Tax Reform’s Impact on Tech Companies: The Good, the Bad, and the Ugly

Under previous tax law, income from pass-through entities (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) were taxed as ordinary income to individual owners. Under the new tax law, owners may be permitted to deduct up to 20 percent of their “qualified business income” from pass-through entities on their individual income tax return from the total amount of income that is “passed through” to them.

Under this provision, “qualified business income” is defined as “domestic income from a pass-through entity” but does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments.

In general, the pass-through deduction would be further limited to the greater of:

• 50 percent of the individual’s share of W-2 wages paid by the pass-through entity for its workforce, or
• the sum of 25 percent of the individual’s share of W-2 wages paid by the pass-through entity plus 2.5 percent of the unadjusted basis of all qualified property.

As a general rule, income resulting from a “specified service trade or business” does not qualify for the deduction for pass-through income. Examples of specified service trade or businesses include businesses engaged in the performance of services in the fields of health, consulting, law, accounting, and financial services.

However, an individual taxpayer would be exempt from this provision, as well as the W-2 limitation, if their taxable income does not exceed $315,000 for married-filing-jointly filers or $157,500 for single filers.

Business loss limitation

The new tax law disallows excess business losses in a taxable year. However, the excess business losses can be carried forward under the net operating loss provisions discussed below. To determine the “excess business loss” under the new law, a taxpayer would determine the excess of aggregate trade or business deductions over the taxpayer’s aggregate gross income or gain plus the taxpayer’s threshold amount. The taxpayer’s “threshold amount” will be $500,000 for married-filing-jointly filers or $250,000 for single filers (these amounts are indexed for inflation).

Investors of profitable technology companies could see some benefits in the “pass-through income deduction” dependent upon workforce W-2 wages. On the other hand, investors in technology companies still in development or early stages that generate losses will be affected by limitations to currently deductible of losses under the “business loss limitations.”

We do not yet know how the “specified service business” rule will be applied to technology companies with multiple revenue streams, which contain a service or consulting component. More to come on this specific implication as we receive further clarification.

Corporate tax rate

Under prior law, C corporations were taxed based on a graduated system with a top rate of 35 percent. The new tax law eliminates the graduated system and replaces it with a flat 21 percent income tax for C corporations. Additionally, the new tax law will not have a special tax rate for personal service corporations.

Corporate alternative minimum tax

The new tax law repeals the corporate alternative minimum tax. However, corporations with prior year minimum tax credits will continue to be able to carry forward the credit and offset it against the corporation’s regular tax liability.

The reduction in the corporate income tax rate will generally result in increased cash flow for profitable corporations (less income tax expense). Companies may consider using the excess cash flow to pay down debt (provided the interest deduction is limited; see below).

Exit Implications: The mechanics of an asset sale versus a stock sale are unchanged from prior law. However, more deals may be structured as asset sales as the effect of the “double tax” is less than under prior law.

If an asset sale is in the future, companies should be aware that C corporations will face “double taxation.” The gain on the sale of assets will be assessed corporate level taxes, then the remaining proceeds distributed to the C corporation owners will also be assessed tax on the gain. Even with the new 21 percent C corporation tax, the remaining 79 percent of funds will be taxed to owners when the funds are liquidated at a potential 20 percent individual tax rate for long-term capital gains. This equates to a 37 percent overall tax rate. If a stock sale is possible, the owners will owe a 20 percent long-term capital gain tax on the gain on the sale.

Potential purchasers of tech companies will have an impact on how the sale is structured as well; thus, the correct decision on structure will depend greatly on the vision and timing of liquidation as well as the negotiations between the two parties.

Corporations who issue Generally Accepted Accounting Principles (GAAP) financial statements need to assess accruals for income taxes under ASC 740 as a result of the tax reform provisions. For calendar-year taxpayers, the impact of the law changes will need to be reflected in the Dec. 31, 2017, GAAP financial statements. Deferred tax assets and liabilities are valued at the anticipated tax rate in which the temporary differences are expected to reverse. With the corporate tax rate reduction to 21 percent, companies will need to remeasure their deferred tax assets and liabilities using the new, lower rate. The impact of the rate change will be reflected in the company’s income statement in continuing operations.

The change in the tax rates for C corporations has raised the question about whether C corporations should now be the entity of choice over pass-through entities.

Technology companies are generally either structured as an LLC or C corporation. Most technology companies begin with capital funding from founders, family, friends, and angel investors. An LLC structure provides investors the additional benefit of passing start-up losses through to the owners as ordinary losses, which may be deductible. When the companies begin accessing capital from more institutional investors or venture capital firms, many entities convert to C corporations. The new legislation could have an impact on entity choice for technology companies. A driver of this decision is likely the anticipated exit strategy of the company (see the implications discussed previously) and whether or not the company will be profitable and intends to distribute cash flow to owners.

Under the new tax law, gain from the sale of a self-created patent, invention, model or design, or secret formula will result in ordinary income for the taxpayer who created the property or the taxpayer with a substituted or transferred basis from the creator.

For technology companies, significant value is attributable to intangible assets, such as goodwill, customer lists, know-how, patents, process, etc. Because the C corporation tax regime does not differentiate between ordinary and capital gain income, the sale of these particular assets will not be treated differently under a C corporation structure. LLCs, in contrast, were entitled to preferential capital gain rates in most circumstances. However, under the new law this preferential treatment is eliminated. In pass-through disposition transactions it will be critical to allocate income away from self-created intangibles to the extent possible because self-created intangibles will now be subject to ordinary income rates instead of capital gain rates.

Bonus depreciation

Businesses will be entitled to expense 100 percent of the qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Beginning Jan. 1, 2023, the amount of qualified property a business will be able to expense will decrease 20 percent per year. As a significant departure from prior law, most used property will also qualify for this 100 percent write-off.

Section 179

Businesses could previously deduct up to $500,000 (indexed for inflation) of qualified property placed in service each year. The new law increases the deduction amount to $1 million per year. Additionally, the new law expands the definition of qualified real property to include all qualified improvement property and certain improvements made to non-residential real property.

Companies can now continue to take bonus depreciation on new capital expenditures, and the benefit is extended to the acquisition of used property.

Standing alone, this provision may make asset acquisitions more desirable. It may shift the calculation of ROI for an asset deal and make it more appealing than purchasing an equity interest. The amount of purchase price that is allocated to eligible assets will be completely deductible in the first year.

Under the new tax law, net operating loss (NOL) deductions will be limited to 80 percent of a business’s taxable income. NOLs can no longer be carried back but carried forward indefinitely. NOLs generated prior to Jan. 1, 2018, are not affected.

The change in NOL deduction limitations could create some cash flow needs for taxes while a company uses its NOL carryforwards. Because NOL carryforwards cannot completely offset taxable income, companies will have to pay tax even though NOL carryforwards are not completely exhausted.

Deductions for business interest expenses will be limited to the sum of:

• Business interest income,
• 30 percent of the business’s adjusted taxable income, and
• Interest from floor plan financing

Businesses with average annual gross receipts of $25 million or less will be exempt from this limitation and would be able to deduct interest expense in full. For this provision, adjusted taxable income is determined without regard to depreciation, amortization, or depletion deductions – effectively, EBITDA (earnings before interest, taxes, depreciation, and amortization). The interest limitation is further restricted after 2021 to 30 percent of EBIT. There is no grandfathering provision for existing debt; therefore, current structures will be affected immediately.

Because technology companies may utilize significant debt in its capital structure, the impact of this provision may be particularly meaningful. Limits on the deductibility of interest will make debt more expensive (on an after-tax basis), and will influence the mix of debt and equity employed in leveraged transactions.

The new tax law repeals the deduction for domestic production activities.

Many software companies were previously able to take advantage of this deduction that is now no longer available. The deduction was approximately nine percent of the company’s taxable income.

Previously, a business could deduct 50 percent of expenses incurred for entertainment, amusement, or recreation. The new tax law eliminates this deduction, meaning that no amount of these expenses are deductible by a business.

The law also disallows deductions for expenses associated with providing qualified transportation fringe benefits to employees and any expense incurred in providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of business.

The law retains the current 50 percent deduction limitation on food and beverage expenses. The law disallows the deduction for meals provided for the convenience of the employer on the employer’s business premises (effective 2025).

Businesses will no longer be able to deduct most moving expense reimbursements provided to employees, nor can employees exclude these amounts from income if reimbursed by the employer.

Technology companies have been at the forefront of offering employees ahead-of-the curve working environments and amenities. Employers will have to decide whether to continue these practices based on whether they want to absorb the tax cost of these now nondeductible expenses.

Companies will need to account for entertainment expenses separately from food and beverage as the classification will affect deductibility on a go-forward basis.

Under the old law, research and experimentation expenses were fully deductible in the year they were incurred. The new law requires research and experimentation expenses incurred after Dec. 31, 2021, to be amortized over a five-year period.

The new tax law preserves the research tax credit.

There should be some proactive planning on the timing of research and experimentation expenses as the timing of the deductibility of the expenses could be impacted. Generally this means accelerating expenses to tax years prior to 2022 in order to utilize expensing before companies are required to amortize these expenses.

The law includes new Code section 83(i), which would delay up to five years the taxation of compensation paid to employees of “eligible corporations” in the form of “qualified stock.”

An “eligible corporation”:

• Is one with stock that is not readily tradable on an established securities market; and
• Has a written plan in place to grant stock options or restricted stock units (RSUs) to at least 80 percent of all full-time, U.S.-based employees.

“Qualified stock” is:

• Received in connection with the exercise of options or settlement of RSUs, and
• Provided for an employee’s performance of services during a calendar year in which the corporation was an eligible corporation.

Income taxes on qualified stock would be due upon the earliest of the following:

• The date the stock is transferrable, including to the employer.
• The date the employee first becomes an “excluded employee” (i.e., CEO, CFO, or a one-percent owner or one of the top four highest-paid employees for any of the 10 preceding taxable years, determined on the basis of the Securities and Exchange Commission disclosure rules for compensation, as if such rules applied to such a corporation).
• The first date any stock of the employer becomes readily tradable on an established securities market.
• The date five years after the date the employee’s right to the stock is not subject to a substantial risk of forfeiture.
• The date on which the employee revokes a deferral election.

These changes could provide some relief for tech start-ups. The ability for the employees to defer taxation of a stock award until it becomes transferable helps reduce some of the recipient’s risk and may be viewed as a more valuable employee incentive.