Tax Reform Q&A: The Implications for Emerging Growth Enterprises and Start-Ups

Tax Reform Q&A: The Implications for
Emerging Growth Enterprises and Start-Ups

Congress recently enacted the most significant overhaul to the U.S. Internal Revenue Code (the Code) in decades. The legislation, commonly known as the Tax Cuts and Jobs Act (the Act), includes a number of changes to the Code that apply to corporate and pass-through businesses. This Q&A summarizes the key tax and employee benefits changes in the Act that impact domestic emerging growth enterprises and start-ups. For additional information on the Act, see our prior alerts: Congress Passes Tax Cuts and Jobs Act and U.S. House and Senate Pass Reconciled Tax Cuts and Jobs Act.

Tax Rates and Choice of Entity

1. Q. How does the Act impact the overall tax rate that applies to corporate and pass-through businesses?

   A. The Act significantly lowers the U.S. federal income tax rate applicable to both corporate and pass-through businesses.

   First, the Act significantly lowers the U.S. federal income tax rate applicable to U.S. C corporations, from 35% to 21%, effective for taxable years beginning after December 31, 2017. In addition, consistent with an overall reduction in the corporate tax rate, the Act adopts a number of changes that reduce the U.S. federal income effective tax rate applicable to income earned by individuals from certain pass-through businesses (e.g., sole proprietorships, LLCs that are taxed as partnerships, and S corporations).

   In general, the Act provides that individuals can deduct 20% of their “qualified domestic business income,” which translates to a maximum marginal effective U.S. federal income tax rate on such income of 29.6%, subject to a W-2 wage-based limitation. Married taxpayers filing jointly who recognize income from specified service businesses and have a combined taxable income of $315,000 or less are also eligible for the deduction, which is phased out over the next $100,000 of taxable income (different limitations apply to single taxpayers and married taxpayers filing separately).

   The effect of these changes is to significantly lower the U.S. federal income tax applicable to income earned by a domestic enterprise or start-up, whether in corporate or pass-through form. 

2. Q. How does the Act impact the decision to operate a business as a pass-through or incorporate?

   A. The reduction in the corporate tax rate reduces (but does not necessarily eliminate) the disparity in net effective tax rates between businesses operating as corporations or pass-throughs. Many factors relevant to choice of entity were not impacted by the Act, including the potential availability of the qualified small business stock (QSBS) exemption from capital gain with respect to certain dispositions of corporate stock.

   As described above, the Act significantly lowers the U.S. federal corporate income tax rate, as well as the effective tax rate on certain business income earned by individuals who own pass-through businesses. To illustrate the difference between the taxation of corporations and pass-through entities, consider the tax treatment of a business that receives $100 of taxable income and distributes the after-tax proceeds to its owners, all of whom are individuals.¹ An enterprise operating as a C corporation would incur $21 of corporate tax and would have $79 remaining to distribute as a dividend to its owners. The owners would generally be taxed on the receipt of the $79 at qualified dividend income rates (maximum of 20%), and would have net after-tax proceeds of $63.20. For comparison, under prior law and with the same assumptions, the owners would have net proceeds of $52. On the other hand, the owners of the pass-through business would be taxed at a rate ranging from 29.6% to 37% (depending on whether, and to what extent, the income qualifies as qualified domestic business income) and have between $63 and $70.40 of net after-tax proceeds.

   As illustrated in this example, the reduction in the corporate income tax rate eliminates some, but not necessarily all, of the disparity in tax rates between corporations and pass-throughs. The precise impact will depend on factors that include the tax status of the business owners, the nature of the income earned, and whether the business intends to reinvest earnings or distribute cash.

   The Act did not alter a number of pre-Act factors that should also be considered in determining whether to operate a business in pass-through or corporate form, including the potential availability of the federal income tax exemption from capital gain from the sale of QSBS and the reluctance or inability of venture capital funds with tax-exempt and/or foreign investors to invest in pass-through businesses.

3. Q. What changes were made to the usability of net operating losses (NOLs)?

   A. The Act generally increases the limitations applicable to a taxpayer’s use of NOLs.

   The Act limits the deduction of NOL carryforwards to 80% of a taxpayer’s taxable income for NOLs generated in taxable years beginning after December 31, 2017 (although with the repeal of the corporate alternative minimum tax (AMT), the deductibility of NOLs generated in taxable years beginning before January 1, 2018 is not subject to either the new 80% limitation or the 90% AMT limitation under prior law). The Act also eliminates the ability of taxpayers to carry back NOLs to prior years (although the carryforward period has been extended indefinitely, from 20 years). The increased limitations on a taxpayer’s use of NOLs tends to reduce the value of the NOLs and could increase the tax liability of a company despite significant NOLs on the balance sheet, although this may be mitigated by the indefinite carryforward period under the Act.

   ¹This example is intended for illustrative purposes only and makes a number of simplifying assumptions including the absence of state income tax.

Mergers & Acquisitions (M&A)

1. Q. How do the changes to the NOL limitations impact “build-to-buy” transactions?

   A. The repeal of the NOL carryback and limitation on the use of NOL carryforwards have potentially significant adverse tax impacts on biotech, medical device, and other start-ups that engage in so-called “build-to-buy” transactions. 

   In a typical build-to-buy transaction, a potential acquirer provides a start-up with development funding, and often has a right to acquire the enterprise in the future at a predetermined price. From a tax perspective, the development funding may be structured to be taxable income to the enterprise, which is expected to be offset by existing NOLs.

   Under prior law, a company with significant existing NOLs could deduct NOL carryforwards to offset up to 90% of its taxable income, and to the extent its taxable income was not fully offset by current year losses and NOLs, deductions for expenses paid in future years could potentially be carried back to claim a refund of taxes paid in prior years. Accordingly, for many enterprises, the actual tax impact of a build-to-buy transaction was manageable, even if the development funding generated significant taxable income.

   However, as described above, for NOLs generated in taxable years after December 31, 2017, the Act limits the deduction of NOL carryforwards to 80% of a company’s taxable income and eliminates the NOL carryback. Accordingly, companies that were counting on the use of NOLs (either carryforwards or carrybacks) to minimize their tax liability on income recognized in a build-to-buy transaction may now be subject to increased taxes.

   Q. Will the Act affect M&A structures?

2. A. Potentially. Changes in the Act could encourage parties to consider asset acquisitions in lieu of stock acquisitions in an M&A transaction.

   As under prior law, the acquirer in an M&A transaction would generally prefer to acquire assets of the target, as the acquirer gets a fair market value basis in the assets that can be depreciated and/or amortized over time, providing it with significant tax benefits, whereas an acquisition of stock leaves the acquirer with a fair market value basis in the stock of the target (assuming a taxable deal) that does not generate a tax benefit unless and until the target (now a subsidiary) is sold. Lower corporate tax rates reduce the tax cost of an asset sale for a corporate target. 

   In addition, acquirers may be able to benefit from 100% expensing with respect to acquired assets. Under the Act, qualified property (including certain used property) placed in service before January 1, 2023 is eligible for 100% expensing (with a phase-down of the depreciation percentage thereafter). Qualified property excludes intangible property (which is generally amortized over 15 years), but generally includes other property used in a trade or business, subject to certain exceptions. Given the immediate potential benefit of an asset purchase to acquirers, we expect more acquirers to push for asset deals, particularly acquirers of tangible property-intensive businesses.

Other Income Tax Provisions

1. Q. Does the Act impact the tax treatment of research expenditures?

   A. Yes, the Act limits the deductibility of certain research expenditures. 

   Under prior law, research or experimental expenditures paid or incurred in connection with a taxpayer’s trade or business were deductible in the year paid or incurred. Under the Act, such expenditures must be amortized by the taxpayer over 5 years, or, in the case of expenditures attributable to foreign research, over 15 years. Accordingly, since research and experimentation expenses are no longer immediately deductible, the tax benefit of such expenditures to taxpayers is decreased, particularly for businesses that are currently profitable. 

2. Q. Does the Act affect the tax treatment of patents and other inventions?

   A.  Yes, but it’s complicated. As a general rule, the Act provides that the sale of a self-created patent or invention is taxed at ordinary income rates. However, the Act does not change a provision of the Code that taxes the sale of a patent by its holder at long-term capital gains rates, and it is unclear how the Act interacts with this provision.

   The Act revised the Code to provide that self-created patents, models, inventions, designs, and secret formulas or processes are not considered capital assets, meaning, as a general matter, sales of such items are taxed at ordinary income rates. The provision does not apply to goodwill, the sale of which therefore may result in capital gain. A separate provision of the Code (that was not changed by the Act), however, continues to tax gain from the sale or exchange of a patent by the holder of the patent (generally, inventors and individuals who acquired their interest in the patent before it was reduced to practice) at long-term capital gains rates, regardless of the individual’s holding period in the patent. Under applicable regulations, sales of patentable inventions (as opposed to issued patents or patent applications) should be eligible for the long-term capital gains rate. It is unclear how the Act and this provision applicable to holders of patents or patentable inventions will interact. However, sales of self-created models, inventions, designs, formulas, and processes that are not patentable would now be taxed at ordinary income rates, because they are not subject to the provision of the Code applicable to holders.

3. Q. Does the Act contain any other provisions to help small businesses?

   A.  Yes. The Act generally allows more small businesses to use the cash method of accounting.

   Businesses are generally allowed to calculate their U.S. federal income tax liability by using one of two methods of tax accounting: the cash method or the accrual method. In general, the cash method of tax accounting is simpler to implement and maintain. The Act expands the businesses eligible for the cash method of tax accounting to all businesses for which the average annual gross receipts for the prior three years is less than $25 million.

Employee Benefits and Compensation

1. Q. Does the Act affect the tax treatment of equity awards?

   A. Yes, the Act introduces a new federal income tax deferral program that is available with respect to certain stock options and restricted stock units (RSUs) granted by private companies.

   The Act adds a new opportunity for employees who are not executives of a privately-held company and who are not and have not been significant stockholders of the company in the previous 10 years, to make an election (83(i) election) pursuant to a program established by the company (83(i) program), to defer federal income tax on certain stock options and RSUs granted by the company until the earliest date of any of the following: (1) the award recipient becomes an executive or significant stockholder of the company, (2) the stock issued to the employee becomes transferable, (3) the company’s stock becomes publicly traded, (4) the five-year anniversary of the date the employee’s right to the stock becomes substantially vested, or (5) the employee revokes the 83(i) election. The 83(i) election may be made within the 30-day period after the right to the stock received in connection with the stock options or RSUs becomes substantially vested or transferable (whichever occurs first).

   Privately held companies generally must make available an 83(i) program if they: (1) have offered stock options or RSUs on terms that provide the same rights and privileges (other than with respect to number of underlying shares) in the calendar year to at least 80% of the company’s U.S. employees, and (2) have not repurchased any of their outstanding stock in the preceding year, subject to certain exceptions. Companies that maintain an 83(i) program are required to maintain a written plan and provide notice to each employee eligible to make an 83(i) election at the time (or a reasonable period before) the employee is eligible to make the 83(i) election and can face monetary penalties for failing to do so. 

   As of the date of this Tax Reform Q&A, many issues with respect to the new 83(i) program rules remain unresolved and are expected to be addressed by the IRS through future guidance. Until that occurs, taxpayers may make good faith interpretations of the new law.

2. Q. Does the Act impact incentive stock options? 

   A. Yes, but the impact is limited to the changes made to the alternative minimum tax for individual taxpayers. 

   Under current law, generally, when the holder of an incentive stock option exercises any shares underlying the option, he or she does not recognize ordinary income. However, to the extent the individual continued to hold the exercised shares through the end of the year in which the shares were exercised, he or she would be required to include an amount equal to the fair market value of the exercised shares over the exercise price as an adjustment in determining his or her alternative minimum tax for the year of exercise.

   The Act has made various changes to the alternative minimum tax for individual taxpayers, some of which may have the effect of increasing the alternative minimum tax for some taxpayers. However, the Act also allows for significantly more income to be exempt from the alternative minimum tax for individual taxpayers. The Act substantially increased the alternative minimum tax exemption amounts to $70,300 for single filers and $109,400 for married couples filing jointly (indexed for inflation). Additionally, the Act substantially increased the threshold amounts at which the exemptions would not be reduced to $500,000 for single filers and $1 million for married couples filing jointly (indexed for inflation). 

   While the effect of these changes will impact taxpayers differently depending on the taxpayer’s personal circumstances, the significant increase in the exemption thresholds potentially could exempt more taxpayers from being subject to the alternative minimum tax. In this case, the granting of incentive stock options (in lieu of nonstatutory stock options, which generally can subject the option holder to income recognition and income taxes at exercise) has the potential to become a more attractive practice among companies, because exercising incentive stock options may not subject as many company employees to the alternative minimum tax, who then might be more motivated to exercise their options and hold the shares for the statutory holding periods to receive favorable tax treatment upon sale of the shares.

3. Q. Does the Act affect the tax treatment of deductions for employer-provided meals and entertainment expenses?

   A. Yes, the Act provides greater restrictions on the deductibility of meals and entertainment expenses covered by employers.

   Entertainment. Under the Act, entertainment expenses incurred or paid beginning in 2018, even if directly business-related, do not qualify as a deductible business expense by employers except in limited circumstances, such as expenses for recreation, social or similar activities primarily for the benefit of the employer’s employees other than highly compensated employees (e.g., office holiday parties), or reimbursed entertainment expenses included in the employee’s taxable wages. Under the Act, companies generally no longer can deduct expenses for entertaining clients.

   Meals. Under prior law, meals provided for an employer’s convenience generally were fully deductible by employers for corporate income tax purposes to the extent excludible from an employee’s income as a de minimis fringe benefit. Any other qualified business meals and meals provided for the convenience of the employer generally were 50% deductible by employers. Under the Act, this 50% limitation on deductibility generally applies to all meal expenses from 2018 through 2025, even those that previously would have qualified as a de minimis fringe benefit. Further, beginning in 2026, no employer deduction will be available for meals provided for an employer’s convenience.