Requirement that Corporation Must Be Controlled for
30 Days Before Subpart F Inclusions Apply (sec. 14215 of the Act and
sec. 951(a)(1) of the Code)
Explanation of Provision
The provision eliminates the requirement that a corporation
must be a CFC for an uninterrupted period of 30 days in a
taxable year before a U.S. shareholder is required to include
its pro rata share of the subpart F income of the foreign
corporation. Instead, a U.S. shareholder is required to include
its pro rata share of the subpart F income of a foreign
corporation that is a CFC at any time during any taxable year
(assuming the stock ownership requirements of section 951(a)(1)
are satisfied with respect to the shareholder).
Effective Date
The provision is effective for taxable years of foreign
corporations beginning after December 31, 2017, and for taxable
years of U.S. shareholders with or within which such taxable
years of foreign corporations end.
H. Limitations on Income Shifting Through Intangible Property Transfers
(sec. 14221 of the Act and secs. 367 and 482 of the Code)
Explanation of Provision
Background on prior law
Profits from transfers of intangible property between
related taxpayers generally are allocated to each related
taxpayer by reference to the amount of profit that a similarly
situated taxpayer would realize in similar transactions with
unrelated parties.\1765\ A U.S. person may transfer intangible
property to a related person (typically, a foreign affiliate)
in one of four ways.\1766\ Whether for purposes of determining
gain recognition under section 367(d) or determining whether
profits should be reallocated under section 482, the definition
of intangible property was found in the former section
936(h)(3)(B).\1767\ That provision defined intangible property
to include the several enumerated categories, including ``any
similar item.'' \1768\ Recurring definitional and
methodological issues have arisen in controversies with respect
to the identification and appropriate valuation of intangible
property transferred in related party transactions.\1769\
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\1765\ See discussion of intercompany transfers in the summary of
Prior Law above.
\1766\ The four methods are an outright transfer of the intangible
property; a license of the intangible property, in which the U.S.
person transfers less than all substantial rights in the intangible
property to the foreign affiliate; the provision of a service by the
U.S. person to the foreign affiliate using the intangible property,
rather than a direct transfer of the property; and finally, a transfer
by the U.S. person of intangible property through a qualified cost-
sharing arrangement with one or more foreign affiliates, under which
the participants make resources available and contribute funds (through
a combination of cash and existing intangible property rights) toward
the joint development of a new marketable product or service. The
method of transfer may determine whether the applicable section is
section 482 or section 367(d). Special rules may apply in the case of a
U.S. taxpayer's transfer or property to a partnership with related
foreign partners under sections 704(c) and 721(c) and related
regulations.
\1767\ Sec. 936(h)(3)(B). The operative definition of intangible
property, as amended by the Act, was moved to section 367(d) as a
conforming amendment to the repeal of section 936 as deadwood, in the
Consolidated Appropriations Act 2018. See, Pub. L. No. 115-141,
Division U, Title IV, at sec. 401(d)(1)(C) (the repeal of section 936)
and sec. 401(d)(1)(D)(viii)(I) (definition of intangible property added
to section 367(d)) (March 23, 2018).
\1768\ Prior to amendment, subparagraph (B) of section 936(h)(3)
and its concluding flush language read as follows: The term
``intangible property means any--(i) patent, invention, formula,
process, design, pattern or know-how; (ii) copyright and literary,
musical or artistic composition; (iii) trademark, trade name or brand
name; (iv) franchise, license or contract; (v) method, program, system,
procedure, campaign, survey, study, forecast, estimate, customer list
or technical data; or (vi) any similar item, which has substantial
value independent of any individual.
\1769\ Veritas v. Commissioner, 133 T.C. No. 14 (December 10,
2009), (including goodwill and going concern value within the
definition would ``expand'' the regulatory definition in effect for the
tax year before the Court), non-acq., IRB 2010-49 (December 6, 2010).
Amazon v. Commissioner, 148 T.C. No. 8 (2017) (holding that ``workforce
in place, going concern value, goodwill, and what trial witnesses
described as `growth options' and corporate `resources' or
`opportunities' '' all fell outside the definition under prior law).
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Extensive guidance promulgated under section 482 with
respect to intangibles provide guidance on how to determine
whether the intangibles transferred should be valued
collectively or separately. The interrelation of intangible
assets that are transferred in one or more contemporaneous
transactions may produce synergies that increase the value of
the assets if viewed in the aggregate, compared to the sum of
values assigned if assets are valued asset-by-asset. If a
valuation method fails to take into account such synergies, it
may not reach an arm's length result.\1770\
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\1770\ See Treas. Reg. secs. 1.482-1(f)(2), 1.482-4(c)(1) and
1.482-1T (sunset September 14, 2018).
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The regulations also establish a realistic alternative
principle that underlies the evaluation of all transfer pricing
methodologies for a transfer of intangibles. In determining the
income attributable to a taxpayer that participated in a
specific transfer of intangibles, the method of valuation
chosen must yield results consistent with the economic results
from alternative arrangements that were realistically available
to that taxpayer. The degree of consistency between anticipated
benefits from the transactions under the chosen pricing method
and the anticipated benefits of a realistic alternative to the
transaction indicates the reliability and appropriateness of
the valuation.\1771\ This principle is predicated on the notion
that a taxpayer enters into a particular transaction only if
none of its realistic alternatives is economically preferable
to the transaction under consideration.
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\1771\ See Treas. Reg. sec. 1.482-7(g)(2)(iii) and Exs. (1), (2)
and (3), thereunder.
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Revisions to definition of intangible property
The provision revises the definition of intangible
property. First, it adds any goodwill (both foreign and
domestic), going concern value and workforce in place to the
list of specific property within the scope of the definition.
The residual category of ``any similar item'' is replaced by
``any item the value of which is not attributable to tangible
property or the services of any individual'' and flush language
at the end of the former subparagraph is removed, thus
clarifying that neither source nor amount of value is relevant
to determining whether property in one of the other enumerated
categories of intangible property is within the scope of the
definition.
Codification of valuation guidance
The provision also clarifies the authority of the Secretary
to specify the method to be used to determine the value of
intangible property that is transferred. It does not modify the
basic approach of the existing transfer pricing rules with
regard to income from intangible property. In particular, the
provision amends section 482 and expands the grant of
regulatory authority under section 367 to make clear that the
IRS may require the use of aggregate basis valuation and may
apply the realistic alternative principle in valuation of
intangibles transferred in either outbound restructuring of
U.S. operations or intercompany pricing allocations.\1772\
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\1772\ Secs. 367(d) and 482.
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The provision requires the use of the aggregate basis
valuation method in cases in which multiple intangible
properties are transferred in one or more related transactions
if the Secretary determines that the result of the aggregation
method is a more reliable measure of the income properly
allocable to a taxpayer. This approach is consistent with Tax
Court decisions in cases outside of the section 482 context,
where collections of multiple, related intangible assets were
viewed by the Tax Court in the aggregate.\1773\ Finally, it is
also consistent with the cost-sharing regulations.\1774\
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\1773\ See, e.g., Kraft Foods Co. v. Commissioner, 21 T.C. 513
(1954) (thirty-one related patents must be valued as a group and the
useful life for depreciation should be based on the average of the
patents' useful lives); Standard Conveyor Co. v. Commissioner, 25
B.T.A. 281, p. 283 (1932) (``[I]t is evident that it is impossible to
value these seven patents separately. Their value, as in the case of
many groups of patents representing improvements on the prior art,
appears largely to consist of their combination.''); Massey-Ferguson,
Inc. v. Commissioner, 59 T.C. 220 (1972) (taxpayer who abandoned a
distribution network of contracts with separate distributorships was
entitled to an abandonment loss for the entire network in the taxable
year during which the last of the contracts was terminated because that
was the year in which the entire intangible value was lost).
\1774\ See Treas. Reg. sec. 1.482-7(g)(2)(iv) (if multiple
transactions in connection with a cost-sharing arrangement involve
platform, operating and other contributions of resources, capabilities
or rights that are reasonably anticipated to be interrelated, then
determination of the arm's-length charge for platform contribution
transactions and other transactions on an aggregate basis may provide
the most reliable measure of an arm's-length result).
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The provision codifies application of the realistic
alternative principle to determine valuation of transferred
intangible property. As a result, the IRS may require that an
arm's-length price be determined by reference to a transaction
(for example, the U.S. owner of intangible property such as a
patent uses it to manufacture a product) that is different from
the transaction that was actually completed (the U.S. owner of
that same intangible property licenses the manufacturing rights
to a foreign affiliate and then buys the resulting product from
the licensee).
Effective Date
The provision applies to transfers in taxable years
beginning after December 31, 2017. No inference is intended
with respect to application of section 936(h)(3)(B) or the
authority of the Secretary to provide by regulation for such
application with respect to taxable years beginning before
January 1, 2018.
I. Certain Related Party Amounts Paid or Accrued in Hybrid Transactions
or With Hybrid Entities (sec. 14222 of the Act and sec. 267A of the
Code)
Explanation of Provision
In general
The provision denies a deduction for any disqualified
related party amount that is paid or accrued pursuant to a
hybrid transaction or that is paid by or to a hybrid entity. A
disqualified related party amount is any interest or royalty
paid or accrued to a related party to the extent that: (1)
there is no corresponding inclusion to the related party under
the tax law of the country of which such related party is a
resident for tax purposes or in which such related party is
subject to tax, or (2) such related party is allowed a
deduction with respect to such amount under the tax law of such
country. A disqualified related party amount does not include
any payment to the extent such payment is included in the gross
income of a U.S. shareholder under subpart F. In general, a
related party is any person that controls, or is controlled by,
the taxpayer, with control being direct or indirect ownership
of more than 50 percent of the vote, value, or beneficial
interests of the relevant person.
Hybrid transactions
A hybrid transaction is any transaction, series of
transactions, agreement, or instrument one or more payments
with respect to which are treated as interest or royalties for
Federal income tax purposes and which are not so treated for
purposes of the tax law of the foreign country of which the
recipient of such payment is resident for tax purposes or in
which the recipient is subject to tax.
Hybrid entities
A hybrid entity is any entity which is either: (1) treated
as fiscally transparent for Federal income tax purposes but not
so treated for purposes of the tax law of the foreign country
of which the entity is resident for tax purposes or in which
the entity is subject to tax, or (2) treated as fiscally
transparent for purposes of the tax law of the foreign country
of which the entity is resident for tax purposes or in which
the entity is subject to tax but not so treated for Federal
income tax purposes.
Regulatory authority
The Secretary has broad authority to issue regulations or
other guidance as may be necessary or appropriate to carry out
the purposes of the provision, including by issuing regulations
or other guidance providing: (1) rules for treating certain
conduit arrangements which involve a hybrid transaction or
hybrid entity as subject to the provision; (2) rules for
applying this provision to branches (domestic or foreign) or
domestic entities, even if such branches or entities do not
meet the statutory definition of a hybrid entity; \1775\ (3)
rules for applying this provision to certain structured
transactions; (4) rules for denying all or a portion of a
deduction claimed for an interest or a royalty payment that, as
a result of the hybrid transaction or entity, is included in
the recipient's income under a preferential tax regime of the
country of residence of the recipient and has the effect of
reducing the country's generally applicable statutory tax rate
by at least 25 percent; (5) rules for denying all of a
deduction claimed for an interest or a royalty payment if such
amount is subject to a participation exemption system or other
system which provides for the exclusion or deduction of a
substantial portion of such amount; (6) rules for determining
the tax residence of a foreign entity if the foreign entity is
otherwise considered a resident of more than one country or of
no country; (7) exceptions to the general rule set forth in the
provision with respect to (A) cases in which the disqualified
related party amount is taxed under the laws of a foreign
country other than the country of which the related party is a
resident for tax purposes, and (B) other cases which the
Secretary determines do not present a risk of eroding the
Federal tax base; and (8) requirements for record keeping and
information in addition to any requirements imposed by section
6038A.
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\1775\ For example, Treasury may issue guidance that addresses
certain disregarded branch structures or diverted branch payments.
Unlike hybrid mismatches, branch mismatches could arise when the
ordinary rules for allocating income and expenditure between a branch
and head office result in a portion of the taxpayer's net income
escaping tax in both the branch and residence jurisdictions.
A simple example illustrates a disregarded branch structure. Assume
a foreign multinational corporation (``Foreign Parent'') resident in
country X has a U.S. subsidiary (``U.S. Sub'') and forms a separate
financing branch in the United States (``U.S. Branch'') which lacks
sufficient presence in the United States to be subject to Federal
income tax. Foreign Parent lends money to U.S. Sub through U.S. Branch.
Country X exempts or excludes the interest paid by U.S. Sub to U.S.
Branch from taxation on the grounds that it is attributable to a
foreign branch. U.S. Branch's interest income is not, however, taxed in
the United States because U.S. Branch does not have sufficient presence
in the United States for its interest to be subject to tax there. Thus,
the result of this disregarded branch structure is a deduction for the
interest paid by U.S. Sub to U.S. Branch, with no corresponding income
inclusion for Foreign Parent in either country X or the United States.
A diverted branch payment has the same structure and outcome as a
payment to a disregarded branch. The mismatch arises, however, not
because of conflict in the characterization of the branch, but rather
as a result of a difference between the laws of the residence and
branch jurisdictions in the attribution of the payments to the branch.
For example, consider the same facts as above, except that now the
United States treats U.S. Branch as subject to Federal income tax. A
mismatch may still arise if U.S. Branch treats the interest payment as
made directly to the Foreign Parent head office in country X, while the
Foreign Parent head office treats the payment as made to U.S. Branch.
---------------------------------------------------------------------------
The Secretary's authority includes addressing overly broad
or under-inclusive application of this provision. An example of
an under-inclusive application of provision may involve an
imported mismatch arrangement (i.e., an arrangement where
deductible payments made through an intermediary payee are not
taxable on ultimate receipt). To illustrate this type of
arrangement, assume that a foreign multinational corporation
(``Foreign Parent'') resident in country X has a foreign
subsidiary in country Y (``Foreign Sub''), which in turn wholly
owns a U.S. corporation (``U.S. Sub''). Foreign Parent
capitalizes Foreign Sub with cash in exchange for a hybrid
instrument that is treated as debt for country Y purposes, but
as equity for country X purposes. Foreign Sub then lends the
cash to U.S. Sub in exchange for a note on which interest paid
is deductible. The result is a deduction for interest in the
United States, and an inclusion (of interest income) offset by
a deductible payment on the hybrid instrument by Foreign Sub in
country Y. Furthermore, the payment on the hybrid instrument
made by Foreign Sub to Foreign Parent may not be includible to
Foreign Parent in country X if such payment is treated as a
distribution on equity that is exempt from taxation in country
X.
A similar example might involve a hybrid entity. Using the
same facts as above, assume Foreign Parent and a country X
subsidiary (``Foreign X Sub'') form a financing company in
country Y that is treated as a partnership for country Y
purposes and as a corporation for country X purposes (``Reverse
Hybrid''). Reverse Hybrid lends cash to U.S. Sub in exchange
for a note on which interest paid is deductible. Interest
income of Reverse Hybrid is not includible to Foreign Parent
and Foreign Sub in country X. Furthermore, country Y does not
impose tax on interest income of Reverse Hybrid. The result is
a deduction for interest in the United States with no
corresponding income inclusion in either country X or Y.
An example of an overly broad application of this provision
may involve a debt issuance that is primarily targeted and sold
to a tax-exempt domestic investor base, but a minor portion of
which is acquired by unrelated persons who benefit from hybrid
treatment in their countries of residence. Such a debt issuance
should not be considered a structured transaction because the
hybrid treatment is unrelated to the tax-exempt status of the
domestic investor base. Treasury may also issue guidance
identifying circumstances under which the hybrid nature of a
transaction or entity is deemed to be unrelated to the
application of a preferential tax regime. For example, assume
Foreign Parent from country X wholly owns U.S. Sub, which
wholly owns an entity that is disregarded for U.S. tax purposes
(``DRE''). DRE pays a royalty directly to Foreign Parent.
Several years after the formation of DRE, country X implements
a preferential tax regime under which royalties paid by DRE to
Foreign Parent are subject to a reduced rate of tax. Under
these facts, Treasury could determine that the hybrid nature of
DRE is unrelated to the application of country X's preferential
regime.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
J. Shareholders of Surrogate Foreign Corporations Not Eligible for
Reduced Rate on Dividends (sec. 14223 of the Act and sec.
1(h)(11)(C)(iii) of the Code)
Explanation of Provision
The provision states that dividends from certain surrogate
foreign corporations are excluded from qualified dividend
income within the meaning of section 1(h)(11)(B) and are
ineligible to be taxed as net capital gains. As a result,
individual shareholders in such corporations cannot claim the
reduced rate on dividends. The term surrogate foreign
corporation is given the same meaning as in section 7874 and
generally refers to a foreign corporation that is a surrogate
for a domestic entity that migrated its tax home from the
United States to a foreign jurisdiction pursuant to a plan or
series of related transactions completed after March 4,
2003.\1776\ However, this provision applies only to those
companies that first become surrogate foreign corporations
after date of enactment.
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\1776\ Under section 7874(a)(2)(B), a foreign-incorporated entity
is a surrogate foreign corporation if, pursuant to a plan, (1) the
foreign entity acquired substantially all properties held by a domestic
corporation (or properties constituting a trade or business of a
domestic partnership); (2) at least 60 percent but less than 80 percent
(by vote or value) of the stock of the foreign entity after the
transaction is held by the former shareholders of the domestic
corporation (by reason of the stock they had held in the domestic
corporation), and (3) the foreign corporation, considered together with
all companies connected to it by a chain of greater than 50 percent
ownership (that is, the ``expanded affiliated group''), does not have
substantial business activities in the entity's country of
incorporation, compared to the total worldwide business activities of
the expanded affiliated group.
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Effective Date
The provision is effective for dividends received after the
date of enactment (December 22, 2017).
SUBPART C--MODIFICATIONS RELATED TO FOREIGN TAX CREDIT SYSTEM
A. Repeal of Section 902 Indirect Foreign Tax Credits; Determination of
Section 960 Credit on Current Year Basis (sec. 14301 of the Act and
secs. 902, 960, and 78 of the Code)
Explanation of Provision
Background on prior law
The United States allows a foreign tax credit for foreign
taxes paid on income derived from direct operations (conducted,
e.g., through a branch office) or passive investments in a
foreign country. Under prior law, the United States also
allowed a credit with respect to dividends received from
foreign subsidiary corporations out of earnings that had been
subject to foreign taxes.\1777\ The latter credit is called a
deemed-paid credit or an indirect credit.
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\1777\ Sec. 902.
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The United States also provides a deemed-paid credit with
respect to any income inclusion under subpart F.\1778\ Under
prior law, the deemed-paid credit is limited to the amount of
foreign income taxes \1779\ that would have been deemed paid if
the inclusion were treated as a dividend.
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\1778\ Sec. 960.
\1779\ Foreign income taxes under the provision include income, war
profits, or excess profits taxes paid or accrued by the CFC to any
foreign country or possession of the United States.
---------------------------------------------------------------------------
Section 78 requires that a domestic corporation claiming a
deemed-paid credit include, as additional dividend income, an
amount equal to the foreign taxes deemed paid. This section 78
``gross-up'' ensures that the full amount of the earnings on
which the foreign taxes were paid are included in taxable
income and reflected in the calculation of the foreign tax
credit limitation under section 904.\1780\
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\1780\ The separate foreign tax credit limitations are discussed in
greater detail in the explanation of section 14302 of the Act.
---------------------------------------------------------------------------
Repeal of section 902
The provision repeals the deemed-paid credit under section
902 with respect to dividends received by a domestic
corporation that owns 10 percent or more of the voting stock of
a foreign corporation.
Modification and expansion of section 960
The provision retains but modifies the deemed-paid credit
rules under section 960. The deemed-paid credit under section
960(a) is limited to the amount of foreign income taxes
properly attributable to a subpart F inclusion. The provision
eliminates the need for computing and tracking cumulative tax
pools. In addition to modifying the rules with respect to
deemed-paid foreign tax credits attributable to subpart F
inclusions, the provision further expands the deemed-paid
credit rules to a portion of the foreign income taxes properly
attributable to GILTI inclusions.\1781\
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\1781\ New section 960(d) is discussed in greater detail in the
explanation of section 14201 of the Act.
---------------------------------------------------------------------------
The provision also provides rules applicable to foreign
taxes attributable to distributions from previously taxed
earnings and profits, including distributions made through
tiered CFCs. These rules allow foreign tax credits under
section 960 in the year the previously taxed income is
distributed to a corporation that is a U.S. shareholder of the
CFC. For example, if a U.S. shareholder excludes any part of a
distribution received from a lower-tier CFC through a chain of
CFCs as previously taxed income, the U.S. shareholder will be
deemed to have paid any withholding or other taxes paid by an
upper-tier CFC that are properly attributable to distributions
of the previously taxed income by the lower-tier CFC. A credit
is allowed under section 901 only for 80 percent of the foreign
income taxes imposed with respect to previously taxed earnings
and profits attributable to GILTI and no credit is allowed for
any taxes paid or accrued (or treated as paid or accrued) with
respect to distributions of previously taxed amounts described
in section 965(b)(4)(A).\1782\
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\1782\ A technical correction may be necessary to reflect this
intent.
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Furthermore, the provision does not allow a credit for
taxes that are not attributable to actual distributions of
previously taxed earnings and profits. For example, no credit
is allowed for taxes related to earnings and profits that were
not included in income by reason of section 965(b) (reduction
in amounts included in gross income of U.S. shareholders of
specified foreign corporations with deficits of earnings and
profits), or for the portion of taxes not allowed as a deemed
paid credit for taxes properly attributable to tested income by
reason of the inclusion percentage or 80 percent multiplicand
in section 960(d)(1).\1783\
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\1783\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
The Secretary is granted authority under the provision to
provide regulations and other guidance as may be necessary and
appropriate to carry out the purposes of this provision. Under
such rules, taxes are not attributable to an item of subpart F
income if the base upon which the tax was imposed does not
include the item of subpart F income. For example, if foreign
law exempts a certain type of income from its tax base, no
deemed-paid credit results from the inclusion of such income as
subpart F. Tax imposed on income that is not included in
subpart F income is not considered attributable to subpart F
income.
Extension of section 78
The provision extends the existing language of section 78,
which treats the gross up as a dividend to the domestic
corporation, to new section 245A (i.e., the deemed dividend
does not receive the benefit of the participation
exemption).\1784\ The provision further revises new section
250(a)(1)(B) to apply the section 250 deduction to the section
78 gross-up with respect to a section 951A inclusion.\1785\ The
section 78 gross-up amount attributable to a GILTI inclusion is
considered GILTI for foreign tax credit limitation
purposes.\1786\
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\1784\ A technical correction to the effective date of the changes
to section 78 may be necessary to reflect the intent that fiscal-year
taxpayers are not eligible to claim the benefit of the participation
exemption for section 78 gross-ups made in taxable years beginning
before December 31, 2017. A technical correction to section 78 may also
be necessary to reflect the intent to allow previously taxed income
from lower-tier CFCs that give rise to deemed paid credits under
section 960(b) to be distributed without additional U.S. taxation.
Furthermore, a technical correction may be necessary to reflect the
intent that the section 78 gross-up amount attributable to a GILTI
inclusion should be assigned to the basket to which the taxes relate
for foreign tax credit limitation purposes.
\1785\ New section 250 is discussed in greater detail in the
explanation of section 14202 of the Act.
\1786\ A technical correction may be necessary to reflect this
intent.
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Other rules
The provision also allows deemed-paid credits to reduce the
U.S. tax on an inclusion of income of a qualified electing fund
(as defined in section 1295) consistent with prior law.
Further, the provision preserves the prior-law suspension of
taxes and credits until related income is taken into account
under section 909 for all taxpayers that claim foreign tax
credits, including shareholders of qualified electing funds.
The Treasury Department has issued proposed regulations
addressing these provisions.\1787\
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\1787\ REG-105600-18, November 28, 2018, available at https://
www.irs.gov/pub/irs-drop/res-105600-18.pdf.
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Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
B. Separate Foreign Tax Credit Limitation Basket for Foreign Branch
Income (sec. 14302 of the Act and sec. 904 of the Code)
Explanation of Provision
Background on prior law
Under prior law, the amount of allowable foreign tax
credits is limited to the amount of U.S. tax attributable to
foreign-source net income, with separate limitations for
passive category income, general category income, and income
that is resourced under applicable treaties.\1788\ For each
category (or ``basket'') of foreign-source income, the maximum
amount of foreign tax credits equals the same proportion of the
overall U.S. tax liability (as determined without regard to
foreign tax credits) that the amount of foreign-source income
in the relevant basket bears to the U.S. taxpayer's worldwide
income.
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\1788\ See sec. 904(d).
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A domestic corporation may operate in a foreign country
through an actual foreign branch, or may own a foreign entity
that is classified as a disregarded entity and treated as a
foreign branch for U.S. tax purposes. All income of a foreign
branch is included in the taxable income of the domestic
corporation, regardless of whether any amounts are remitted to
the United States in the year earned. Foreign taxes imposed on
the foreign branch income may be claimed as credits against any
U.S. tax liability. Furthermore, the losses of a foreign branch
reduce the taxable income of such domestic corporation. Dual
consolidated loss rules under section 1503(d), however, provide
that such losses cannot be used currently if the losses can
also be used by a foreign subsidiary to reduce its income under
foreign law.
Separate foreign tax credit limitation basket for foreign branch income
In addition to the separate limitation categories for
passive income, general income, and, for taxable years
beginning after December 31, 2017, amounts includible in gross
income under section 951A (i.e., GILTI), the provision provides
that the foreign tax credit limitation is applied separately to
foreign branch income.\1789\ As a result, the U.S. tax on
foreign branch income can be reduced only by credits for taxes
paid by foreign branches of a U.S. person, and any excess
credits for foreign income taxes paid by a U.S. person's
foreign branches cannot be used to reduce U.S. tax on other
foreign-source income.\1790\
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\1789\ Sec. 904(d)(1)(B). Clerical corrections may be necessary to
reflect the intent to add two new foreign tax credit limitation
categories (i.e., GILTI and foreign branch income) to section
904(d)(1). For example, the cross-reference in section 904(d)(2)(H)(i)
to section 904(d)(1)(B) (foreign branch income) should be changed to
section 904(d)(1)(D) (general category income).
\1790\ Pursuant to section 904(c), excess credits can be carried
back one year and forward 10 years.
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Foreign branch income means the business profits of a U.S.
person \1791\ which are attributable to one or more qualified
business units \1792\ (``QBUs''') in one or more foreign
countries. Under the provision, business profits of a QBU are
determined under rules established by the Secretary. Business
profits of a QBU, however, do not include any income that is
passive category income. Financial services income attributable
to a QBU shall not be treated as passive category income.\1793\
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\1791\ Sec. 904(d)(2)(J)(i).
\1792\ As defined in section 989(a).
\1793\ A technical correction may be necessary to reflect this
intent.
---------------------------------------------------------------------------
Like the passive and general foreign tax credit separate
limitation categories, the separate limitation category for
foreign branch income is intended to prevent so-called ``cross-
crediting'' of foreign tax paid with respect to foreign-source
income in one limitation category (here, foreign branch income)
against U.S. tax imposed on income in another limitation
category (e.g., general limitation category income). Like the
other separate limitation categories, the foreign branch income
limitation allows blending of foreign tax credits for foreign
taxes imposed on different income streams within the same
category (e.g., income from two or more foreign branches). For
an example of a restriction created by the provision, assume
that a U.S. taxpayer receives foreign-source royalty income
that has been subject to little or no foreign tax and that is
in the general limitation category. Assume the U.S. taxpayer
also has manufacturing sales income in one or more foreign
branches that has been subject to foreign tax at a rate higher
than the applicable U.S. tax rate. If the U.S. taxpayer has
foreign tax credits related to foreign tax paid on its foreign
branch manufacturing sales income in excess of the separate
foreign branch limitation amount, the taxpayer is not permitted
to use those excess foreign tax credits to offset residual U.S.
tax on the foreign-source royalty income in the general
limitation category. If, by contrast, the royalty income were
instead derived by another foreign branch (``Foreign Branch
2'') subject to little foreign tax, the taxpayer would be
permitted to take into account foreign tax attributable to, and
foreign income derived by, the high-tax foreign branch in the
same foreign tax credit limitation computation as foreign tax
attributable to, and foreign income derived by, Foreign Branch
2.
Effective Dates
The provision is effective for taxable years beginning
after December 31, 2017.
C. Source of Income from Sales of Inventory Determined Solely on Basis
of Production Activities (sec. 14303 of the Act and sec. 863(b) of the
Code)
Explanation of Provision
Background on prior law
Income from the sale of inventory is generally sourced
based on where title to the property and risk of loss pass to
the purchaser (the ``title passage'' rule).\1794\ For example,
income from the sale of inventory where title passes outside
the United States generally is foreign-source income. Income
from production activity, conversely, is generally sourced
where the taxpayer's production assets are located.\1795\
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\1794\ Secs. 861(a)(6), 862(a)(6), and 865(b); see also Treas. Reg.
sec. 1.861-7.
\1795\ Treas. Reg. sec. 1.863-3(c)(1)(i)(A).
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Prior law sourced gross income from the sale of inventory
manufactured or produced within and sold without the United
States, or vice versa, by attributing some gross income from
the sale to the production activity and the remainder to sales
activity. While not the only sourcing method provided in the
applicable regulations under section 863(b), a commonly used
approach under prior law was the ``50/50 method,'' under which
gross income was apportioned one-half to production activity
and one-half to sales activity. Where inventory was produced in
the United States and sold outside the United States, or vice
versa, the 50/50 method resulted in 50 percent of the income
being treated as U.S. source and 50 percent as foreign source.
This general rule is modified where a sale of personal property
made by a nonresident was attributable to its office or fixed
place of business in the United States.\1796\ In those cases,
all of the income is U.S. source except in the case of
inventory sold for use, disposition, or consumption outside the
United States if a foreign office or other fixed place of
business of the nonresident materially participated in the
sale.\1797\
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\1796\ Sec. 865(e)(2).
\1797\ Ibid.
---------------------------------------------------------------------------
As a general matter, if sales income is treated as foreign
source, the U.S. tax on such sales income generally can be
reduced by excess foreign tax credits on other business income
in the same foreign tax credit basket.
Changes to section 863(b)
The provision overrides the general title passage rule and
the 50/50 method and provides that gains, profits, and income
from the sale or exchange of inventory property that is either
(1) produced (in whole or in part) inside the United States and
then sold or exchanged outside the United States or (2)
produced (in whole or part) outside the United States and then
sold or exchanged inside the United States, is allocated and
apportioned solely on the basis of the location of production
activity.\1798\ For example, income derived from the sale of
inventory property outside the United States is sourced wholly
within the United States if the property was produced entirely
in the United States, even if title passage occurred elsewhere.
Likewise, income derived from inventory property sold in the
United States, but produced entirely in another country, has a
foreign source even if title passage occurs in the United
States. If inventory property is produced partly in, and partly
outside, the United States, the income derived from its sale is
sourced partly in the United States regardless of where title
to the property passes.
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\1798\ The provision does not modify section 865(e)(2).
Furthermore, the rule addressing sales of inventory property purchased
in the United States and sold in a U.S. possession was not changed by
the Act.
---------------------------------------------------------------------------
Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
D. Election to Increase Percentage of Domestic Taxable Income Offset by
Overall Domestic Loss Treated as Foreign Source (sec. 14304 of the Act
and sec. 904(g) of the Code)
Explanation of Provision
Background on prior law
If a taxpayer has an overall domestic loss (``ODL'') for
any taxable year beginning after 2006, then in a succeeding
taxable year an amount of the taxpayer's U.S.-source income
equal to the lesser of (1) 50 percent of the taxpayer's U.S.-
source income or (2) the amount of the ODL (to the extent not
recharacterized under this ODL rule in prior taxable years) is
treated as foreign-source income (the ``ODL recapture
rule'').\1799\
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\1799\ Sec. 904(g)(1). Any U.S.-source income recharacterized under
the ODL rules is allocated among and increases the various foreign tax
credit separate limitation categories in the same proportion that those
categories were reduced by the prior ODLs.
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An ODL means any domestic loss to the extent it offsets
foreign-source taxable income for the current taxable year or
for any preceding taxable year by reason of a loss
carryback.\1880\
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\1800\ Sec. 904(g)(2)(A). For this purpose, a domestic loss means
the amount by which the U.S.-source gross income for the taxable year
is exceeded by the sum of the deductions properly apportioned or
allocated thereto, determined without regard to any loss for any
taxable year unless the taxpayer elected the use of the foreign tax
credit for such taxable year. Sec. 904(g)(2)(B).
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Election to increase percentage of domestic taxable income offset by
ODL
For any pre-2018 unused ODL taken into account under the
ODL recapture rule in an applicable taxable year, the provision
allows a taxpayer to elect to have the ODL recapture rule
applied by substituting for the 50-percent limitation a
limitation with a percentage greater than 50 percent but not
more than 100 percent.\1801\ The term pre-2018 unused ODL means
any ODL which: (1) arises in a qualified taxable year \1802\
beginning before January 1, 2018, and (2) has not been used
under the general rule set forth in section 904(g)(1).\1803\
The term ``applicable taxable year'' means any taxable year of
the taxpayer beginning after December 31, 2017, and before
January 1, 2028.
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\1801\ Sec. 904(g)(5)(A).
\1802\ For this purpose, qualified taxable year means any taxable
year for which the taxpayer elected the use of the foreign tax credit.
Sec. 904(g)(2)(C).
\1803\ Sec. 904(g)(5)(B).
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For example, assume that a taxpayer has a $100 pre-2018
unused ODL. In its 2019 taxable year, taxpayer earns $75 of
U.S.-source income and $100 of foreign-source income, resulting
in $175 of total taxable income. For purposes of taking into
account its $100 pre-2018 unused ODL under the ODL recapture
rule, the taxpayer may elect to increase the percentage of
U.S.-source income treated as foreign source to a percentage
greater than 50 percent but not more than 100 percent for
purposes of determining the foreign tax credit limitation under
section 904 for its 2019 taxable year, meaning that, in this
case, up to $75 of U.S.-source income may be recharacterized as
foreign-source.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
PART II--INBOUND TRANSACTIONS
A. Base Erosion and Anti-Abuse Tax (sec. 14401 of the Act and sec.
6038A and new sec. 59A of the Code)
Explanation of Provision
In general
Section 59A of the Act imposes a tax on certain corporate
taxpayers in addition to any other regular tax liability the
taxpayer may have. Several new terms are defined to effectuate
this tax. These terms and the mechanics of this base erosion
and anti-abuse additional tax are explained in more detail
below.
Liability for this additional tax is generally limited to
those taxpayers with substantial gross receipts and is
determined, in part, by the extent to which the taxpayer has
made deductible payments to foreign related parties. Taxpayers
potentially liable for this additional tax have three-year
average gross receipts in excess of $500 million and a ``base
erosion percentage'' exceeding a specified threshold. The base
erosion percentage is generally determined by dividing ``base
erosion tax benefits'' by the amount of deductions allowable to
the taxpayer for the taxable year.
The taxpayer's additional tax is computed by comparing the
taxpayer's ``modified taxable income'' to the taxpayer's
regular tax liability (as defined in section 26(b)) after the
regular tax liability has been reduced by certain credits
against tax. Modified taxable income is the taxpayer's regular
taxable income increased by any base erosion tax benefit with
respect to any ``base erosion payment'' and an adjustment for
the taxpayer's NOL deduction, if any. The taxpayer has an
additional tax liability equal to the difference between 10
percent of the taxpayer's modified taxable income and the
taxpayer's regular tax liability after adjustment has been made
to account for certain credits against the taxpayer's regular
tax liability. Special rules apply in the case of banks and
securities dealers. Special rules also apply in the case of the
taxpayer's taxable year beginning in 2018 and for taxable years
beginning after December 31, 2025.
Applicable taxpayer
In general
With respect to any taxable year, an applicable taxpayer is
a taxpayer: (1) which is a corporation other than a RIC, a
REIT, or an S corporation; (2) which has average annual gross
receipts of at least $500 million over the three preceding
taxable years; and (3) which has a base erosion percentage for
the taxable year of three percent or higher.\1804\ All persons
treated as a single employer under section 52(a) are aggregated
and treated as one person for purposes of applying the $500
million gross receipts test and determining the base erosion
percentage, except that in applying section 1563 for purposes
of section 52, the exception for foreign corporations under
section 1563(b)(2)(C) is disregarded.
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\1804\ Sec. 59A(e).
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Gross receipts test and foreign persons
A foreign person's gross receipts are generally taken into
account for purposes of applying the $500 million gross
receipts test only if they are taken into account in
determining income effectively connected with the conduct of a
U.S. trade or business.\1805\ In other words, if the foreign
person has a foreign branch, gross receipts of that foreign
branch are generally not taken into account in the $500 million
gross receipts test. In contrast, the gross receipts of the
foreign branch of a U.S. person are generally taken into
account in the $500 million gross receipts test. In cases where
the gross receipts of a taxpayer that is a foreign person are
aggregated with the gross receipts of any U.S. person, the
gross receipts from all sources of those U.S. persons are
included in the aggregation with the foreign person's gross
receipts in applying the $500 million gross receipts test to
determine whether the foreign person is an applicable taxpayer.
For example, if the gross receipts of a taxpayer that is a
foreign person are aggregated with the gross receipts of a U.S.
person with a foreign branch, gross receipts of that foreign
branch are generally taken into account for purposes of
applying the $500 million gross receipts test to the foreign
person.
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\1805\ Sec. 59A(e)(2)(A).
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Base erosion payment
In general
A base erosion payment is generally any amount paid or
accrued by a taxpayer to a foreign person that is a related
party of the taxpayer and with respect to which a deduction is
allowable under Chapter 1.\1806\
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\1806\ Sec. 59A(d)(1). Chapter 1 encompasses section 1 through
section 1400Z-2 of the Code.
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A base erosion payment includes any amount paid or accrued
by the taxpayer to a foreign related party in connection with
the acquisition by the taxpayer from the related party of
property of a character subject to the allowance for
depreciation (or amortization in lieu of depreciation). A base
erosion payment also includes any premium or other
consideration paid or accrued by the taxpayer to a foreign
related party for any reinsurance payments that are taken into
account under sections 803(a)(1)(B) or 832(b)(4)(A).
Base erosion payments do not generally include any amount
that constitutes a reduction in gross receipts, including
payments for cost of goods sold. However, base erosion payments
include any amount that constitutes a reduction in gross
receipts of the taxpayer that is paid or accrued by the
taxpayer with respect to: (1) a surrogate foreign corporation
that is a related party of the taxpayer, but only if the person
first became a surrogate foreign corporation after November 9,
2017, or (2) a foreign person that is a member of the same
expanded affiliated group \1807\ as the surrogate foreign
corporation. A surrogate foreign corporation has the meaning
given in section 7874(a)(2)(B) but does not include a foreign
corporation treated as a domestic corporation under section
7874(b).
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\1807\ The definition of expanded affiliated group follows the
definition in section 7874(c)(1), under which an expanded affiliated
group is an affiliated group as defined in section 1504(a) but without
regard to the exception for foreign corporations and applied by
substituting ``more than 50 percent'' for ``at least 80 percent'' each
place it appears.
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Foreign persons and related parties
For purposes of section 59A, a foreign person is generally
any person who is not a U.S. person within the meaning of
section 7701(a)(30).\1808\
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\1808\ Secs. 59A(g), citing 6038A(c)(3). Under section 6038A(c)(3),
any individual who is a citizen of any possession of the United States
(but is not otherwise a U.S. citizen) and who is not a U.S. resident is
not treated as a U.S. person.
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In addition, for purposes of section 59A, a related party
is, with respect to the taxpayer, any 25-percent owner of the
taxpayer; any person who is related (within the meaning of
sections 267(b) or 707(b)(1)) to the taxpayer or any 25-percent
owner of the taxpayer; and any other person who is related
(within the meaning of section 482) to the taxpayer.\1809\
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\1809\ Sec. 59A(g). The 25-percent ownership threshold is
determined by vote or value. In addition, section 318 applies in
determining who is a related party except that (1) the threshold for
attribution of corporate stock ownership under section 318(a)(2)(C) is
reduced from 50 percent to 10 percent and (2) the rules of section
318(a)(3) are not applied so as to consider a U.S. person as owning
stock that is owned by a person who is not a U.S. person.
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Base erosion payment exceptions
Certain payments for services \1810\
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\1810\ Sec. 59A(d)(5).
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A base erosion payment does not include any amount paid or
accrued by a taxpayer for services if (1) such services meet
the requirements for eligibility for use of the services cost
method under section 482 (determined without regard to the
requirement that the services not contribute significantly to
fundamental risks of business success or failure) and (2) such
amount constitutes the total services cost with no markup
component.
Qualified derivative payments
A base erosion payment does not include any qualified
derivative payment.\1811\ A qualified derivative payment is any
payment made by a taxpayer pursuant to a derivative with
respect to which the taxpayer: (1) recognizes gain or loss as
if such derivative were sold for its fair market value on the
last business day of the taxable year (and such additional
times as are required by the Code or by the taxpayer's method
of accounting), (2) treats any gain or loss so recognized as
ordinary, and (3) treats the character of all items of income,
deduction, gain or loss with respect to a payment pursuant to
the derivative as ordinary.
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\1811\ Sec. 59A(h).
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No payment is treated as a qualified derivative payment for
any taxable year unless the taxpayer includes as part of the
reporting requirements under section 6038A(b)(2) \1812\
information identifying the payments to be treated as qualified
derivative payments for the taxable year and any other
information that the Secretary determines is necessary to carry
out the exception for qualified derivative payments.\1813\
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\1812\ A clerical correction may be needed to reflect this intent.
\1813\ Sec. 59A(h)(2)(B).
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The exception for qualified derivative payments does not
apply if (1) a payment with respect to a derivative is in
substance, or is disguising, the kind of payment that would be
treated as a base erosion payment if it were not made pursuant
to a derivative, including any interest, royalty, or service
payment, (or any other payment subject to this provision) or,
(2) in the case of a contract which has derivative and
nonderivative components, the payment is properly allocable to
the nonderivative component.
For purposes of determining whether a base erosion payment
is a qualified derivative payment, the term ``derivative''
means any contract (including any option, forward contract,
futures contract, short position, swap, or similar contract)
the value of which, or any payment or other transfer with
respect to which, is (directly or indirectly) determined by
reference to one or more of the following: (1) any share of
stock of a corporation,\1814\ (2) any evidence of indebtedness,
(3) any commodity that is actively traded, (4) any currency,
(5) any rate, price, amount, index, formula, or
algorithm.\1815\ A derivative does not include any item
described in (1) through (5) above or any insurance, annuity,
or endowment contract issued by an insurance company to which
subchapter L applies (or issued by any foreign corporation to
which such subchapter would apply if such foreign corporation
were a domestic corporation).
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\1814\ Except as otherwise provided by the Secretary, American
depository receipts and similar instruments with respect to shares of
stock in foreign corporations are treated as shares of stock in such
foreign corporations.
\1815\ Sec. 59A(h)(4)(A).
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Base erosion tax benefit
A base erosion tax benefit generally reflects the reduction
in taxable income arising from the associated base erosion
payment.
A base erosion tax benefit is: (1) any deduction allowed
under Chapter 1 for the taxable year with respect to a base
erosion payment; (2) in the case of a base erosion payment with
respect to the purchase of property of a character subject to
the allowance for depreciation (or amortization in lieu of
depreciation), any deduction allowed under Chapter 1 for
depreciation or amortization in lieu of depreciation with
respect to the property acquired with such payment; (3) any
reduction under section 803(a)(1)(B) in the gross amount of
premiums and other consideration arising out of indemnity
insurance and any deduction under section 832(b)(4)(A) from the
amount of gross premiums paid for reinsurance; and (4) in the
case of a base erosion payment the amount of which constitutes
a reduction in gross receipts, any reduction in gross receipts
with respect to such payment.\1816\
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\1816\ Sec. 59A(c)(2).
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In the case of a taxpayer to which new section 163(j)
applies to limit a taxpayer's interest deduction for the
taxable year, the reduction in the amount of interest for which
a deduction is allowed by reason of section 163(j) is treated
as allocable first to interest paid or accrued to persons who
are not related parties with respect to the taxpayer and then
to related parties.\1817\
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\1817\ Sec. 59A(c)(3).
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Any base erosion tax benefit attributable to any base
erosion payment on which tax is imposed by section 871 or 881,
and with respect to which tax has been deducted and withheld
under section 1441 or 1442, is generally not taken into account
in computing modified taxable income or the base erosion
percentage. However, in computing modified taxable income, the
portion (if any) not taken into account is determined under
rules similar to the rules under former section
163(j)(5)(B).\1818\ For example, if the withholding tax rate on
a particular base erosion payment is reduced by two-thirds from
the regular rate of 30 percent to 10 percent (so that the
payment is subject to withholding at one-third of the regular
withholding tax rate), then the base erosion tax benefit
attributable to the base erosion payment is reduced by one-
third for purposes of calculating modified taxable income.
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\1818\ As in effect before the date of enactment of the Act. Sec.
59A(c)(2)(B)(ii).
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Base erosion percentage
For purposes of calculating modified taxable income, and
determining whether a taxpayer is an applicable taxpayer and
subject to the base erosion and anti-abuse additional tax, the
base erosion percentage means, for any taxable year, the
percentage equal to the aggregate amount of base erosion tax
benefits of the taxpayer for the taxable year divided by the
sum of: (1) the aggregate amount of the deductions allowable to
the taxpayer under Chapter 1 for the taxable year and (2) the
amount of other base erosion tax benefits to the extent they
are not included in (1).\1819\ The denominator for the base
erosion percentage is computed without regard to any deduction
allowed under sections 172, 245A, or 250 and any deduction for
amounts reflecting service payments, or qualified derivative
payments, that are excluded as base erosion payments.
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\1819\ Sec. 59A(d)(4)
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Modified taxable income of applicable taxpayers
An applicable taxpayer's modified taxable income is its
taxable income for the taxable year increased by (1) any base
erosion tax benefit with respect to any base erosion payment
and (2) the base erosion percentage of any NOL deduction
allowed under section 172 for such taxable year.\1820\
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\1820\ Sec. 59A(c)(1).
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Calculation of tax liability
Under the base erosion and anti-abuse additional tax,
applicable taxpayers are required to pay a tax equal to the
base erosion minimum tax amount for the taxable year in
addition to any other regular tax liability they may
have.\1821\ The base erosion minimum tax amount equals the
excess, if any, of 10 percent of modified taxable income over
the amount of regular tax liability reduced (but not below
zero) by the sum of a certain amount of Chapter 1 credits.
Specifically, the amount of regular tax liability is reduced
(and the base erosion minimum tax amount increased) by all
Chapter 1 credits except for the research credit \1822\ and a
certain portion of applicable section 38 credits.
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\1821\ Sec. 59A(a).
\1822\ Sec. 41(a).
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Applicable section 38 credits \1823\ are credits allowed
under section 38 for the taxable year that are properly
allocable to the low-income housing credit,\1824\ the renewable
energy production credit,\1825\ and the energy investment
credit.\1826\ In general, no more than 80 percent of the amount
of applicable section 38 credits for a taxable year can be used
to reduce an applicable taxpayer's base erosion minimum tax
liability, and in no case can applicable section 38 credits
reduce the taxpayer's base erosion minimum tax liability by
more than 80 percent.\1827\
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\1823\ Sec. 59A(b)(4).
\1824\ Sec. 42(a).
\1825\ Sec. 45(a).
\1826\ Sec. 48.
\1827\ Sec. 59A(b)(1)(B)(i)(II)
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Special rules
Special rules for a taxable year beginning in 2018 and for
taxable years beginning after December 31, 2025
For a taxable year beginning in 2018, the 10-percent rate
on modified taxable income is reduced to five percent.\1828\
For taxable years beginning after December 31, 2025, the 10-
percent rate on modified taxable income is increased to 12.5
percent, and the amount of regular tax liability is reduced
(and the base erosion minimum tax amount is therefore
increased) by the sum of all the taxpayer's Chapter 1 credits
for the taxable year, when computing the base erosion minimum
tax amount.\1829\
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\1828\ Sec. 59A(b)(1)(A).
\1829\ Sec. 59A(b)(2).
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Special rules for banks and securities dealers
An applicable taxpayer that is a member of an affiliated
group that includes a bank (as defined in section 581) or
securities dealer registered \1830\ under section 15(a) of the
Securities Exchange Act of 1934 is subject to a tax rate on its
modified taxable income that is one-percentage point higher
than the generally applicable tax rate (e.g., six percent
instead of five percent for a taxable year beginning in
2018).\1831\ In addition, for purposes of determining whether
they are applicable taxpayers, banks and securities dealers are
subject to a two-percent base erosion percentage threshold
(rather than three percent).\1832\
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\1830\ A clerical correction may be needed to reflect this intent.
\1831\ Sec. 59A(b)(3).
\1832\ Sec. 59A(e)(1)(C).
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Information reporting requirements
The provision introduces additional information reporting
requirements with respect to certain foreign-owned corporations
under section 6038A.\1833\ The provision authorizes the
Secretary to prescribe additional reporting requirements under
section 6038A relating to: (1) the name, principal place of
business, and the country or countries of organization or
residence of each person which is a related party to the
reporting corporation and had any transaction with the
reporting corporation during its taxable year; (2) the manner
of relation between the reporting corporation and each person
referred to in (1); and (3) transactions between the reporting
corporation and each related foreign person.
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\1833\ Sec. 6038A(b).
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In addition, for purposes of information reporting under
sections 6038A and 6038C, if the reporting corporation or the
foreign corporation to which section 6038C applies is an
applicable taxpayer under this provision, the taxpayer is
required to report (1) such information as the Secretary finds
necessary to determine the base erosion minimum tax amount,
base erosion payments, and base erosion tax benefits of the
taxpayer for the taxable year and (2) any other information as
the Secretary determines is necessary.\1834\
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\1834\ Sec. 6038A(b)(2).
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The penalties for failure to furnish information or
maintain records under sections 6038A(d)(1) and (2) are both
increased to $25,000.
Regulations
New section 59A(i) authorizes the Secretary to prescribe
such regulations or other guidance necessary or appropriate to
carry out the provisions section 59A, including regulations
providing for such adjustments to the application of this
provision necessary to prevent avoidance of the provision,
including through (1) the use of unrelated persons, conduit
transactions, or other intermediaries, or (2) transactions or
arrangements designed in whole or in part to (A) characterize
payments otherwise subject to this provision as payments not
subject to this provision or (B) substitute payments not
subject to this provision for payments otherwise subject to
this provision. In addition, the Secretary is authorized to
prescribe such regulations or other guidance necessary or
appropriate for purposes of applying the exception for
qualified derivative payments, including rules to prevent
avoidance.\1835\
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\1835\ A clerical correction may be needed to reflect this intent.
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Examples
The following examples illustrate components of the base
erosion minimum tax calculation. Example 1 presents the base
facts for all of the examples and shows how the base erosion
percentage and base erosion minimum tax amount are calculated
when the taxpayer has neither an NOL deduction nor any allowed
credit. Example 2 shows how modified taxable income is computed
when the taxpayer has an NOL deduction. Examples 3 through 5
illustrate the different effects that the research credit,
applicable section 38 credits, and other Chapter 1 credits have
on the calculation of the base erosion minimum tax amount.
Example 6 shows how the calculation operates for taxable years
beginning after December 31, 2025.
Example 1: Base Case
Assume USCo, a domestic C corporation that is neither a RIC
nor a REIT, has gross receipts of $600,000,000 for its 2019 tax
year and an average of $500,000,000 in gross receipts for the
prior three taxable years. USCo is not a bank or securities
dealer. USCo is a calendar-year taxpayer. It has no other
sources of income and no foreign operations, and is wholly-
owned by a foreign corporation (which has no other U.S.
operations). For 2019 it pays its employees $100,000,000 in
salary (all of which is deductible) and makes $50,000,000 in
interest payments and $250,000,000 in royalty payments to its
foreign parent. USCo has carried over no NOLs into 2019. Also,
for 2019, assume that USCo has made no payments reflected in
cost of goods sold, has no other expenses, and has no credits
available to reduce its regular tax liability. All calculations
in these examples are for USCo's 2019 tax year.
Base erosion percentage
USCo has base erosion payments, and base erosion tax
benefits, of $300,000,000 ($50,000,000 + $250,000,000). Its
base erosion percentage equals its base erosion tax benefits of
$300,000,000 divided by its $400,000,000 in overall deductible
payments, or 75 percent. USCo is therefore an applicable
taxpayer and subject to the base erosion minimum tax because it
is a C corporation that is not a RIC or REIT and has met the
gross receipts and base erosion percentage thresholds for being
an applicable taxpayer.
Base erosion minimum tax
USCo has taxable income of $200,000,000
($600,000,000-$400,000,000). At a 21-percent corporate tax
rate, USCo's regular tax liability is $42,000,000.
USCo's modified taxable income is its taxable income
determined without regard to its $300,000,000 in base erosion
tax benefits, or $500,000,000.
USCO's base erosion minimum tax liability equals 10 percent
of its modified taxable income less its amount of regular tax
liability, or $50,000,000-$42,000,000 = $8,000,000. USCo is
required to pay its base erosion minimum tax liability of
$8,000,000 in addition to its regular tax liability of
$42,000,000 for a total tax liability of $50,000,000.
Example 2: Variant of Example 1 with NOL Deduction
Assume the same facts as Example 1, except that USCo has an
NOL deduction (originating from a loss in tax year 2018) in tax
year 2019 of $100,000,000. For simplicity, also assume that
USCo's base erosion percentage for tax year 2018 is the same as
that for tax year 2019, or 75 percent.
With the $100,000,000 NOL, USCo has taxable income of
$100,000,000 ($600,000,000-$400,000,000-$100,000,000). At a 21-
percent corporate tax rate, USCo's regular tax liability is
$21,000,000.
USCo's modified taxable income is its taxable income
determined without regard to its $300,000,000 in base erosion
tax benefits and the base erosion percentage of its NOL
deduction allowed under section 172 for tax year 2019, or
$100,000,000 + $300,000,000 + (75 percent * $100,000,000) =
$475,000,000.
USCo's base erosion minimum tax liability equals 10 percent
of its modified taxable income less its amount of regular tax
liability adjusted by credits, or $47,500,000-$21,000,000 =
$26,500,000. USCo is required to pay its base erosion minimum
tax liability of $26,500,000 in addition to its regular tax
liability of $21,000,000 for a total tax liability of
$47,500,000. Relative to the scenario in Example 1, USCo's
$100,000,000 NOL reduces its regular tax liability by
$21,000,000 but increases its base erosion minimum tax
liability by $18,500,000, resulting in a tax savings of
$2,500,000 (or 2.5 percent of its NOL amount).
Example 3: Variant of Example 2 with Foreign Tax Credit
Assume the same facts as Example 2, except that USCo is
allowed a section 901 foreign tax credit of $8,000,000 for
2019.
As in Example 2, USCo has regular tax liability of
$21,000,000 and modified taxable income of $475,000,000.
For purposes of the base erosion minimum tax calculation,
USCo is required to reduce the amount of its regular tax
liability by the excess of all allowable Chapter 1 credits
($8,000,000) over the sum of its research credit ($0) and a
certain portion of applicable section 38 credits ($0).\1836\ In
particular, USCo's base erosion minimum tax liability equals 10
percent of its modified taxable income less its amount of
regular tax liability adjusted by credits, or
$47,500,000-($21,000,000-[$8,000,000-($0 + $0)]) = $34,500,000.
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\1836\ Sec. 59A(b)(1)(B)(ii)(I).
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USCo is required to pay its base erosion minimum tax
liability of $34,500,000 in addition to its regular tax
liability of $21,000,000 for a total tax liability, prior to
allowed credits, of $55,500,000. USCo's total tax liability
after allowed credits is $47,500,000 ($55,500,000-$8,000,000).
Example 4: Variant of Example 3 with Research Credit
Assume the same facts as Example 3, except that USCo is
also allowed a section 41 research credit of $5,000,000 for
2019.
As in Example 2, USCo has regular tax liability of
$21,000,000 and modified taxable income of $475,000,000.
For purposes of the base erosion minimum tax calculation,
USCo is required to reduce the amount of its regular tax
liability by the excess of all allowable Chapter 1 credits
($8,000,000 + $5,000,000) over the sum of its research credit
($5,000,000) and a certain portion of applicable section 38
credits ($0).\1837\ In particular, USCo's base erosion minimum
tax liability equals 10 percent of its modified taxable income
less its amount of regular tax liability adjusted by credits,
or $47,500,000-($21,000,000-[($8,000,000 +
$5,000,000)-($5,000,000 + $0)]) = $34,500,000.
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\1837\ Ibid.
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USCo is required to pay its base erosion minimum tax
liability of $34,500,000 in addition to its regular tax
liability of $21,000,000 for a total tax liability, prior to
allowed credits, of $55,500,000. USCo's total tax liability
after allowed credits is $42,500,000
($55,500,000-$8,000,000-$5,000,000). While USCo's total post-
credit tax liability is $47,500,000 in Example 3, USCo's total
post-credit tax liability is $42,500,000 in Example 4.
Example 5: Variant of Example 4 with an Applicable Section
38 Credit
Assume the same facts as in Example 4, except that USCo is
allowed a section 42 low-income housing credit of $6,000,000.
As in Example 4, USCo has regular tax liability of
$21,000,000 and modified taxable income of $475,000,000.
For purposes of the base erosion minimum tax calculation,
USCo is required to reduce the amount of its regular tax
liability by the excess of all allowable Chapter 1 credits
($8,000,000 + $5,000,000 + $6,000,000) over the sum of the full
amount of its research credit ($5,000,000) and a certain
portion of applicable section 38 credits (80 percent *
$6,000,000 = $4,800,000). In particular, USCo's base erosion
minimum tax liability equals 10 percent of its modified taxable
income less its amount of regular tax liability adjusted by
credits, or $47,500,000-($21,000,000-[($8,000,000 + $5,000,000
+ $6,000,000)-($5,000,000 + (80 percent * $6,000,000))]) =
$35,700,000.
The portion is $4,800,000 because no more than 80 percent
of the amount of applicable section 38 credits for a taxable
year can be used to reduce USCo's base erosion minimum tax
liability, and in no case can applicable section 38 credits
reduce USCo's base erosion minimum tax liability by more than
80 percent.\1838\ Without regard to the special rule for
applicable section 38 credits, USCo's base erosion minimum tax
liability would be $40,500,000 ($47,500,000-$21,000,000 +
($8,000,000 + $6,000,000)). Applicable section 38 credits
cannot be used to reduce the base erosion minimum tax liability
by more than 80 percent of this amount, or $32,400,000 (80
percent * $40,500,000). For purposes of computing its base
erosion minimum tax liability, USCo's applicable section 38
credit adjustment to its Chapter 1 credit amount is the lesser
of $32,400,000 or $4,800,000. Therefore, the applicable section
38 credit adjustment is $4,800,000.
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\1838\ Sec. 59A(b)(1)(B)(ii)(II).
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USCo is required to pay its base erosion minimum tax
liability of $35,700,000 in addition to its regular tax
liability of $21,000,000 for a total tax liability, prior to
allowed credits, of $56,700,000. USCo's total tax liability
after allowed credits is $37,700,000
($56,700,000-$8,000,000-$5,000,000-$6,000,000). While USCo's
total post-credit tax liability is $42,500,000 in Example 4,
USCo's total post-credit tax liability is $37,700,000 in
Example 5.
Example 6: Variant of Example 5 for Tax Year 2026
Assume the same facts as in Example 5, except that the
figures for tax year 2019 are for tax year 2026.
As in Example 5, USCo has regular tax liability of
$21,000,000 and modified taxable income of $475,000,000.
When computing the base erosion minimum tax amount for
taxable years beginning after December 31, 2025, the 10-percent
tax rate on modified taxable income is increased to 12.5
percent, and the amount of regular tax liability is reduced by
the sum of all the taxpayer's Chapter 1 credits for the taxable
year. As a result, USCo's base erosion liability for 2026
equals 12.5 percent of its modified taxable income less its
amount of regular tax liability (reduced by the sum of all
Chapter 1 credits), or (12.5 percent *
$475,000,000)-[$21,000,000-($8,000,000 + $5,000,000 +
$6,000,000] = $59,375,000-$2,000,000 = $57,375,000. USCo's
total post-credit tax liability is $57,375,000 +
$21,000,000-$19,000,000 = $59,375,000, so that, in effect, USCo
is unable to utilize any of its allowed Chapter 1 credits to
reduce its total tax liability.\1839\
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\1839\ To see this, note that, if USCo had no allowed Chapter 1
credits, its regular tax liability is $21,000,000 and its base erosion
minimum tax amount equals $59,375,000-$21,000,000 = $38,375,000, so
that its total tax liability equals $21,000,000 + $38,375,000 =
$59,375,000.
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Effective Date
The provision applies to base erosion payments paid or
accrued in taxable years beginning after December 31, 2017.
PART III--OTHER PROVISIONS
A. Restriction on Insurance Business Exception to the Passive Foreign
Investment Company Rules (sec. 14501 of the Act and sec. 1297 of the
Code)
Prior Law
Passive foreign investment companies and insurance
Under the PFIC regime, passive income is any income which
is of a kind that would be foreign personal holding company
income, including dividends, interest, royalties, rents, and
certain gains on the sale or exchange of property, commodities,
or foreign currency. However, among other exceptions, passive
income does not include any income derived in the active
conduct of an insurance business by a corporation that is
predominantly engaged in an insurance business and that would
be subject to tax under subchapter L if it were a domestic
corporation.\1840\ In applying the insurance exception, the IRS
analyzes whether risks assumed under contracts issued by a
foreign company organized as an insurer are truly insurance
risks, whether the risks are limited under the terms of the
contracts, and the status of the company as an insurance
company.\1841\
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\1840\ Sec. 1297(b)(2)(B).
\1841\ Notice 2003-34, 2003-C.B. 1 990, June 9, 2003. See also,
Prop. Treas. Reg. sec. 1.1297-4, 26 CFR Part 1, REG-108214-15, April
24, 2015.
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Explanation of Provision
The provision modifies the requirements for a corporation
the income of which is not included in passive income for
purposes of the PFIC rules. The provision replaces the test
based on whether a corporation is predominantly engaged in an
insurance business with a test based on the corporation's
insurance liabilities.\1842\ The requirement that the foreign
corporation would be subject to tax under subchapter L if it
were a domestic corporation is retained.
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\1842\ Treasury regulations proposed in 2015 have taken a different
approach that is based on the prior statutory rule. Prop. Treas. Reg.
sec. 1.1297-4, 26 CFR Part 1, REG-108214-15, April 24, 2015. The
proposed regulations provide that ``the term insurance business means
the business of issuing insurance and annuity contracts and the
reinsuring of risks underwritten by insurance companies, together with
those investment activities and administrative services that are
required to support or are substantially related to insurance and
annuity contracts issued or reinsured by the foreign corporation.'' The
proposed regulations provide that an investment activity is an activity
producing foreign personal holding company income, and that is
``required to support or [is] substantially related to insurance and
annuity contracts issued or reinsured by the foreign corporation to the
extent that income from the activities is earned from assets held by
the foreign corporation to meet obligations under the contracts.'' The
preamble to the proposed regulations specifically requests comments on
the proposed regulations ``with regard to how to determine the portion
of a foreign insurance company's assets that are held to meet
obligations under insurance contracts issued or reinsured by the
company,'' for example, if the assets ``do not exceed a specified
percentage of the corporation's total insurance liabilities for the
year.'' Ibid.
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Under the provision, passive income for purposes of the
PFIC rules does not include income derived in the active
conduct of an insurance business by a corporation (1) that
would be subject to tax under subchapter L if it were a
domestic corporation; and (2) the applicable insurance
liabilities of which constitute more than 25 percent of its
total assets as reported on the company's applicable financial
statement for the last year ending with or within the taxable
year.
For the purpose of the provision's exception from passive
income, applicable insurance liabilities mean, with respect to
any property and casualty or life insurance business (1) loss
and loss adjustment expenses, (2) reserves (other than
deficiency, contingency, or unearned premium reserves) for life
and health insurance risks and life and health insurance claims
with respect to contracts providing coverage for mortality or
morbidity risks. This includes loss reserves for property and
casualty, life, and health insurance contracts and annuity
contracts. Unearned premium reserves with respect to any type
of risk are not treated as applicable insurance liabilities for
purposes of the provision. For purposes of the provision, the
amount of any applicable insurance liability may not exceed the
lesser of such amount (1) as reported to the applicable
insurance regulatory body in the applicable financial statement
(or, if less, the amount required by applicable law or
regulation), or (2) as determined under regulations prescribed
by the Secretary.
An applicable financial statement is a statement for
financial reporting purposes that (1) is made on the basis of
generally accepted accounting principles, (2) is made on the
basis of international financial reporting standards, but only
if there is no statement made on the basis of generally
accepted accounting principles, or (3) except as otherwise
provided by the Secretary in regulations, is the annual
statement required to be filed with the applicable insurance
regulatory body, but only if there is no statement made on
either of the foregoing bases. Unless otherwise provided in
regulations, it is intended that generally accepted accounting
principles means U.S. GAAP.
The applicable insurance regulatory body means, with
respect to any insurance business, the entity established by
law to license, authorize, or regulate such insurance business
and to which the applicable financial statement is provided.
For example, in the United States, the applicable insurance
regulatory body is the State insurance regulator to which the
corporation provides its annual statement.
If a corporation fails to qualify solely because its
applicable insurance liabilities constitute 25 percent or less
of its total assets, a United States person who owns stock of
the corporation may elect in such manner as the Secretary
prescribes to treat the stock as stock of a qualifying
insurance corporation if (1) the corporation's applicable
insurance liabilities constitute at least 10 percent of its
total assets, and (2) based on the applicable facts and
circumstances, the corporation is predominantly engaged in an
insurance business, and its failure to qualify under the 25
percent threshold is due solely to runoff-related or rating-
related circumstances involving such insurance business.
Facts and circumstances that tend to show the firm may not
be predominantly engaged in an insurance business include a
small number of insured risks with low likelihood but large
potential costs; workers focused to a greater degree on
investment activities than underwriting activities; and low
loss exposure. Additional relevant facts for determining
whether the firm is predominantly engaged in an insurance
business include: claims payment patterns for the current and
prior years; the firm's loss exposure as calculated for a
regulator such as the SEC or for a rating agency, or if those
are not calculated, for internal pricing purposes; the
percentage of gross receipts constituting premiums for the
current and prior years; and the number and size of insurance
contracts issued or taken on through reinsurance by the firm.
The fact that a firm has been holding itself out as an insurer
for a long period is not determinative either way.
Runoff-related or rating-related circumstances include, for
example, the fact that the company is in runoff, that is, it is
not taking on new insurance business (and consequently has
little or no premium income), and is using its remaining assets
to pay off claims with respect to pre-existing insurance risks
on its books. Such circumstances also include, for example, the
application to the company of specific requirements with
respect to capital and surplus relating to insurance
liabilities imposed by a rating agency as a condition of
obtaining a rating necessary to write new insurance business
for the current year.
Effective Date
The provision applies to taxable years beginning after
December 31, 2017.
B. Repeal of Fair Market Value Method of Interest Expense Apportionment
(sec. 14502 of the Act and sec. 864 of the Code)
Explanation of Provision
The provision prohibits members of an affiliated group from
allocating and apportioning interest expense on the basis of
either gross income or the fair market value of assets for
purposes of the income and expense sourcing provisions of the
Code.\1843\ Instead, the members must allocate and apportion
interest expense based on the adjusted tax basis of assets.
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\1843\ Section 864(e) provides that members of an affiliated group
must allocate and apportion interest expense of each member as if all
members of such group were a single corporation. An affiliated group is
an affiliated group within the meaning of section 1504, with exceptions
that take into account a foreign corporation if it is owned 80-percent
owned by affiliated members and if more than 50 percent of its gross
income is effectively connected with the conduct of a trade or business
in the United States.
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Effective Date
The provision is effective for taxable years beginning
after December 31, 2017.
APPENDIX: TECHNICAL EXPLANATION OF MODIFICATION OF DEDUCTION FOR
QUALIFIED BUSINESS INCOME OF A COOPERATIVE AND ITS PATRONS (ENACTED
MARCH 23, 2018, PUB. L. NO. 115-141)
Below is Part B of the Technical Explanation of the revenue
provisions of the House amendment to the Senate amendment to
H.R. 1625 (Rules Committee Print 115-66), as introduced in the
House on March 21, 2018. Part B describes modifications to
section 199A. The Technical Explanation, prepared by the staff
of the Joint Committee on Taxation, was published online at
www.jct.gov as: Joint Committee on Taxation, Technical
Explanation of the Revenue Provisions of the House Amendment to
the Senate Amendment to H.R. 1625 (Rules Committee Print 115-
66), (JCX-6-18), March 22, 2018, pages 5-28. H.R. 1625 was
enacted on March 23, 2018, as Pub. L. No. 115-141.\1844\
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\1844\ The section 199A modification is contained in Pub. L. No
115-141, the Consolidated Appropriations Act, 2018, Division T, sec.
101.
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Modification of Deduction for Qualified Business Income of a
Cooperative and Its Patrons
Prior Law
1. Treatment of taxpayers with domestic production activities income
In general
Former section 199 \1845\ provides a deduction from taxable
income (or, in the case of an individual, adjusted gross income
\1846\) that is equal to nine percent of the lesser of the
taxpayer's qualified production activities income or taxable
income (determined without regard to the section 199 deduction)
for the taxable year.\1847\ The amount of the deduction for a
taxable year is limited to 50 percent of the W-2 wages paid by
the taxpayer, and properly allocable to domestic production
gross receipts, during the calendar year that ends in such
taxable year.\1848\ W-2 wages are the total wages subject to
wage withholding,\1849\ elective deferrals,\1850\ and deferred
compensation \1851\ paid by the taxpayer with respect to
employment of its employees during the calendar year ending
during the taxable year of the taxpayer.\1852\ W-2 wages do not
include any amount that is not properly allocable to domestic
production gross receipts as a qualified item of
deduction.\1853\ In addition, W-2 wages do not include any
amount that was not properly included in a return filed with
the Social Security Administration on or before the 60th day
after the due date (including extensions) for such
return.\1854\
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\1845\ Section 199 was repealed by Pub. L. No. 115-97, An Act to
Provide for Reconciliation Pursuant to Titles II and V of the
Concurrent Resolution on the Budget for Fiscal Year 2018, for taxable
years beginning after December 31, 2017. All references to former
section 199 in this document refer to section 199 as in effect before
its repeal.
\1846\ For this purpose, adjusted gross income is determined after
application of sections 86, 135, 137, 219, 221, 222, and 469, and
without regard to the section 199 deduction. Sec. 199(d)(2).
\1847\ Sec. 199(a).
\1848\ Sec. 199(b).
\1849\ Defined in sec. 3401(a).
\1850\ Within the meaning of sec. 402(g)(3).
\1851\ Deferred compensation includes compensation deferred under
section 457, as well as the amount of any designated Roth contributions
(as defined in section 402A).
\1852\ Sec. 199(b). In the case of a taxpayer with a short taxable
year that does not contain a calendar year ending during such short
taxable year, the following amounts are treated as the W-2 wages of the
taxpayer for the short taxable year: (1) wages paid during the short
taxable year to employees of the qualified trade or business; (2)
elective deferrals (within the meaning of section 402(g)(3)) made
during the short taxable year by employees of the qualified trade or
business; and (3) compensation actually deferred under section 457
during the short taxable year with respect to employees of the
qualified trade or business. Amounts that are treated as W-2 wages for
a taxable year are not treated as W-2 wages of any other taxable year.
See Treas. Reg. sec. 1.199-2(b). In addition, in the case of a taxpayer
who is an individual with otherwise qualified production activities
income from sources within the commonwealth of Puerto Rico, if all the
income for the taxable year is taxable under section 1 (income tax
rates for individuals), the determination of W-2 wages with respect to
the taxpayer's trade or business conducted in Puerto Rico is made
without regard to any exclusion under the wage withholding rules (as
provided in section 3401(a)(8)) for remuneration paid for services in
Puerto Rico. See sec. 199(d)(8)(B).
\1853\ Sec. 199(b)(2)(B).
\1854\ Sec. 199(b)(2)(C).
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In the case of oil related qualified production activities
income, the deduction is reduced by three percent of the least
of the taxpayer's oil related qualified production activities
income, qualified production activities income, or taxable
income (determined without regard to the section 199 deduction)
for the taxable year.\1855\ For this purpose, oil related
qualified production activities income for any taxable year is
the portion of qualified production activities income
attributable to the production, refining, processing,
transportation, or distribution of oil, gas, or any primary
product thereof \1856\ during the taxable year.
---------------------------------------------------------------------------
\1855\ Sec. 199(d)(9).
\1856\ Within the meaning of sec. 927(a)(2)(C) as in effect before
its repeal.
---------------------------------------------------------------------------
In general, qualified production activities income is equal
to domestic production gross receipts reduced by the sum of:
(1) the cost of goods sold that are allocable to those
receipts; \1857\ and (2) other expenses, losses, or deductions
which are properly allocable to those receipts.\1858\ Domestic
production gross receipts generally are gross receipts of a
taxpayer that are derived from: (1) any sale, exchange, or
other disposition, or any lease, rental, or license, of
qualifying production property \1859\ that was manufactured,
produced, grown, or extracted by the taxpayer in whole or in
significant part within the United States; \1860\ (2) any sale,
exchange, or other disposition, or any lease, rental, or
license, of any qualified film \1861\ produced by the taxpayer;
(3) any sale, exchange, or other disposition, or any lease,
rental, or license, of electricity, natural gas, or potable
water produced by the taxpayer in the United States; (4)
construction of real property performed in the United States by
a taxpayer in the ordinary course of a construction trade or
business; or (5) engineering or architectural services
performed in the United States by the taxpayer for the
construction of real property in the United States.\1862\
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\1857\ For this purpose, any item or service brought into the
United States is treated as acquired by purchase, and its cost is
treated as not less than its value immediately after it entered the
United States. A similar rule applies in determining the adjusted basis
of leased or rented property where the lease or rental gives rise to
domestic production gross receipts. In addition, for any property
exported by the taxpayer for further manufacture, the increase in cost
or adjusted basis may not exceed the difference between the value of
the property when exported and the value of the property when brought
back into the United States after the further manufacture. See sec.
199(c)(3)(A) and (B).
\1858\ Sec. 199(c)(1). In computing qualified production activities
income, the domestic production activities deduction itself is not an
allocable deduction. Sec. 199(c)(1)(B)(ii). See Treas. Reg. secs.
1.199-1 through 1.199-9 where the Secretary has prescribed rules for
the proper allocation of items of income, deduction, expense, and loss
for purposes of determining qualified production activities income.
\1859\ Qualifying production property generally includes any
tangible personal property, computer software, and sound recordings.
Sec. 199(c)(5).
\1860\ When used in the Code in a geographical sense, the term
``United States'' generally includes only the States and the District
of Columbia. Sec. 7701(a)(9). A special rule for determining domestic
production gross receipts, however, provides that for taxable years
beginning after December 31, 2005, and before January 1, 2018, in the
case of any taxpayer with gross receipts from sources within the
Commonwealth of Puerto Rico, the term ``United States'' includes the
Commonwealth of Puerto Rico, but only if all of the taxpayer's Puerto
Rico-sourced gross receipts are taxable under the Federal income tax
for individuals or corporations for such taxable year. Sec.
199(d)(8)(A) and (C). In computing the 50-percent wage limitation, the
taxpayer is permitted to take into account wages paid to bona fide
residents of Puerto Rico for services performed in Puerto Rico. Sec.
199(d)(8)(B).
\1861\ Qualified film includes any motion picture film or videotape
(including live or delayed television programming, but not including
certain sexually explicit productions) if 50 percent or more of the
total compensation relating to the production of the film (including
compensation in the form of residuals and participations) constitutes
compensation for services performed in the United States by actors,
production personnel, directors, and producers. Sec. 199(c)(6).
\1862\ Sec. 199(c)(4)(A).
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Domestic production gross receipts do not include any gross
receipts of the taxpayer derived from property leased,
licensed, or rented by the taxpayer for use by any related
person.\1863\ In addition, domestic production gross receipts
do not include gross receipts which are derived from (1) the
sale of food and beverages prepared by the taxpayer at a retail
establishment, (2) the transmission or distribution of
electricity, natural gas, or potable water, or (3) the lease,
rental, license, sale, exchange, or other disposition of
land.\1864\
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\1863\ Sec. 199(c)(7). For this purpose, a person is treated as
related to another person if such persons are treated as a single
employer under subsection (a) or (b) of section 52 or subsection (m) or
(o) of section 414, except that determinations under subsections (a)
and (b) of section 52 are made without regard to section 1563(b).
\1864\ Sec. 199(c)(4)(B).
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Special rules
All members of an expanded affiliated group \1865\ are
treated as a single corporation and the deduction is allocated
among the members of the expanded affiliated group in
proportion to each member's respective amount, if any, of
qualified production activities income. In addition, for
purposes of determining domestic production gross receipts, if
all of the interests in the capital and profits of a
partnership are owned by members of a single expanded
affiliated group at all times during the taxable year of such
partnership, the partnership and all members of such group are
treated as a single taxpayer during such period.\1866\
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\1865\ For this purpose, an expanded affiliated group is an
affiliated group as defined in section 1504(a) determined (i) by
substituting ``more than 50 percent'' for ``more than 80 percent'' each
place it appears, and (ii) without regard to paragraphs (2) and (4) of
section 1504(b). See sec. 199(d)(4)(B).
\1866\ Sec. 199(d)(4)(D).
---------------------------------------------------------------------------
For a tax-exempt taxpayer subject to tax on its unrelated
business taxable income by section 511, the section 199
deduction is determined by substituting unrelated business
taxable income for taxable income where applicable.\1867\
---------------------------------------------------------------------------
\1867\ Sec. 199(d)(7).
---------------------------------------------------------------------------
The section 199 deduction is determined by only taking into
account items that are attributable to the actual conduct of a
trade or business.\1868\
---------------------------------------------------------------------------
\1868\ Sec. 199(d)(5).
---------------------------------------------------------------------------
Partnerships and S corporations
With regard to the domestic production activities income of
a partnership or S corporation, the deduction is determined at
the partner or shareholder level. Each partner or shareholder
generally takes into account such person's allocable share of
the components of the calculation (including domestic
production gross receipts; the cost of goods sold allocable to
such receipts; and other expenses, losses, or deductions
allocable to such receipts) from the partnership or S
corporation, as well as any items relating to the partner or
shareholder's own qualified production activities income, if
any.\1869\
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\1869\ Sec. 199(d)(1)(A).
---------------------------------------------------------------------------
In applying the wage limitation, each partner or
shareholder is treated as having been allocated wages from the
partnership or S corporation in an amount that is equal to such
person's allocable share of W-2 wages.\1870\
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\1870\ In the case of a trust or estate, the components of the
calculation are apportioned between (and among) the beneficiaries and
the fiduciary. See sec. 199(d)(1)(B) and Treas. Reg. sec. 1.199-5(d)
and (e).
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Specified agricultural and horticultural cooperatives
In general
With regard to specified agricultural and horticultural
cooperatives, section 199 provides the same treatment of
qualified production activities income derived from
agricultural or horticultural products that are manufactured,
produced, grown, or extracted by such cooperatives,\1871\ as it
provides for qualified production activities income of other
taxpayers, including non-specified cooperatives (i.e., the
cooperative may claim a deduction for qualified production
activities income). The cooperative is treated as having
manufactured, produced, grown, or extracted in whole or
significant part any qualifying production property marketed by
the cooperative if such items were manufactured, produced,
grown, or extracted in whole or significant part by its
patrons.\1872\ In addition, the cooperative is treated as
having manufactured, produced, grown, or extracted agricultural
products with respect to which the cooperative performs
storage, handling, or other processing activities (other than
transportation activities) within the United States related to
the sale, exchange, or other disposition of agricultural
products, provided the products are consumed in connection with
or incorporated into the manufacturing, production, growth, or
extraction of qualifying production property (whether or not by
the cooperative).\1873\ Finally, for purposes of determining
the cooperative's section 199 deduction, qualified production
activities income and taxable income are determined without
regard to any deduction allowable under section 1382(b) and (c)
(relating to patronage dividends, per-unit retain allocations,
and nonpatronage distributions) for the taxable year.\1874\
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\1871\ For this purpose, agricultural or horticultural products
also include fertilizer, diesel fuel, and other supplies used in
agricultural or horticultural production that are manufactured,
produced, grown, or extracted by the cooperative. See Treas. Reg. sec.
1.199-6(f).
\1872\ Sec. 199(d)(3)(D) and Treas. Reg. sec. 1.199-6(d).
\1873\ See Treas. Reg. sec. 1.199-3(e)(1).
\1874\ See sec. 199(d)(3)(C) and Treas. Reg. sec. 1.199-6(c).
---------------------------------------------------------------------------
Definition of a specified agricultural or horticultural
cooperative
A specified agricultural or horticultural cooperative is an
organization to which part I of subchapter T applies that is
engaged in (a) the manufacturing, production, growth, or
extraction in whole or significant part of any agricultural or
horticultural product, or (b) the marketing of agricultural or
horticultural products that its patrons have so manufactured,
produced, grown, or extracted.\1875\
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\1875\ Sec. 199(d)(3)(F). For this purpose, agricultural or
horticultural products also include fertilizer, diesel fuel and other
supplies used in agricultural or horticultural production that are
manufactured, produced, grown, or extracted by the cooperative. See
Treas. Reg. sec. 1.199-6(f).
---------------------------------------------------------------------------
Allocation of the cooperative's deduction to patrons
Any patron that receives a qualified payment from a
specified agricultural or horticultural cooperative is allowed
as a deduction for the taxable year in which such payment is
received an amount equal to the portion of the cooperative's
deduction for qualified production activities income that is
(i) allowed with respect to the portion of the qualified
production activities income to which such payment is
attributable, and (ii) identified by the cooperative in a
written notice mailed to the patron during the payment period
described in section 1382(d).\1876\ A qualified payment is any
amount that (i) is described in paragraph (1) or (3) of section
1385(a) (i.e., patronage dividends and per-unit retain
allocations), (ii) is received by an eligible patron from a
specified agricultural or horticultural cooperative, and (iii)
is attributable to qualified production activities income with
respect to which a deduction is allowed to such
cooperative.\1877\
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\1876\ Sec. 199(d)(3)(A) and Treas. Reg. sec. 1.199-6(a). The
written notice must be mailed by the cooperative to it patrons no later
than the 15th day of the ninth month following the close of the taxable
year. The cooperative must report the amount of the patron's section
199 deduction on Form 1099-PATR, ``Taxable Distributions Received From
Cooperatives,'' issued to the patron. Treas. Reg. sec. 1.199-6(g).
\1877\ Sec. 199(d)(3)(E). For this purpose, patronage dividends and
per-unit retain allocations include any advances on patronage and per-
unit retains paid in money during the taxable year. Treas. Reg. sec.
1.199-6(e).
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The cooperative cannot reduce its income under section 1382
for any deduction allowable to its patrons under this rule
(i.e., the cooperative must reduce its deductions allowed for
certain payments to its patrons in an amount equal to the
section 199 deduction allocated to its patrons).\1878\
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\1878\ Sec. 199(d)(3)(B) and Treas. Reg. sec. 1.199-6(b).
---------------------------------------------------------------------------
Present Law
1. Treatment of taxpayers other than corporations
In general
Individual income tax rates
To determine regular tax liability, an individual taxpayer
generally must apply the tax rate schedules (or the tax tables)
to his or her regular taxable income. The rate schedules are
broken into several ranges of income, known as income brackets,
and the marginal tax rate increases as a taxpayer's income
increases. Separate rate schedules apply based on an
individual's filing status (i.e., single, head of household,
married filing jointly, or married filing separately). For
2018, the regular individual income tax rate schedule provides
rates of 10, 12, 22, 24, 32, 35, and 37 percent.
Partnerships
Partnerships generally are treated for Federal income tax
purposes as pass-through entities not subject to tax at the
entity level.\1879\ Items of income (including tax-exempt
income), gain, loss, deduction, and credit of the partnership
are taken into account by the partners in computing their
income tax liability (based on the partnership's method of
accounting and regardless of whether the income is distributed
to the partners).\1880\ A partner's deduction for partnership
losses is limited to the partner's adjusted basis in its
partnership interest.\1881\ Losses not allowed as a result of
that limitation generally are carried forward to the next year.
A partner's adjusted basis in the partnership interest
generally equals the sum of (1) the partner's capital
contributions to the partnership, (2) the partner's
distributive share of partnership income, and (3) the partner's
share of partnership liabilities, less (1) the partner's
distributive share of losses allowed as a deduction and certain
nondeductible expenditures, and (2) any partnership
distributions to the partner.\1882\ Partners generally may
receive distributions of partnership property without
recognition of gain or loss, subject to some exceptions.\1882\
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\1879\ Sec. 701.
\1880\ Sec. 702(a).
\1881\ Sec. 704(d). In addition, passive loss and at-risk
limitations limit the extent to which certain types of income can be
offset by partnership deductions (sections 469 and 465). These
limitations do not apply to corporate partners (except certain closely-
held corporations) and may not be important to individual partners who
have partner-level passive income from other investments.
\1882\ Sec. 705.
\1883\ Sec. 731. Gain or loss may nevertheless be recognized, for
example, on the distribution of money or marketable securities,
distributions with respect to contributed property, or in the case of
disproportionate distributions (which can result in ordinary income).
---------------------------------------------------------------------------
Partnerships may allocate items of income, gain, loss,
deduction, and credit among the partners, provided the
allocations have substantial economic effect.\1884\ In general,
an allocation has substantial economic effect to the extent the
partner to which the allocation is made receives the economic
benefit or bears the economic burden of such allocation and the
allocation substantially affects the dollar amounts to be
received by the partners from the partnership independent of
tax consequences.\1885\
---------------------------------------------------------------------------
\1884\ Sec. 704(b)(2).
\1885\ Treas. Reg. sec. 1.704-1(b)(2).
---------------------------------------------------------------------------
State laws of every State provide for limited liability
companies \1886\ (``LLCs''), which are neither partnerships nor
corporations under applicable State law, but which are
generally treated as partnerships for Federal tax
purposes.\1887\
---------------------------------------------------------------------------
\1886\ The first LLC statute was enacted in Wyoming in 1977. All
States (and the District of Columbia) now have an LLC statute, though
the tax treatment of LLCs for State tax purposes may differ.
\1887\ Any domestic nonpublicly traded unincorporated entity with
two or more members generally is treated as a partnership for federal
income tax purposes, while any single-member domestic unincorporated
entity generally is treated as disregarded for Federal income tax
purposes (i.e., treated as not separate from its owner). Instead of the
applicable default treatment, however, an LLC may elect to be treated
as a corporation for Federal income tax purposes. Treas. Reg. sec.
301.7701-3 (known as the ``check-the-box'' regulations).
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A publicly traded partnership generally is treated as a
corporation for Federal tax purposes.\1888\ For this purpose, a
publicly traded partnership means any partnership if interests
in the partnership are traded on an established securities
market or interests in the partnership are readily tradable on
a secondary market (or the substantial equivalent
thereof).\1889\
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\1888\ Sec. 7704(a).
\1889\ Sec. 7704(b).
---------------------------------------------------------------------------
An exception from corporate treatment is provided for
certain publicly traded partnerships, 90 percent or more of
whose gross income is qualifying income.\1890\
---------------------------------------------------------------------------
\1890\ Sec. 7704(c)(2). Qualifying income is defined to include
interest, dividends, and gains from the disposition of a capital asset
(or of property described in section 1231(b)) that is held for the
production of income that is qualifying income. Sec. 7704(d).
Qualifying income also includes rents from real property, gains from
the sale or other disposition of real property, and income and gains
from the exploration, development, mining or production, processing,
refining, transportation (including pipelines transporting gas, oil, or
products thereof), or the marketing of any mineral or natural resource
(including fertilizer, geothermal energy, and timber), industrial
source carbon dioxide, or the transportation or storage of certain fuel
mixtures, alternative fuel, alcohol fuel, or biodiesel fuel. Qualifying
income also includes income and gains from commodities (not described
in section 1221(a)(1)) or futures, options, or forward contracts with
respect to such commodities (including foreign currency transactions of
a commodity pool) where a principal activity of the partnership is the
buying and selling of such commodities, futures, options, or forward
contracts. However, the exception for partnerships with qualifying
income does not apply to any partnership resembling a mutual fund
(i.e., that would be described in section 851(a) if it were a domestic
corporation), which includes a corporation registered under the
Investment Company Act of 1940 (Pub. L. No. 76-768 (1940)) as a
management company or unit investment trust. Sec. 7704(c)(3).
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S corporations
For Federal income tax purposes, an S corporation \1891\
generally is not subject to tax at the corporate level.\1892\
Items of income (including tax-exempt income), gain, loss,
deduction, and credit of the S corporation are taken into
account by the S corporation shareholders in computing their
income tax liabilities (based on the S corporation's method of
accounting and regardless of whether the income is distributed
to the shareholders). A shareholder's deduction for corporate
losses is limited to the sum of the shareholder's adjusted
basis in its S corporation stock and the indebtedness of the S
corporation to such shareholder. Losses not allowed as a result
of that limitation generally are carried forward to the next
year. A shareholder's adjusted basis in the S corporation stock
generally equals the sum of (1) the shareholder's capital
contributions to the S corporation and (2) the shareholder's
pro rata share of S corporation income, less (1) the
shareholder's pro rata share of losses allowed as a deduction
and certain nondeductible expenditures, and (2) any S
corporation distributions to the shareholder.\1893\
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\1891\ An S corporation is so named because its Federal tax
treatment is governed by subchapter S of the Code.
\1892\ Secs. 1363 and 1366.
\1893\ Sec. 1367. If any amount that would reduce the adjusted
basis of a shareholder's S corporation stock exceeds the amount that
would reduce that basis to zero, the excess is applied to reduce (but
not below zero) the shareholder's basis in any indebtedness of the S
corporation to the shareholder. If, after a reduction in the basis of
such indebtedness, there is an event that would increase the adjusted
basis of the shareholder's S corporation stock, such increase is
instead first applied to restore the reduction in the basis of the
shareholder's indebtedness. Sec. 1367(b)(2).
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In general, an S corporation shareholder is not subject to
tax on corporate distributions unless the distributions exceed
the shareholder's basis in the stock of the corporation.
To be eligible to elect S corporation status, a corporation
may not have more than 100 shareholders and may not have more
than one class of stock.\1894\ Only individuals (other than
nonresident aliens), certain tax-exempt organizations, and
certain trusts and estates are permitted shareholders of an S
corporation.
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\1894\ Sec. 1361. For this purpose, a husband and wife and all
members of a family are treated as one shareholder. Sec. 1361(c)(1).
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Sole proprietorships
Unlike a C corporation, partnership, or S corporation, a
business conducted as a sole proprietorship is not treated as
an entity distinct from its owner for Federal income tax
purposes.\1895\ Rather, the business owner is taxed directly on
business income, and files Schedule C (sole proprietorships
generally), Schedule E (rental real estate and royalties), or
Schedule F (farms) with his or her individual tax return.
Furthermore, transfer of a sole proprietorship is treated as a
transfer of each individual asset of the business. Nonetheless,
a sole proprietorship is treated as an entity separate from its
owner for employment tax purposes,\1896\ for certain excise
taxes,\1897\ and certain information reporting
requirements.\1898\
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\1895\ A single-member unincorporated entity is disregarded for
Federal income tax purposes, unless its owner elects to be treated as a
C corporation. Treas. Reg. sec. 301.7701-3(b)(1)(ii). Sole
proprietorships often are conducted through legal entities for nontax
reasons. While sole proprietorships generally may have no more than one
owner, a married couple that files a joint return and jointly owns and
operates a business may elect to have that business treated as a sole
proprietorship under section 761(f).
\1896\ Treas. Reg. sec. 301.7701-2(c)(2)(iv).
\1897\ Treas. Reg. sec. 301.7701-2(c)(2)(v).
\1898\ Treas. Reg. sec. 301.7701-2(c)(2)(vi).
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Taxpayers other than corporations with qualified business income
For taxable years beginning after December 31, 2017, and
before January 1, 2026, an individual taxpayer generally may
deduct 20 percent of qualified business income from a
partnership, S corporation, or sole proprietorship, as well as
20 percent of aggregate qualified REIT dividends, qualified
cooperative dividends, and qualified publicly traded
partnership income.\1899\ Limitations based on W-2 wages and
capital investment phase in above a threshold amount of taxable
income.\1900\ A disallowance of the deduction on income of
specified service trades or businesses also phases in above the
threshold amount of taxable income.
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\1899\ Sec. 199A. Eligible taxpayers also include fiduciaries and
beneficiaries of trusts and estates with qualified business income.
\1900\ For this purpose, taxable income is computed without regard
to the 20-percent deduction. Sec. 199A(e)(1).
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Qualified business income
In general
Qualified business income is determined for each qualified
trade or business of the taxpayer. For any taxable year,
qualified business income means the net amount of qualified
items of income, gain, deduction, and loss with respect to the
qualified trade or business of the taxpayer. The determination
of qualified items of income, gain, deduction, and loss takes
into account such items only to the extent included or allowed
in the determination of taxable income for the year.
Items are treated as qualified items of income, gain,
deduction, and loss only to the extent they are effectively
connected with the conduct of a trade or business within the
United States.\1901\ In the case of an individual with
qualified business income from sources within the commonwealth
of Puerto Rico, if all such income for the taxable year is
taxable under section 1 (income tax rates for individuals),
then the term ``United States'' is considered to include Puerto
Rico for purposes of determining the individual's qualified
business income.\1902\
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\1901\ For this purpose, section 864(c) is applied by substituting
``qualified trade or business (within the meaning of section 199A)''
for ``nonresident alien individual or a foreign corporation'' or for
``a foreign corporation,'' each place they appear. Sec. 199A(c)(3)(A).
\1902\ Sec. 199A(f)(1)(C).
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Certain items are not qualified items of income, gain,
deduction, or loss.\1903\ Specifically, qualified items of
income, gain, deduction, and loss do not include (1) any item
taken into account in determining net capital gain or net
capital loss, (2) dividends, income equivalent to a dividend,
or payments in lieu of dividends, (3) interest income other
than that which is properly allocable to a trade or business,
(4) the excess of gain over loss from commodities transactions
other than (i) those entered into in the normal course of the
trade or business or (ii) with respect to stock in trade or
property held primarily for sale to customers in the ordinary
course of the trade or business, property used in the trade or
business, or supplies regularly used or consumed in the trade
or business, (5) the excess of foreign currency gains over
foreign currency losses from section 988 transactions other
than transactions directly related to the business needs of the
business activity, (6) net income from notional principal
contracts other than clearly identified hedging transactions
that are treated as ordinary (i.e., not treated as capital
assets), and (7) any amount received from an annuity that is
not received in connection with the trade or business.
Qualified items do not include any item of deduction or loss
properly allocable to any of the preceding items.
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\1903\ See sec. 199A(c)(3)(B).
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If the net amount of qualified business income from all
qualified trades or businesses during the taxable year is a
loss, then such loss is carried forward and in the next taxable
year is treated as a loss from a qualified trade or
business.\1904\ Any deduction that would otherwise be allowed
in a subsequent taxable year with respect to the taxpayer's
qualified trades or businesses is reduced by 20 percent of any
carryover qualified business loss.
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\1904\ Sec. 199A(c)(2).
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Reasonable compensation and guaranteed payments
Qualified business income does not include any amount paid
by an S corporation that is treated as reasonable compensation
of the taxpayer.\1905\ Similarly, qualified business income
does not include any guaranteed payment for services rendered
with respect to the trade or business,\1906\ and, to the extent
provided in regulations, does not include any amount paid or
incurred by a partnership to a partner, acting other than in
his or her capacity as a partner, for services.\1907\
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\1905\ Sec. 199A(c)(4).
\1906\ Described in sec. 707(c).
\1907\ Described in sec. 707(a).
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Qualified trade or business
A qualified trade or business means any trade or business
other than a specified service trade or business and other than
the trade or business of performing services as an
employee.\1908\
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\1908\ Sec. 199A(d)(1).
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Specified service trade or business
A specified service trade or business means any trade or
business involving the performance of services in the fields of
health, law, accounting, actuarial science, performing arts,
consulting, athletics, financial services, brokerage services,
or any trade or business where the principal asset of such
trade or business is the reputation or skill of one or more of
its employees or owners, or which involves the performance of
services that consist of investing and investment management,
trading, or dealing in securities, partnership interests, or
commodities.\1909\ For this purpose a security and a commodity
have the meanings provided in the rules for the mark-to-market
accounting method for dealers in securities (section 475(c)(2)
and (e)(2), respectively).
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\1909\ Sec. 199A(d)(2).
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The exclusion from the definition of a qualified trade or
business for specified service trades or businesses phases in
for a taxpayer with taxable income in excess of a threshold
amount. The threshold amount is $157,500 (200 percent of that
amount, or $315,000, in the case of a joint return) (together,
the ``threshold amount''), adjusted for inflation in taxable
years beginning after 2018.\1910\ The exclusion from the
definition of a qualified trade or business for specified
service trades or businesses is fully phased in for a taxpayer
with taxable income in excess of the threshold amount plus
$50,000 ($100,000 in the case of a joint return).\1911\
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\1910\ Sec. 199A(e)(2).
\1911\ See sec. 199A(d)(3).
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Tentative deductible amount for a qualified trade or
business
In general
For a taxpayer with taxable income below the threshold
amount, the deductible amount for each qualified trade or
business is equal to 20 percent of the qualified business
income with respect to the trade or business.\1912\ For a
taxpayer with taxable income above the threshold, the taxpayer
is allowed a deductible amount for each qualified trade or
business equal to the lesser of (1) 20 percent of the qualified
business income with respect to such trade or business, or (2)
the greater of (a) 50 percent of the W-2 wages paid with
respect to the qualified trade or business, or (b) the sum of
25 percent of the W-2 wages paid with respect to the qualified
trade or business plus 2.5 percent of the unadjusted basis,
immediately after acquisition, of all qualified property of the
qualified trade or business.\1913\
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\1912\ Sec. 199A(b)(3).
\1913\ Sec. 199A(b)(2).
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Limitations based on W-2 wages and capital
The wage and capital limitations phase in for a taxpayer
with taxable income in excess of the threshold amount.\1914\
The wage and capital limitations apply fully for a taxpayer
with taxable income in excess of the threshold amount plus
$50,000 ($100,000 in the case of a joint return).
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\1914\ See sec. 199A(b)(3)(B).
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W-2 wages are the total wages subject to wage
withholding,\1915\ elective deferrals,\1916\ and deferred
compensation \1917\ paid by the qualified trade or business
with respect to employment of its employees during the calendar
year ending during the taxable year of the taxpayer.\1918\ In
the case of a taxpayer who is an individual with otherwise
qualified business income from sources within the commonwealth
of Puerto Rico, if all the income for the taxable year is
taxable under section 1 (income tax rates for individuals), the
determination of W-2 wages with respect to the taxpayer's trade
or business conducted in Puerto Rico is made without regard to
any exclusion under the wage withholding rules \1919\ for
remuneration paid for services in Puerto Rico. W-2 wages do not
include any amount that is not properly allocable to qualified
business income as a qualified item of deduction.\1920\ In
addition, W-2 wages do not include any amount that was not
properly included in a return filed with the Social Security
Administration on or before the 60th day after the due date
(including extensions) for such return.\1921\
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\1915\ Defined in sec. 3401(a).
\1916\ Within the meaning of sec. 402(g)(3).
\1917\ Deferred compensation includes compensation deferred under
section 457, as well as the amount of any designated Roth contributions
(as defined in section 402A).
\1918\ Sec. 199A(b)(4). In the case of a taxpayer with a short
taxable year that does not contain a calendar year ending during such
short taxable year, the following amounts are treated as the W-2 wages
of the taxpayer for the short taxable year: (1) wages paid during the
short taxable year to employees of the qualified trade or business; (2)
elective deferrals (within the meaning of section 402(g)(3)) made
during the short taxable year by employees of the qualified trade or
business; and (3) compensation actually deferred under section 457
during the short taxable year with respect to employees of the
qualified trade or business. Amounts that are treated as W-2 wages for
a taxable year are not treated as W-2 wages of any other taxable year.
See Conference Report to accompany H.R. 1, Tax Cuts and Jobs Act, H.R.
Rep. No. 115-466, December 15, 2017, p. 217.
\1919\ As provided in sec. 3401(a)(8).
\1920\ Sec. 199A(b)(4)(B).
\1921\ Sec. 199A(b)(4)(C).
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Qualified property means tangible property of a character
subject to depreciation under section 167 that is held by, and
available for use in, the qualified trade or business at the
close of the taxable year, which is used at any point during
the taxable year in the production of qualified business
income, and for which the depreciable period has not ended
before the close of the taxable year.\1922\ The depreciable
period with respect to qualified property of a taxpayer means
the period beginning on the date the property is first placed
in service by the taxpayer and ending on the later of (a) the
date that is 10 years after the date the property is first
placed in service, or (b) the last day of the last full year in
the applicable recovery period that would apply to the property
under section 168 (determined without regard to section
168(g)).
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\1922\ Sec. 199A(b)(6).
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Partnerships and S corporations
In the case of a partnership or S corporation, the section
199A deduction is determined at the partner or shareholder
level. Each partner in a partnership takes into account the
partner's allocable share of each qualified item of income,
gain, deduction, and loss, and is treated as having W-2 wages
and unadjusted basis of qualified property for the taxable year
equal to the partner's allocable share of W-2 wages and
unadjusted basis of qualified property of the partnership. The
partner's allocable share of W-2 wages and unadjusted basis of
qualified property are required to be determined in the same
manner as the partner's allocable share of wage expenses and
depreciation, respectively. Similarly, each shareholder of an S
corporation takes into account the shareholder's pro rata share
of each qualified item of income, gain, deduction, and loss of
the S corporation, and is treated as having W-2 wages and
unadjusted basis of qualified property for the taxable year
equal to the shareholder's pro rata share of W-2 wages and
unadjusted basis of qualified property of the S corporation.
Qualified REIT dividends, cooperative dividends, and
publicly traded partnership income
A deduction is allowed for 20 percent of the taxpayer's
aggregate amount of qualified REIT dividends, qualified
cooperative dividends, and qualified publicly traded
partnership income for the taxable year.\1923\
---------------------------------------------------------------------------
\1923\ See sec. 199A(a) and (b).
---------------------------------------------------------------------------
Qualified REIT dividends do not include any portion of a
dividend received from a REIT that is a capital gain dividend
\1924\ or a qualified dividend.\1925\
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\1924\ Defined in sec. 857(b)(3).
\1925\ Defined in sec. 1(h)(11). See sec. 199A(e)(3).
---------------------------------------------------------------------------
A qualified cooperative dividend means any patronage
dividend,\1926\ per-unit retain allocation,\1927\ qualified
written notice of allocation,\1928\ or any other similar
amount, provided such amount is includible in gross income and
is received from either (1) a tax-exempt organization described
in section 501(c)(12) \1929\ or a taxable or tax-exempt
cooperative that is described in section 1381(a), or (2) a
taxable cooperative governed by tax rules applicable to
cooperatives before the enactment of subchapter T of the Code
in 1962.\1930\
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\1926\ Defined in sec. 1388(a).
\1927\ Defined in sec. 1388(f).
\1928\ Defined in sec. 1388(c).
\1929\ Organizations described in section 501(c)(12) are benevolent
life insurance associations of a purely local character, mutual ditch
or irrigation companies, mutual or cooperative telephone companies, or
like organizations; but only if 85 percent or more of the income
consists of amounts collected from members for the sole purpose of
meeting losses and expenses. Sec. 501(c)(12)(A).
\1930\ Sec. 199A(e)(4).
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Qualified publicly traded partnership income means (with
respect to any qualified trade or business of the taxpayer) the
sum of (a) the net amount of the taxpayer's allocable share of
each qualified item of income, gain, deduction, and loss of the
partnership from a publicly traded partnership not treated as a
corporation,\1931\ and (b) gain recognized by the taxpayer on
disposition of its interest in such partnership that is treated
as ordinary income (for example, by reason of section
751).\1932\
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\1931\ Such items must be effectively connected with a U.S. trade
or business, be included or allowed in determining taxable income for
the taxable year, and not constitute excepted enumerated investment-
type income. Such items do not include the taxpayer's reasonable
compensation, guaranteed payments for services, or (to the extent
provided in regulations) section 707(a) payments for services.
\1932\ Sec. 199A(e)(5).
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Determination of the taxpayer's deduction
The taxpayer's deduction for qualified business income for
the taxable year is equal to the sum of (1) the lesser of (a)
the combined qualified business income amount for the taxable
year, or (b) an amount equal to 20 percent of taxable income
(reduced by any net capital gain \1933\ and qualified
cooperative dividends), plus (2) the lesser of (a) 20 percent
of qualified cooperative dividends, or (b) taxable income
(reduced by net capital gain). This sum may not exceed the
taxpayer's taxable income for the taxable year (reduced by net
capital gain).\1934\ The combined qualified business income
amount for the taxable year is the sum of the deductible
amounts determined for each qualified trade or business carried
on by the taxpayer and 20 percent of the taxpayer's qualified
REIT dividends and qualified publicly traded partnership
income.\1935\
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\1933\ Defined in sec. 1(h).
\1934\ Sec. 199A(a).
\1935\ Sec. 199A(b)(1).
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The taxpayer's deduction for qualified business income is
not allowed in computing adjusted gross income; instead, the
deduction is allowed in computing taxable income.\1936\ The
deduction is available to both individuals who do itemize their
deductions and individuals who do not itemize their
deductions.\1937\
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\1936\ Sec. 62(a).
\1937\ Sec. 63(b) and (d).
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2. Treatment of cooperatives and their patrons
In general
Certain corporations are eligible to be treated as
cooperatives and taxed under the special rules of subchapter T
of the Code.\1938\ In general, the subchapter T rules apply to
any corporation operating on a cooperative basis (except mutual
savings banks, insurance companies, most tax-exempt
organizations, and certain utilities).
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\1938\ Secs. 1381-1388.
---------------------------------------------------------------------------
For Federal income tax purposes, a cooperative subject to
the cooperative tax rules of subchapter T generally computes
its income as if it were a taxable corporation, except that, in
determining its taxable income, the cooperative does not take
into account amounts paid for the taxable year as (1) patronage
dividends, to the extent paid in money, qualified written
notices of allocation,\1939\ or other property (except
nonqualified written notices of allocation) \1940\ with respect
to patronage occurring during such taxable year, and (2) per-
unit retain allocations, to the extent paid in money, qualified
per-unit retain certificates,\1941\ or other property (except
nonqualified per-unit retain certificates) \1942\ with respect
to marketing occurring during such taxable year.\1943\
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\1939\ As defined in sec. 1388(c).
\1940\ As defined in sec. 1388(d).
\1941\ As defined in sec. 1388(h).
\1942\ As defined in sec. 1388(i).
\1943\ Sec. 1382(b)(1) and (3). In determining its taxable income,
the cooperative also does not take into account amounts paid in money
or other property in redemption of a nonqualified written notice of
allocation which was paid as a patronage dividend during the payment
period for the taxable year during which the patronage occurred, or in
redemption of a nonqualified per-unit retain certificate which was paid
as a per-unit retain allocation during the payment period for the
taxable year during which the marketing occurred. Sec. 1382(b)(2) and
(4).
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Patronage dividends are amounts paid to a patron (1) on the
basis of quantity or value of business done with or for such
patron, (2) under an obligation of the cooperative to pay such
amount that existed before the cooperative received the amount
so paid, and (3) which are determined by reference to the net
earnings of the cooperative from business done with or for its
patrons.\1944\ Per-unit retain allocations are allocations to a
patron with respect to products marketed for him, the amount of
which is fixed without reference to the net earnings of the
organization pursuant to an agreement between the organization
and the patron.\1945\
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\1944\ Sec. 1388(a).
\1945\ Sec. 1388(f).
---------------------------------------------------------------------------
Because a patron of a cooperative that receives patronage
dividends or per-unit retain allocations generally must include
such amounts in gross income,\1946\ excluding patronage
dividends and per-unit retain allocations paid by the
cooperative from the cooperative's taxable income in effect
allows the cooperative to be a conduit with respect to profits
derived from transactions with its patrons.
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\1946\ Sec. 1385(a)(1) and (3).
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Specified agricultural or horticultural cooperatives with qualified
business income
For taxable years beginning after December 31, 2017, and
before January 1, 2026, a deduction is allowed to any specified
agricultural or horticultural cooperative equal to the lesser
of (a) 20 percent of the excess (if any) of the cooperative's
gross income over the qualified cooperative dividends paid
during the taxable year for the taxable year, or (b) the
greater of 50 percent of the W-2 wages paid by the cooperative
with respect to its trade or business or the sum of 25 percent
of the W-2 wages of the cooperative with respect to its trade
or business plus 2.5 percent of the unadjusted basis
immediately after acquisition of qualified property of the
cooperative.\1947\ The cooperative's section 199A(g) deduction
may not exceed its taxable income \1948\ for the taxable year.
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\1947\ Sec. 199A(g).
\1948\ For this purpose, taxable income is computed without regard
to the cooperative's deduction under section 199A(g).
---------------------------------------------------------------------------
A specified agricultural or horticultural cooperative is an
organization to which part I of subchapter T applies that is
engaged in (a) the manufacturing, production, growth, or
extraction in whole or significant part of any agricultural or
horticultural product, (b) the marketing of agricultural or
horticultural products that its patrons have so manufactured,
produced, grown, or extracted, or (c) the provision of
supplies, equipment, or services to farmers or organizations
described in the foregoing.
Explanation of Provision
1. Treatment of specified agricultural or horticultural cooperatives
Deduction for qualified production activities income
The provision modifies the deduction for qualified business
income of a specified agricultural or horticultural cooperative
under section 199A(g) to instead provide a deduction for
qualified production activities income of a specified
agricultural or horticultural cooperative that is similar to
the deduction for qualified production activities income under
former section 199.
The provision provides a deduction from taxable income that
is equal to nine percent of the lesser of the cooperative's
qualified production activities income or taxable income
(determined without regard to the cooperative's section 199A(g)
deduction and any deduction allowable under section 1382(b) and
(c) (relating to patronage dividends, per-unit retain
allocations, and nonpatronage distributions)) for the taxable
year. The amount of the deduction for a taxable year is limited
to 50 percent of the W-2 wages paid by the cooperative during
the calendar year that ends in such taxable year. For this
purpose, W-2 wages are determined in the same manner as under
the other provisions of section 199A, except that such wages do
not include any amount that is not properly allocable to
domestic production gross receipts.\1949\
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\1949\ Under the proposal, because Puerto Rico is not treated as
part of the United States for purposes of determining domestic
production gross receipts under section 199A(g), W-2 wages do not
include any remuneration paid for services in Puerto Rico.
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In the case of oil related qualified production activities
income, the provision provides that the section 199A(g)
deduction is reduced by three percent of the least of the
cooperative's oil related qualified production activities
income, qualified production activities income, or taxable
income (determined without regard to the cooperative's section
199A(g) deduction and any deduction allowable under section
1382(b) and (c) (relating to patronage dividends, per-unit
retain allocations, and nonpatronage distributions)) for the
taxable year. For this purpose, oil related qualified
production activities income for any taxable year is the
portion of qualified production activities income attributable
to the production, refining, processing, transportation, or
distribution of oil, gas, or any primary product thereof \1950\
during the taxable year.
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\1950\ Within the meaning of section 927(a)(2)(C) as in effect
before its repeal.
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In general, qualified production activities income is equal
to domestic production gross receipts reduced by the sum of:
(1) the cost of goods sold that are allocable to such receipts;
\1951\ and (2) other expenses, losses, or deductions that are
properly allocable to such receipts.\1952\ Domestic production
gross receipts generally are gross receipts of the cooperative
that are derived from any lease, rental, license, sale,
exchange, or other disposition of any agricultural or
horticultural product \1953\ that was manufactured, produced,
grown, or extracted by the cooperative in whole or in
significant part within the United States.\1954\ The
cooperative is treated as having manufactured, produced, grown,
or extracted in whole or significant part any agricultural or
horticultural products marketed by the cooperative if such
items were manufactured, produced, grown, or extracted in whole
or significant part by its patrons.
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\1951\ For this purpose, any item or service brought into the
United States is treated as acquired by purchase, and its cost is
treated as not less than its value immediately after it entered the
United States. A similar rule applies in determining the adjusted basis
of leased or rented property where the lease or rental gives rise to
domestic production gross receipts. In addition, for any property
exported by the cooperative for further manufacture, the increase in
cost or adjusted basis may not exceed the difference between the value
of the property when exported and the value of the property when
brought back into the United States after the further manufacture.
\1952\ In computing qualified production activities income, the
section 199A(g) deduction itself is not an allocable deduction. As
under former section 199, the cooperative's qualified production
activities income is determined without regard to any deduction
allowable under section 1382(b) and (c) (relating to patronage
dividends, per-unit retain allocations, and nonpatronage
distributions). See Treas. Reg. sec. 1.199-6(c).
\1953\ Consistent with former section 199, it is intended that
agricultural or horticultural products also include fertilizer, diesel
fuel, and other supplies used in agricultural or horticultural
production that are manufactured, produced, grown, or extracted by the
cooperative. See Treas. Reg. sec. 1.199-6(f).
\1954\ Consistent with former section 199, it is intended that
domestic production gross receipts include gross receipts of a
cooperative derived from any sale, exchange, or other disposition of
agricultural products with respect to which the cooperative performs
storage, handling, or other processing activities (other than
transportation activities) within the United States, provided such
products are consumed in connection with, or incorporated into, the
manufacturing, production, growth, or extraction of agricultural or
horticultural products (whether or not by the cooperative). See Treas.
Reg. sec. 1.199-3(e)(1).
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Domestic production gross receipts do not include any gross
receipts of the cooperative derived from property leased,
licensed, or rented by the taxpayer for use by any related
person.\1955\ In addition, domestic production gross receipts
do not include gross receipts that are derived from the lease,
rental, license, sale, exchange, or other disposition of land.
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\1955\ For this purpose, a person is treated as related to another
person if such persons are treated as a single employer under
subsection (a) or (b) of section 52 or subsection (m) or (o) of section
414, except that determinations under subsections (a) and (b) of
section 52 are made without regard to section 1563(b).
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Definition of specified agricultural or horticultural cooperative
The provision limits the definition of specified
agricultural or horticultural cooperative to organizations to
which part I of subchapter T applies that (1) manufacture,
produce, grow, or extract in whole or significant part any
agricultural or horticultural product, or (2) market any
agricultural or horticultural product that their patrons have
so manufactured, produced, grown, or extracted in whole or
significant part.\1956\ The definition no longer includes a
cooperative solely engaged in the provision of supplies,
equipment, or services to farmers or other specified
agricultural or horticultural cooperatives.
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\1956\ Consistent with former section 199, it is intended that
agricultural or horticultural products also include fertilizer, diesel
fuel, and other supplies used in agricultural or horticultural
production that are manufactured, produced, grown, or extracted by the
cooperative. See Treas. Reg. sec. 1.199-6(f).
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Special rules
All members of an expanded affiliated group \1957\ are
treated as a single corporation and the deduction is allocated
among the members of the expanded affiliated group in
proportion to each member's respective amount, if any, of
qualified production activities income. In addition, for
purposes of determining domestic production gross receipts, if
all of the interests in the capital and profits of a
partnership are owned by members of a single expanded
affiliated group at all times during the taxable year of such
partnership, the partnership and all members of such group are
treated as a single taxpayer during such period.
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\1957\ For this purpose, an expanded affiliated group is an
affiliated group as defined in section 1504(a) determined (i) by
substituting ``more than 50 percent'' for ``more than 80 percent'' each
place it appears, and (ii) without regard to paragraphs (2) and (4) of
section 1504(b).
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In the case of a specified agricultural or horticultural
cooperative that is a partner in a partnership, rules similar
to the rules applicable to a partner in a partnership under
section 199A(f)(1) apply.
For a tax-exempt cooperative subject to tax on its
unrelated business taxable income by section 511, the provision
is applied by substituting unrelated business taxable income
for taxable income where applicable.
The section 199A(g) deduction is determined by only taking
into account items that are attributable to the actual conduct
of a trade or business.
Allocation of the cooperative's deduction to patrons
The provision provides that an eligible patron that
receives a qualified payment from a specified agricultural or
horticultural cooperative is allowed as a deduction for the
taxable year in which such payment is received an amount equal
to the portion of the cooperative's deduction for qualified
production activities income that is (i) allowed with respect
to the portion of the qualified production activities income to
which such payment is attributable, and (ii) identified by the
cooperative in a written notice mailed to the patron during the
payment period described in section 1382(d).\1958\
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\1958\ Consistent with the allocation of the cooperative's
deduction to its patrons under former section 199 and consistent with
the requirements for the payment of patronage dividends in section
1388(a)(1), the cooperative's section 199A(g) deduction is allocated
among its patrons on the basis of the quantity or value of business
done with or for such patron by the cooperative.
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The patron's deduction of such amount may not exceed the
patron's taxable income for the taxable year (determined
without regard to such deduction but after taking into account
the patron's other deductions under section 199A(a)). A
qualified payment is any amount that (i) is described in
paragraph (1) or (3) of section 1385(a) (i.e., patronage
dividends and per-unit retain allocations), (ii) is received by
an eligible patron from a specified agricultural or
horticultural cooperative, and (iii) is attributable to
qualified production activities income with respect to which a
deduction is allowed to such cooperative. An eligible patron is
(i) a taxpayer other than a corporation,\1959\ or (ii) another
specified agricultural or horticultural cooperative.
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\1959\ For this purpose, corporation does not include an S
corporation.
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Finally, the cooperative cannot reduce its income under
section 1382 for any deduction allowable to its patrons under
this rule (i.e., the cooperative must reduce its deductions
allowed for certain payments to its patrons in an amount equal
to the section 199A(g) deduction allocated to its patrons).
Regulatory authority
Specific regulatory authority is provided for the Secretary
of the Treasury to promulgate necessary regulations under
section 199A(g), including regulations that prevent more than
one cooperative taxpayer from being allowed a deduction with
respect to the same activity (i.e., the same lease, rental,
license, sale, exchange, or other disposition of any
agricultural or horticultural product that was manufactured,
produced, grown, or extracted in whole or in significant part
within the United States). In addition, regulatory authority is
provided to address the proper allocation of items of income,
deduction, expense, and loss for purposes of determining
qualified production activities income. The provision provides
that the regulations be based on the regulations applicable to
cooperatives and their patrons under former section 199 (as in
effect before its repeal).\1960\
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\1960\ See Treas. Reg. secs. 1.199-1 through -9.
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2. Treatment of cooperative patrons
Repeal of special deduction for qualified cooperative dividends
The provision repeals the special deduction for qualified
cooperative dividends. In addition, the provision repeals the
rule that excludes qualified cooperative dividends from
qualified business income of a qualified trade or business. The
provision also clarifies that items of income excluded from
qualified items of income, and thus excluded from qualified
business income, do not include any amount described in section
1385(a)(1) (i.e., patronage dividends). Accordingly, qualified
business income of a qualified trade or business includes any
patronage dividend,\1961\ per-unit retain allocation,\1962\
qualified written notice of allocation,\1963\ or any other
similar amount received from a cooperative, provided such
amount is otherwise a qualified item of income, gain,
deduction, or loss (i.e., such amount is (i) effectively
connected with the conduct of a trade or business within the
United States, and (ii) included or allowed in determining
taxable income for the taxable year).\1964\
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\1961\ Defined in sec. 1388(a).
\1962\ Defined in sec. 1388(f).
\1963\ Defined in sec. 1388(c).
\1964\ See sec. 199A(c)(3)(A).
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Reduced deduction for qualified payments received from a specified
agricultural or horticultural cooperative
In the case of any qualified trade or business of a patron
of a specified agricultural or horticultural cooperative, the
deductible amount determined under section 199A(b)(2) for such
trade or business is reduced by the lesser of (1) nine percent
of the amount of qualified business income with respect to such
trade or business as is properly allocable to qualified
payments received from such specified agricultural or
horticultural cooperative, or (2) 50 percent of the amount of
W-2 wages with respect to such qualified trade or business that
are properly allocable to such amount.
3. Transition rule relating to the repeal of section 199
The provision clarifies that the repeal of section 199 for
taxable years beginning after December 31, 2017, does not apply
to a qualified payment received by a patron from a specified
agricultural or horticultural cooperative in a taxable year
beginning after December 31, 2017, to the extent such qualified
payment is attributable to qualified production activities
income with respect to which a deduction is allowable to the
cooperative under former section 199 for a taxable year of the
cooperative beginning before January 1, 2018. Such qualified
payment remains subject to former section 199 and any section
199 deduction allocated by the cooperative to its patrons
related to such qualified payment may be deducted by such
patrons in accordance with former section 199. In addition, no
deduction is allowed under section 199A for such qualified
payments.
4. Examples
The following examples illustrate the provision.
Example 1
Cooperative is a grain marketing cooperative with
$5,250,000 in gross receipts during 2018 from the sale of grain
grown by its patrons. Cooperative paid $4,000,000 to its
patrons at the time the grain was delivered in the form of per-
unit retain allocations and another $1,000,000 in patronage
dividends after the close of the 2018 taxable year. Cooperative
has other expenses of $250,000 during 2018, including $100,000
of W-2 wages.
Cooperative has domestic production gross receipts of
$5,250,000 and qualified production activities income of
$5,000,000 \1965\ for 2018. Cooperative's section 199A(g)
deduction is $50,000 and is equal to the least of nine percent
of qualified production activities income ($450,000), \1966\
nine percent of taxable income ($450,000),\1967\ or 50 percent
of W-2 wages ($50,000).\1968\ Cooperative passes through the
entire section 199A(g) deduction to its patrons. Accordingly,
Cooperative reduces its $5,000,000 deduction allowable under
section 1382(b) and (c) (relating to the $1,000,000 patronage
dividends and $4,000,000 per-unit retain allocations) by
$50,000.
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\1965\ $5,250,000 gross receipts-$250,000 expenses = $5,000,000.
\1966\ $5,000,000 * .09 = $450,000.
\1967\ For this purpose, taxable income is $5,000,000 and is
determined without regarding to the section 199A(g) deduction and
without regard to the $5,000,000 deduction allowable under section
1382(b) and (c) relating to the $1,000,000 patronage dividends and
$4,000,000 per-unit retain allocations.
\1968\ $100,000 * .5 = $50,000.
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Patron's grain delivered to Cooperative during 2018 is two
percent of all grain marketed through Cooperative during such
year. During 2019, Patron receives $20,000 in patronage
dividends and $1,000 of allocated section 199A(g) deduction
from Cooperative related to the grain delivered to Cooperative
during 2018.
Patron is a grain farmer with taxable income of $75,000 for
2019 (determined without regard to section 199A) and has a
filing status of married filing jointly. Patron's qualified
business income related to its grain trade or business for 2019
is $50,000, which consists of gross receipts of $150,000 from
sales to an independent grain elevator, per-unit retain
allocations received from Cooperative during 2019 of $80,000,
patronage dividends received from Cooperative during 2019
related to Cooperative's 2018 net earnings of $20,000, and
expenses of $200,000 (including $50,000 of W-2 wages).
The portion of the qualified business income from Patron's
grain trade or business related to qualified payments received
from Cooperative during 2019 is $10,000, which consists of per-
unit retain allocations received from Cooperative during 2019
of $80,000, patronage dividends received from Cooperative
during 2019 related to Cooperative's 2018 net earnings of
$20,000, and properly allocable expenses of $90,000 (including
$25,000 of W-2 wages).\1969\
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\1969\ Which expenses are properly allocable in a given case will
depend on all the facts and circumstances. The example assumes that the
fraction of properly allocable W-2 wages differs from the fraction of
other properly allocable expenses.
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Patron's deductible amount related to the grain trade or
business is 20 percent of qualified business income ($10,000)
\1970\ reduced by the lesser of nine percent of qualified
business income related to qualified payments received from
Cooperative ($900) \1971\ or 50 percent of W-2 wages related to
qualified payments received from Cooperative ($12,500), \1972\
or $9,100. As Patron does not have any other qualified trades
or business, the combined qualified business income amount is
also $9,100.
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\1970\ $50,000 * .2 = $10,000.
\1971\ $10,000 * .09 = $900.
\1972\ $25,000 * .5 = $12,500.
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Patron's deduction under section 199A for 2019 is $10,100,
which consists of the combined qualified business income amount
of $9,100, plus Patron's deduction passed through from
Cooperative of $1,000.
Example 2
Cooperative and Patron have the same facts as above for
2018 and 2019 except that Patron has expenses of $200,000 that
include zero W-2 wages during 2019.
Patron's deductible amount related to the grain trade or
business is 20 percent of qualified business income ($10,000)
reduced by the lesser of nine percent of qualified business
income related to qualified payments received from Cooperative
($900), or 50 percent of W-2 wages related to qualified
payments received from Cooperative ($0), or $10,000.
Patron's deduction under section 199A for 2019 is $11,000,
which consists of the combined qualified business income amount
of $10,000, plus Patron's deduction passed through from
Cooperative of $1,000.
Effective Date
The provision is effective as if included in the amendments
made by sections 11011 and 13305 of Public Law No. 115-97, that
is, for taxable years beginning after December 31, 2017.
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ESTIMATED BUDGET EFFECTS OF TAX LEGISLATION ENACTED IN PUBLIC LAW 115-
97
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