As the Tax Cuts and Jobs Act makes its way through the House and Senate Conference Committee and put up for vote in both houses of Congress this week, cash basis taxpayers may be considering prepaying certain expenses in order to obtain relief from some of the Act’s provisions that eliminate or place limitations on tax deductions for taxable years beginning after December 31, 2017.
For federal income tax purposes, cash basis taxpayers generally can take into account amounts representing allowable deductions in the taxable year in which paid. However, prepaying a 2018 liability or expense in 2017 without an obligation to do so is not a valid deduction, even for a cash basis taxpayer. Based on case law, the prepayment of the liability or expense could be challenged by the Internal Revenue Service because the payment lacks business purpose or fails to clearly reflect income. Further, if the benefit period or useful life associated with the prepaid expense exceeds 12 months, the payment is required to be capitalized and amortized. That said, to the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability relates has been provided by year-end, and the benefit period does not exceed 12 months, cash basis taxpayers that prepay expenses in 2017 for 2018 expenses can claim a deduction in 2017.
On December 15, 2017, the House-Senate Conference Committee members working on the House and Senate tax reform bills signed off on a revised bill. Issued that evening, the full language of the Tax Cuts and Jobs Act (H.R. 1) encompasses over 1,000 pages, including a 570-page joint explanatory statement describing key differences, if any, between the House and Senate tax reform bill, and a summary of the resolution of such differences in the revised bill. The revised bill will be sent to both houses of Congress during the week beginning December 18, 2017, for a vote and could set the stage for the bill to be signed by the President prior to the end of 2017.
Among the many provisions affecting individuals and businesses, this Insight specifically discusses the (1) modification of deduction for taxes not paid or accrued in a trade or business; (2) repeal of certain miscellaneous itemized deductions subject to the two-percent floor; and (3) entertainment expenses.
Modification of deduction for taxes not paid or accrued in a trade or business (section 164 of the Code)
Under the revised bill, individuals generally can deduct State, local, and foreign property taxes and State and local sales taxes only when paid or accrued in carrying on a trade or business, or an activity described in section 212 (relating to expenses for the production of income). Accordingly, the provision allows only those deductions for State, local, and foreign property taxes, and sales taxes, which are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F on such individual’s tax return. For example, in the case of property taxes, an individual may deduct such items only if these taxes were imposed on business assets (such as residential rental property).
Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.
The provision contains an exception to the above-stated rule. Under the provision, a taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for married taxpayer filing a separate return) for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or an activity described in section 212, and (ii) State and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the taxable year. Foreign real property taxes may not be deducted under this exception.
The above rules apply to taxable years beginning after December 31, 2017, and beginning before January 1, 2026.
The conference agreement also provides that, in the case of an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, the payment shall be treated as paid on the last day of the taxable year for which such tax is so imposed for purposes of applying the provision limiting the dollar amount of the deduction.
MFA Observation: An individual may not claim an itemized deduction in 2017 on a pre-payment of state or local income tax for a future taxable year in order to avoid the dollar limitation applicable for taxable years beginning after 2017. The prepayment in 2017 would have no direct link to taxable income for the 2018 tax year; therefore, a payment made to a state or local government in 2017 to apply against the taxpayer’s 2018 tax liability is merely a deposit for which no tax deduction is permitted. However, if the taxpayer has an estimated income tax payment due in April of 2018 based on 2017 taxable income, prepaying the tax in 2017 rather than 2018 would yield a proper deduction in 2017 and possibly generate the benefit of time value of money if tax rates fall in 2018.
Repeal of certain miscellaneous itemized deductions subject to the two-percent floor (Sections 62, 67, and 212 of the Code)
The conference agreement temporarily suspends all miscellaneous itemized deductions that are subject to the two-percent floor under present law. Miscellaneous itemized deductions include, for example, fees to collect interest and dividends, investment fees and expenses, tax preparation expenses, and unreimbursed business expenses incurred by an employee. Thus, under the provision, taxpayers may not claim items as itemized deductions for the taxable year beginning after December 31, 2017, and before January 1, 2026.
MFA Observation: To the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability has been provided by year-end, thereby establishing an obligation to pay on the taxpayer’s part, a cash basis taxpayer prepaying the expense in 2017 rather than in 2018 could reasonably claim a deduction in the earlier year, so long as the prepaid benefit period does not exceed 12 months.
Entertainment, etc. expenses (Section 274 of the Code)
Under the conference agreement, no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or (3) a facility or portion thereof used in connection with any of the above items. As a result, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions).
In addition, the provision disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). For amounts incurred and paid after December 31, 2017, and until December 31, 2025, the provision expands this 50-percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer.
The provision generally applies to amounts paid or incurred after December 31, 2017. However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025, are not deductible.
MFA Observation: A cash basis taxpayer should take action to immediately pay any entertainment expense invoices and expense reports during 2017. If commitments exist for the 2018 year which are budgeted for (e.g., 2018 season tickets), the taxpayer is advised to request an invoice from the seller before year-end so that the amount can be prepaid in 2017.
Other Types of Expenses
There are a number of expenses that cash basis taxpayers may wish to consider prepaying in order to obtain a tax benefit in 2017. The federal tax treatment below assumes that the benefit period associated with the prepaid expense does not exceed 12 months.
The conference agreement generally suspends the deduction for moving expenses for taxable years 2018 through 2025. However, during that suspension period, the provision retains the deduction for moving expenses and the rules providing for exclusions of amounts attributable to in-kind moving and storage expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces (or their spouse or dependents) on active duty that move pursuant to a military order and incident to a permanent change of station. Taxpayers outside of the Armed Forces exception may wish to prepay an invoice in 2017 for 2018 moving expenses in order to take advantage of the moving expenses deduction before suspension.
Home mortgage indebtedness
The conference agreement suspends the deduction for interest on home equity indebtedness. Thus, for taxable years beginning after December 31, 2017, a taxpayer may not claim a deduction for interest on home equity indebtedness. The suspension ends for taxable years beginning after December 31, 2025. In this regard, cash basis taxpayers should consider prepaying “points” charged in 2017 in order to take advantage of the home equity indebtedness deduction before the suspension period. Although a taxpayer must capitalize interest that is properly allocable to a period that extends beyond the close of the taxable year and amortize it over the period to which it applies, section 461(g)(2) provides an exception for points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the taxpayer’s principal residence to the extent that such payment of points is an established business practice in the area in which such indebtedness is incurred and the amount of such payment does not exceed the amount generally charged in such area. Points paid in refinancings may not meet the exception.
Accelerating a deduction from 2018 to 2017 can provide time value of money benefits to the extent that the tax rates drop in 2018. Generally speaking, prepaid rent can be deducted by a cash basis taxpayer in the year of payment so long as the lease agreement calls for rent to be prepaid prior to the beginning of the month to which the rent payment relates. Cash basis taxpayers must also be aware that the prepaid benefit period cannot exceed 12 months. Thus, for example, if the lease agreement requires January 2018 rent to be paid by the end of December, the lessee can claim an accelerated deduction by prepaying for the next month. On the contrary, if the lease agreement calls for January 2018 rent to be due on the first day of that month, prepaying in 2017 would not result in an earlier deduction.
For more information on the matters discussed above, please contact the tax professionals at MFA.