The Tax Cuts and Jobs Act (TCJA) is the biggest change to the tax code since 1986. Many of the changes will significantly impact technology companies.
The TCJA changed tax rates for all companies. It reduced the corporate tax rate to a flat 21% from the maximum 35% in the graduated tax system under prior law. It also reduced individual tax rates across all tax brackets (the new maximum rate is 37%) and established a deduction of up to 20% of qualified business income. Technology companies need to consider the new disparity in tax rates when deciding on the choice of entity.
Many technology companies incur net losses in their initial years. The potential tax benefit of those losses was impacted by the Tax Cuts and Jobs Act. For companies that are formed as C corporations, the TCJA changed the net operating loss rules. Net operating losses can no longer be carried back 2 years and now must be carried forward indefinitely. However, the losses can only be used to reduce your taxable income by 80%. For owners of pass-through entities, the TCJA disallows net business losses in excess of $500,000 if married filing jointly or $250,00 for single filers. Excess business losses are carried forward indefinitely. Technology companies that were formed as pass-through entities for the purposes of benefiting from these losses may be negatively impacted by this change.
Accounting for the research and development (R&D) costs of technology companies will change as well. Effective for years beginning in 2022, the TCJA requires that domestic R&D expenditures be capitalized and amortized over 5 years, and international research must be capitalized and amortized over 15 years. Any capitalized R&D that is retired, disposed of, or abandoned must continue to be amortized. These changes will significantly delay the benefit of R&D expenses, which under current law may be deducted in the year incurred.
The sale of patents and other self-created property was also significantly impacted by the Tax Cuts and Jobs Act. The gain on sale of these assets is now considered ordinary and will be taxed at ordinary income rates (maximum 37%). This does not impact technology companies that are formed as C corporations as there are no capital gains rates in the corporate tax regime, but this may result in significantly more tax being paid by investors in pass-through entities when these assets are sold.
Economic Opportunity Zones are a new community development program established in the Tax Cuts and Jobs Act to encourage long-term investments in low-income urban and rural communities. The TCJA provides for the temporary deferral of inclusion in income for capital gains reinvested in companies in these areas as well as the permanent exclusion of certain capital gains from the sale or exchange of an investment in a company located in an opportunity zone. Technology companies seeking equity investment should consider a location in these zones as it may provide additional incentive to potential investors.
The impact of the Tax Cuts and Jobs Act is widespread. It is important that technology companies consider these changes when forming the entity, during the years of growth, and finally when considering exit strategies.