A&M Tax Advisor Weekly
First quarter estimated tax payments and income tax provisions might not be top of mind just yet, but they should be with myriad changes that could require new computations, processes, and systems, and affect financial results and cash flow projections. With an ever-changing tax world, and what promises to be a year of increased uncertainty and complexity, we thought it would be helpful to highlight a few items that are changing this year to assist in modeling, analyzing business transactions, and assessing strategic alternatives. The wild card, of course, is whether major tax law changes — as part of a revamped version of the proposed Build Back Better Act (BBBA) passed by the House (discussed in our prior alert) — will be enacted, and if so, whether they will apply retroactively.
Specifically, this alert covers the following topics:
There are two TCJA provisions that take a major turn this year: the limitation on the deduction of business interest (section 163(j)) and the deduction for research and development (R&D) expenses.
More Restrictive Limit on Business Interest Deductions
The TCJA limits net business interest expense deductions to essentially 30% of taxpayers adjusted taxable income (ATI), which is effectively earnings before interest, taxes, depreciation, and amortization (EBITDA), for taxable years beginning in 2018 through 2021. As part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress provided some relief for 2019 and 2020. But this is the year that the calculation of ATI is adjusted to effectively be earnings before interest and taxes (EBIT).
In addition to the change in the ATI calculation, taxpayers should be aware that while Treasury and the IRS have issued final section 163(j) regulations in some areas (discussed in our prior alerts on 2020 regulations and 2021 regulations), they have reserved on several provisions for passthrough entities and controlled foreign corporations. Therefore, some uncertainty remains as to how the business interest expense deduction limitation will be applied in forthcoming years. In the meantime, for those reserved areas, taxpayers may continue to rely on the 2020 proposed regulations.
A&M Insight: Despite various crusades to “Save the DA” — the depreciation and amortization components — restoring the EBITDA rule does not appear to be on Congress’s list for any upcoming legislation. Therefore, highly leveraged businesses with significant depreciation and amortization expenses, such as manufacturing and energy companies, as well as start-up businesses that typically have little to no revenue in the initial years, could see more severe limits on their ability to deduct interest expense. This in turn could result in an increase in interest expense being disallowed and carried over, which increases the effective cost of borrowing due to the delayed, or potentially never allowed, interest expense deduction. As a result, this could affect the cost of operating or acquiring a business and should be factored into modeling and analysis of acquisitions.
Amortization of Research Expenditures
Also effective this year under the TCJA, taxpayers may no longer immediately deduct research and development costs, as discussed previously here. The proposed BBBA would extend the immediate and full deduction to tax years beginning before 2026, which is a provision that has had bipartisan support. But without a legislative change, businesses, such as manufacturers, pharmaceutical companies, and software developers, that design new or improved solutions through research, must capitalize R&D costs and deduct them over a five-year period (fifteen-years for research conducted outside the United States) beginning with the midpoint of the taxable year in which the expense occurs.
A&M Insight: Taxpayers who remained hopeful that the provision extending full expensing of R&D costs would have been enacted by the end of last year may be scrambling to modify procedures, systems, and controls to start amortizing R&D costs. And the change is more than just developing an amortization schedule because taxpayers must first identify what expenses are viewed as “R&D costs” as they previously were not segregable from other deductible expenses and the TCJA expanded the scope. For example, under the now applicable provision, software development costs are R&D costs subject to the amortization rule. The statute also requires that taxpayers further segregate expenses between research performed in the US and abroad. Taxpayers may want to examine whether it remains cost effective to perform their own “research,” which would be subject to the amortization requirement, compared to purchasing a product post-research, which would not be subject to the rule.
Because some form of tax legislation this year remains a possibility, taxpayers continue to face the dilemma of whether to accelerate income and certain transactions to mitigate the potential effects that might occur if new laws are enacted. That said, Congress could consider making some rules retroactive. Several BBBA provisions proposed to be effective immediately upon enactment or beginning in 2022 might be worth looking at for planning purposes.
Potential Individual Tax Increases
Tax increases for high income individuals could come in the form of a change in the tax on investment income or a new law establishing a surcharge on income. One BBBA proposal would impose the 3.8% net investment income tax (NIIT) on income derived in the ordinary course of a trade or business, which is generally not subject to employment tax, for individuals with modified adjusted gross income in excess of $400,000 ($500,000 for joint filers) and for trusts and estates.
Under the BBBA as drafted, a surcharge would also be imposed on modified adjusted gross income (MAGI):
Potential Transaction Accelerators Whether the proposed increase in taxes from the NIIT and surcharge provisions might be offset by changes in the deductibility of state and local taxes remains uncertain as Democrats have not solidified a position on what the regime should be, with some arguing that a more generous deduction rule should only apply to taxpayers below a specified income threshold level.
A handful of BBBA tax provisions might cause some businesses to consider accelerating certain transactions that would be treated differently under the proposed rules. Some proposed changes include:
With the new year, also comes heightened scrutiny by the IRS that could affect taxpayers engaged in certain activities or transactions.
R&D Tax Credit Refund Claims
Late last year, the IRS announced that beginning January 10th, taxpayers must provide substantial information for refund claims for R&D tax credits, including identifying for each business component, all R&D activities that each individual performed and the information they sought to discover. Under new procedures (discussed here), the IRS will assess whether the refund claim on an amended return is “deficient” — lacks sufficient information — before considering the merits of the claim. If taxpayers fail to perfect a deficient claim within 45 days during the one-year transition period or submit a deficient claim after the transition period, they will receive a “No Consideration” letter indicating that their refund claim cannot be processed.
A&M Insight: The IRS’s requirements for R&D tax credit refunds could be onerous, particularly for large companies, and present nuanced issues taxpayers might have to consider as they navigate through the refund claim submission process. Businesses that are improving their manufacturing operations, developing new software, or otherwise enhancing their processes should immediately assess how they are going to collect and report the information required and assess potential implications regarding processing of refund claims on amended returns. This change, along with the TCJA change requiring amortization of research expenditures, will be discussed during our upcoming Virtual Coffee Talk on “Insights Into the Changing R&D Landscape.”
Foreign Investors’ Lending Activities
The IRS is gearing up to launch its latest compliance campaign announced last year aimed at ferreting out non-compliant foreign investors engaged in lending transactions through a US trade or business that would be subject to US tax on effectively connected income. For example, dealers in stocks and securities, entities conducting a lending business, and foreign investors in partnerships conducting lending activities are treated as engaged in a trade or business within the US. The compliance campaign will involve issued-based examinations but will differ from others because the IRS won’t start with a return that includes the tax but instead might start by reviewing a passthrough entity’s information or Form 8804, “Annual Return for Partnership Withholding Tax (Section 1446),” which in turn may lead to the ultimate taxpayers. More information could be released publicly before the exams begin, which might shed light on the structures that are of most concern to the IRS.
This year, it will be even more important for taxpayers to stay on top of the ever-changing legislative and regulatory landscape and assess any implications for their business and tax planning, operations, and technological needs. Complex modeling capabilities are required, along with the ability to adapt quickly as guidance is provided. For example, in the first quarter taxpayers must tackle the recently issued final foreign tax credit regulations to determine whether previously creditable foreign taxes remain creditable under the new rules. New regulations that Treasury and the IRS might release this year include proposed rules for previously taxed earnings and profits and possibly the general dividends received deduction proposed regulations, although legislative changes could affect those rules. A&M tax professionals stand ready to assist you in navigating the 2022 tax year and anticipating future implications and opportunities for your business. Please feel free to reach out to Kevin M. Jacobs to discuss your specific situation and issues keeping you up at night.