The Tax Cuts and Jobs Act of 2017 is unquestionably the most significant change to U.S. tax law since the 1980s. While it is true many businesses will now be subject to lower tax rates, the devil is always in the details when dealing with federal law. Along with lower tax rates, taxpayers are also left with many other changes in tax law that could have a major impact on their annual tax liability.
So what are some of the most significant implications of tax reform for technology companies to consider?
Many technology firms are structured as “pass-through entities,” meaning companies’ profits are passed on to the owners as income on their personal tax returns. To provide the owners of pass-through entities a tax benefit (and to provide a benefit similar to the reduced corporate rates described later), Congress added a potential 20 percent deduction of pass-through income for many pass-through businesses. Software, hardware, and technology services companies structured as pass-through entities may all qualify for this deduction (assuming there are net annual profits to apply against the deduction).
The tax cut for C-corporations — down to 21 percent from 35 percent — was the headline news of the tax package. As the C-corporation structure is often the preferred legal structure for both pre and post-revenue technology companies, this change to tax law is significant for any companies with annual taxable income.
Another hot topic for technology companies organized as C-corporations is the changes in a corporation’s ability to utilize prior net operating losses (NOLs). In the past, a loss from one year could be “carried back” to offset income in prior years (thereby creating a refund) or carried forward to offset future income. Under the new law, NOLs generated in 2018 or later cannot be carried back to offset income in prior years. Further, the new law caps the ability to utilize NOLs generated after 2017 at 80 percent of taxable income (meaning 20 percent of your taxable income would be taxed at the 21 percent corporate tax rate, if pre-2018 NOLs are not available). If your company has NOLs, annual tax planning is advisable to evaluate your company’s ability to utilize NOLs and its impact on operating cash flows.
Another significant change for technology companies (that thus far has not received much attention due to its delayed implementation) is the ability to deduct research and development (R&D) expenses. In the past, taxpayers had the option to deduct, amortize, or charge R&D expenses to a capital account. Many technology companies choose to deduct as the costs are incurred. For tax years beginning after 2021, companies will no longer be able to immediately expense R&D costs; instead, they will be required to amortize R&D expenses over a period of at least five years. Research performed outside of the U.S. must be deducted over 15 years. This change may impact your R&D planning. Companies that invest heavily in R&D should monitor this situation, as we expect to see a great deal of lobbying to remove this provision.
While many of the implications of the new tax law remain to be determined, one thing that is immediately clear is the need to look carefully at how you operate your business under the new rules. Understanding the changes with your tax advisor to be sure you have adopted the most tax-advantageous positions possible should be a top priority for tech companies in 2018.
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