7 Questions We Have About Deductible Expenses Under The Tax Cuts and Jobs Act
When President Trump signed the Tax Cuts and Jobs Act in the waning days of 2017, accounting and finance professionals had to start scrambling to understand the largest change to the US tax code in a generation. Though the package was years in the making in Congress, the actual bill was written hastily and passed just days before it was scheduled to take effect.
Weeks into the new year, many questions remain about the Tax Cuts and Job Act’s practical implementation. As of this writing, the IRS has not yet issued guidance on key parts of the law. Tax professionals are taking advantage of the ambiguity, drawing up creative ideas to help their clients exploit loopholes and avoid penalties. But for finance teams who can’t spend all their time poring over the regulatory changes, some might catch them by surprise.
Parts of the Act have been well publicized, such as the 20% tax deduction for income from “pass-through” businesses and the $10,000 cap on state and local tax deductions. But under the radar, the law also cut or eliminated a number of deductions for fringe benefits, travel and entertainment (T&E), and employee expenses that businesses have taken for years.
Related: Learn more about IRS rules for expense reporting in our free guide
When we combed through the tax law to find what impact it will have on deductible employee expenses, we were left with more questions than answers. We present those questions based on the Tax Cuts and Jobs Act here. Together, they highlight some of what’s new, what’s different, and what’s simply gone in the wake of H.R.1.
Abacus does not provide tax or accounting advice. Please consult with a qualified professional about any questions you have.
7 Questions About the New Tax Cuts & Jobs Act
1. Is the perks war over?
Tax code change: §274(a) now prohibits or limits the deduction of a number of common fringe benefits.
For the better part of a decade, workplace perks have been munitions in the war for talent. Businesses competing to attract elite employees have spent exorbitant sums to turn their offices into lifestyle hubs, complete with personal wellness classes, onsite meals, and more.
But for all the difficulty of hiring and retaining talent, one factor driving the perks arms race was undoubtedly the fact that companies could write off those traditionally deductible expenses.
The new law curtails deductions for fringe benefits, which means we’re about to find out how essential those employee perks really are. Whereas 100% of meals served on-premises used to be tax deductible (as long as they were excluded from employee gross income) now they are only 50% deductible. Transportation and commuter benefits, moving expenses, and onsite gyms are no longer deductible at all, though some are still excludable from employee income.
How many fringe benefits will stick around in a world where they don’t earn businesses deductions? Conversely, if perks are as essential to attracting talent as we’ve been led to believe, will any employer be able to afford cutting them?
2. What does “safety of the employee” mean?
Tax code change: As per §274(l)(1), providing or reimbursing employees for transportation is no longer deductible “except as necessary for ensuring the safety of the employee.”
At first glance, Section 13304 of the Act seems to slash the number of companies that will be able to offer employees commuter benefits. The legislation prohibits the deduction of transit passes, parking, employer-provided transportation, and any other expense associated with “travel between the employee’s residence and place of employment,” with one big caveat: “except as necessary for ensuring the safety of the employee.”
Well, that changes things.
Businesses could, theoretically, deduct the cost of qualified transportation fringe benefits if they can show that their employees’ safety hinges on it. As deduction daredevilry goes, arguing that case might seem pretty inviting to some businesses. Until the IRS delivers guidance on this (which they do not in 2018’s Publication 15-B) don’t be surprised to see employees spared from danger by heroic transit passes and parking reimbursements. (This is a good place to restate that Abacus does not provide tax advice.)
3. Will client entertainment only happen at restaurants?
Tax code change: §274(a) repeals the deduction for entertainment expenses but retains the 50% deduction for client meal expenses.
One of the Tax Cut and Jobs Act’s most dramatic changes is repealing the “E” half of “T&E” — or, repealing the Entertainment portion of Travel and Entertainment.
Until now, client entertainment expenses were 50% tax deductible as long as taxpayers could attribute specific, detailed business purposes to them. In 2018, both the IRS and taxpayers are liberated from this dance entirely. None of it is tax deductible.
The impact of this change is already far reaching. Comped entertainment experiences have formed an integral part of the American business landscape for generations partly because they could be written off. Entertainment vendors from ticket sellers to the golf industry are already preparing for the shock. “You will see behaviors change,” said tax preparer Michael Chen to MarketWatch. The question, then, is how much.
As with the issue of workplace perks attracting talent, we are about to find out how essential entertainment experiences really are to closing deals. Some observers are skeptical that the change will have any impact on sales. “If you have to ply your clients with gifts or meals to get them to do business with your firm, then your product probably isn’t worth its price,” wrote investor Andy Kessler in the Wall Street Journal in December. “Why should taxpayers subsidize your company for producing lame products or you for being a lousy salesman?”
Regardless of the necessity of entertainment expenses, client meals are still 50% deductible. Maybe we’ll see a shift from corporate suites to restaurant experiences. Or maybe businesses will continue to shell out to entertain select few clients, which would surely still be worth full freight if a big deal hinges on it. For now, one thing is for sure: “Meals & Entertainment” as a single line-item is a thing of the past.
4. Will software companies be able to deduct anything in 2022?
Tax code change: Starting in 2022, §174(c)(3) will exclude from deduction “any amount paid or incurred in connection with the development of any software.”
Before this law, taxpayers had two options with certain research and development (R&D) expenditures: Deduct them in the current tax year or capitalize and amortize them over 5 years or more. With this law, those options are largely gone. Starting in 2022, R&D expenditures cannot be deducted. They will have to be recovered over a 5 year period, or 15 years if the spend is conducted outside the US.
When that provision takes effect, though, one bit of sloppy wording is likely to cause some confusion.
According to the text, no amount will be deductible if it is “paid or incurred in connection with the development of any software.” Spending that meets that definition will be considered R&D, and therefore must be capitalized according to the aforementioned method.
For technology companies like Abacus, this definition of R&D arguably applies to every dollar we spend. Our business, after all, is expense management technology. Even our overhead is “in connection with the development of any software,” let alone our ordinary and necessary business expenses. Absent further clarification, every deduction claimed by every software company after 12/31/21 would potentially violate Section 174 of the tax code.
Hopefully IRS guidance will be forthcoming on this issue. They’ve taken care to define software as “any sequence of machine-readable code” in the past, specifically in Rev. Proc. 2000-50. But the recent Act’s wording arguably undoes that clarification. As with many other areas of the Tax Cuts and Jobs Act, taxpayers deserve a clearer statute.
5. Why does Congress hate bicyclists?
Tax code change: §132(f)(8) specifically prohibits the deduction of qualified bicycle commuting reimbursements through 2025.
In an effort to counter the cost of the overall rate cuts, lawmakers took a fine-toothed comb to the tax code to identify any area that could politically stand to raise revenue. Applying a cap to the state and local tax deduction, which typically impacts residents of high-tax “blue” states, was the marquee example. But for political micro-targeting, the most brazen instance might be Section 11047, which suspends the income exclusion for qualified bicycle commuting reimbursements.
Prior to 2018, employees could exclude up to $20 a month from gross income if their employers reimbursed them for any of the various costs of riding a bicycle to work. It was a humble corner of the tax code, but one that seemingly encouraged green, healthy behavior. And if employees could exclude employer-provided commuting reimbursements for mass transit and personal vehicles, why for not bicycle commuting?
Only Congress knows. The suspension is slated to raise less than $50 million for the government over the next decade. Meanwhile, those other, far more common commuting exclusions are still in effect. Only the bicycle reimbursement exclusion was suspended.
This suspension will sunset in 2025, which means that if nothing further is done, employees will be able to exclude qualified bicycle commuting reimbursements again starting in 2026. Hopefully it won’t deter too many people from riding their bikes to work.
6. Will the “Weinstein tax” backfire?
Tax code change: §162(q) now prohibits the deduction of any payment “related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement.”
You might be surprised to learn that businesses have long been able to deduct out-of-court settlements paid to employees who allege sexual harassment.
Prior to 1969, US courts didn’t permit ordinary and necessary business expenses to include the cost of behavior that was deemed to be a violation of “public policy.” But following the Tax Reform Act of 1969, Section 162 of the US tax code only prohibited businesses from deducting lobbying costs, bribe payments, kickbacks, and fines paid for having violated the law. Pretty much any other payment—including $15 billion of BP’s oil spill settlement and $7 billion of JP Morgan’s settlement for faulty mortgages—was deductible from taxable income.
This year, Rep. Ken Buck (R-CO) wrote a provision intended to add confidential sexual misconduct settlements to the list of expenses businesses would not be able to deduct. As Sen. Bob Menendez (D-NJ) said in support: “Corporations should not be allowed to write-off workplace sexual misconduct as a normal cost of doing business when it is far from normal.”
The problem, according to many tax experts, is that the final law is written so broadly that it might cause problems for victims of sexual harassment. Can they deduct their legal costs? Will it incentivize companies to drag allegations out in court? The law leaves all that unclear.
Some in Congress are now calling for a rewrite of Section 162(q). Whether that happens, and whether problems result from the rule, remain to be seen.
7. Will “covered” CFOs change their compensation?
Tax code change: §162(m)(3)(a) now includes a company’s “principal financial officer” as an employee whose compensation cannot be deducted beyond $1 million of salary, including performance-based compensation.
All of the questions we’ve discussed here pertain to a tiny number of the tax overhaul’s many changes. Section 162 alone, which governs business expenses, has been changed in ways we haven’t even mentioned—some of them with sweeping implications.
Just as one example, Section 13601 of the tax law includes language that could change how thousands of CFOs are compensated. Under the old rule, the law stated that publicly-traded companies could only deduct the first $1 million of salary for the “principal executive” (read: the CEO) and the three next highest-paid employees. Performance-based compensation, however, did not count towards that limit.
Three things change under the new law.
- “Principal financial officers” (CFOs) are now automatically “covered employees,” in addition to the CEO.
- The rule is extended to apply to anyone who ever becomes a covered employee from this point forward—which means that instead of having to track compensation for a handful of employees, major firms now have dozens.
- The million-dollar deduction newly includes all compensation. Performance-based pay to those executives can no longer be deducted.
The long-term effect of this rule remains to be seen, but that’s the story with everything pertaining to this massive law.
The nightmare scenario for tax professionals, and for the business community, is that 2018 simply begins the era of the ever-changing tax code. We now face the possibility that every time political power shifts, the party in control will draft partisan tax reform that takes effect a week from the law’s passage, scuttling plans and sending finance teams into tailspins.
As tax professionals across the world get up to speed on this revision of the US tax code, the prospect of repeating this sprint every two or four years spells nothing but headache. On the plus side, finance expertise has never been more in demand. For all we know, this could be the golden age of tax accounting.
Abacus does not provide tax or accounting advice. Please consult with a qualified professional if you have any questions.