Royse Law PATH Act Update: Major Tax Changes Affecting Small to Midsize Businesses
To conclude 2015, Congress passed a major tax bill, the Protecting Americans from Tax Hikes (PATH) Act. The Act focused on making permanent, modifying, or extending several popular tax provisions. It also changed partnership audits to improve administration, altered IRS procedures to help reduce identity theft and misbehavior by IRS agents, and made other incremental changes to Tax Court procedure, international taxation, REITs, and more.
Rather than tackle the entirety of this bill, this update casts a spotlight on some of the provisions most likely to have an impact on small to midsize Silicon Valley businesses.
Permanent extension of research credit, with additional modifications to help small businesses
Congress made the R&D credit permanent, which gives companies additional tax breaks for certain R&D-related costs.
Additionally, Congress added two new tweaks to the credit that make it far more valuable to small and medium businesses. First, for companies with less than $5 million in annual gross receipts in the past five years, the credit can now be applied to offset up to $250,000 of payroll taxes. This is helpful since loss-generating startups cannot otherwise use the credits, as they lack an income tax bill to offset with the credit. Second, the credit can now be used against alternative minimum tax (AMT) for businesses with no more than $50 million in annual gross receipts. This is helpful since companies first starting to become profitable may trigger the AMT.
If you are interested in using the credit, you should consult a tax attorney to see if your costs can qualify for the credit. Not all technological development, particularly certain items of software and computer hardware, will qualify for the credit. That said, recent cases and proposed regulations have expanded what software and hardware costs are eligible for the credit.
Making C-Corporations work for small businesses: Permanent extension of the qualified small business stock 100% exclusion and reduction of the length of the built-in gains tax
In tax law, it has become something of a truism that, unless you’re interested in raising capital from venture capitalists (who prefer C-corporations), C-corporations are a bad choice for small businesses. C-corporations have two layers of tax (once at the corporation, and again when the corporation pays dividends to its shareholders), compared to the single layer of tax for virtually every other entity (S-corporations, partnerships, most LLCs). They cannot pass through losses to their owners, either.
However, Congress has made permanent some provisions that greatly enhance the value of C-corporations to smaller businesses. Specifically, Congress made permanent a 100% exclusion on certain amounts of gain from the sale of “qualified small business stock” (QSBS), which only C-corporations can have. Startups planning to be sold will want to think seriously about the opportunity this creates.
For those who begin as C-corporations and discover that QSBS helps less than being able to pass through losses or distribute future income, they may find themselves wanting to convert to an S-corporation. In past years, doing this was onerous; all property owned by the corporation before the conversion would be “tainted” with the built-in gains tax. For the next 10 years after conversion, if any of these properties were sold, it would essentially be as if they faced the C-corporation double tax. However, thanks to the PATH Act, Congress has permanently changed the built-in gains tax to only survive for 5 years.
Thanks to these new changes, it may now make sense for many startups to use the corporate form, and in particular the C-corporate form. Taxpayers have more reason to consider their choice of entity carefully.
Change in the partnership tax audit rules
Perhaps the most major change made by the PATH Act involves changes to the partnership tax audit rules. The changes are expected to lead to more audits of large partnerships. The Act replaces the existing audit rules, TEFRA, for tax years beginning in 2018, although the new rules can be opted into earlier.
Under the new rules, generally, both audits and assessments of taxes occur at the partnership level. (Under TEFRA, audits were at the partnership level, but assessments at the partner level.) Thus, the IRS will effectively audit and collect money from partnerships, presuming all the income would have gone to partners and been taxed the maximum rate. To reduce the amount owed, partnerships will have a short time window to show the money would have gone to partners who would have paid less than the maximum rate on that income.
Interestingly, what partners will pay for the assessment is a matter of some flexibility. The rules permit payment either by (1) those who are partners in the year the assessment actually occurs, or (2) those who were partners in the year being assessed on. Electing the second option will cause an additional penalty rate of interest on the past-due amounts. Still, even with this flexibility, there is much uncertainty surrounding how partners will pay for the assessment, and how the partnership will account for any payments.
However, certain partnerships can elect out of the new audit rules: Those with fewer than 100 partners, and where only certain eligible entity types (e.g., not partnerships) are partners. If partnerships elect out of the new rules, they are under pre-TEFRA rules, where both audits and assessments occur at the partner level. For such partnerships, the IRS is trying to figure out how to handle returning to pre-TEFRA rules, which were known to be particularly onerous for the IRS.
Other changes to the audit rules include the replacement of the tax matters partner with the partnership representative, who needs not be a partner; the end of amended returns for partnerships in favor of an administrative adjustment process; and much more. There is considerable uncertainty surrounding the new provisions, which the IRS will hopefully address before 2018.
Companies run as partnerships, including various investment funds, should eventually amend their operating agreements to reflect the new rules.
Extension and modification of various favorable deductions, depreciation, and credit provisions
Many business are more burdened by state and local sales taxes than state and local income taxes. Such businesses will be happy to hear Congress has made permanent the ability for businesses to elect to deduct state and local sales taxes instead of state and local income taxes. See IRC §164.
Elsewhere, Congress has made permanent or extended provisions that function to accelerate the rate of depreciation for numerous assets. These include a temporary extension of bonus depreciation under §168(k), increased deductibility for the cost of certain assets under §179, and accelerated depreciation for qualified leasehold improvements, qualified restaurant buildings, qualified restaurant improvements, and retail improvements.
Lastly, the energy sector will enjoy the extension of energy credits which were set to expire.
As noted, there is much more to the PATH Act than simply the above changes. For information on the PATH Act and much more, please contact us at Royse Law.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.