The Tax Cuts and Jobs Act has particular implications for tech firms and start-ups, especially those structured as C corporations. This brief overview can help you start crafting a thoughtful tax strategy.
The final tax reform legislation includes several provisions that particularly affect technology companies, which are primarily structured as C corporations. Here’s a brief overview of them and how your company can adjust to take advantage of the new law’s benefits or address any changes.
Corporate tax rate reduction
The corporate rate has been slashed from 35 percent to a 21 percent. If your company is structured as a C corporation, you stand to save considerably in taxes. But keep in mind you will need to revalue your net deferred tax assets and liabilities under the new enacted rate for financial statement purposes.
Net operating losses (NOLs)
If your technology company has NOLs, you will have some adjustments to make going forward. Losses that arise in tax years after December 31, 2017, will have an unlimited carryover and no carryback period. NOLs recorded prior to 2018 will still expire under their original schedule. This could affect valuation allowances for deferred tax assets, as well as have an impact on limitations related to change in control under Section 382. Furthermore, the limitation rules under Section 382 are likely to change in the near future.
Now that the corporate AMT has been repealed, future utilization of NOLs arising after December 31, 2017, will be limited to 80 percent of taxable income. In the past, NOLs were fully utilizable for regular tax purposes but were limited to 90 percent when the alternative minimum tax (AMT) applied.
Companies that are turning a profit will be paying more cash tax sooner under the new legislation (unless they have research and development credits; more on that below). Be aware that utilization of NOLs that arose prior to January 1, 2018, must be tracked separately, as they are not subject to the 80 percent limitation and, therefore, may reduce taxable income to zero.
Research and development (R&D)
Starting in 2022, R&D expenses must be capitalized. Given the income tax rate change in 2018, companies should consider not electing the reduced credit in 2017, as they will get a much bigger benefit from the credit than they would from the deduction in future years (because of the reduction in the tax rate).
Also, because R&D credits have historically been limited to AMT, which has been repealed, the credit can now reduce income tax to zero (barring other limitations).
Qualified equity grants
The new law permits recipients of qualified stock that is not publicly tradable to elect deferral until the earliest of the following tax-triggering events:
- The stock becomes transferable
- The employee becomes an excluded employee
- The first date the stock becomes readily tradable on an established securities market
- Five years after the employee’s right to the stock is substantially vested
The date on which the employee revokes his or her election
This is very important to startup private tech companies that otherwise restrict the transferability of their stock. Recipients of equity grants have historically had to remit cash to their employer upon exercise (e.g., stock options) to cover the withholding taxes due upon exercise, even though the underlying stock lacked liquidity.
Timing of the election will be important, as they have 30 days from exercise to make the election. The ability to defer taxation of a stock award until it becomes transferable helps to mitigate some of the risk on the part of the recipient. Another consideration will be the timing of the tax deduction to the company, which will only be available when the recipient recognizes the income.
Limitations on interest deductibility
The tax reform bill limits interest expense to interest income plus 30 percent of adjusted taxable income. Companies with gross income under $25 million are exempt from this limitation.
Domestic production activities deduction (DPAD)
DPAD was an attractive tax benefit for technology companies, but it has been eliminated in the final tax reform legislation for taxable years beginning after December 31, 2017. The greatly reduced corporate rate, however, offsets the lost benefit.
International taxes
The final tax reform legislation essentially moves us away from a worldwide to territorial tax regime. If your company is multinational, this a critical area for tax planning purposes. Transfer pricing is going to be key to making sure tax is properly paid in the various jurisdictions. The cash tax and rate benefits will be less important given the reduced corporate rate, so the motivation to implement complex mobile income structures may be reduced.
Entertainment expenses
Entertainment expenses are no longer deductible. Technology companies have tended to be generous with client and employee amenities. Organizations may want to rethink some of your perks and entertainment offerings from a tax perspective.
How we can help
The final tax reform legislation has particular implications for software businesses, tech start-ups, life science companies, and clean technology organizations. A smart tax strategy can help you take advantage of the benefits and address the changes offered in the new law. CLA’s technology industry practitioners can work with you to craft a tax-advantaged plan that addresses the nuances and needs of your industry.