Services firms face moving targets for tax plans

Three major changes in tax law over the last two years have broadly affected the tax treatment of capital and research spending and the debt used to finance it:

• Section 174: For tax years beginning in 2022 and later, domestic R&E costs under Section 174 must now be amortized over five years instead of being expensed. Since a midyear convention must be used, this effectively reduced the deduction for these domestic R&E costs in 2022 by 90%. Foreign R&E must be amortized over 15 years.
• Section 163(j): The deduction for net interest expense is generally limited to 30% of adjusted taxable income under Section 163(j). Previously, adjusted taxable income was similar to earnings before interest, taxes, depreciation and amortization (EBITDA). For tax years beginning in 2022 or later, depreciation and amortization must be included, lowering adjusted taxable income to an amount similar to EBIT.

• Bonus depreciation: Property placed in service this year can no longer be fully expensed and is instead eligible only for 80% bonus depreciation, with the rest of the cost recoverable over the normal depreciable period. This treatment is scheduled to diminish over time, with the bonus rate dropping to 60% for property placed in service in 2024, 40% in 2025, and 20% in 2026. Bonus depreciation is scheduled to disappear entirely in 2027.

Many taxpayers hesitated to address these changes, in hopes that Congress would reverse them legislatively. Most taxpayers were finally forced into implementation when filing 2022 returns, so firms should have completed the significant work of identifying R&E costs under Section 174 and applying the new interest limit. Now is the time to look at more proactive planning. There may be one last chance for lawmakers to provide retroactive relief before the end of this year, so watch out for potential legislation.

“Professional service businesses haven’t been hit as hard by these changes as some more capital-intensive industries, but the impact can still be significant,” Werth said. “Businesses should model out the impact to understand planning options, particularly for firms planning significant transactions.”

High interest rates have proven frustratingly resilient, and the limit under Section 163(j) could affect highly leveraged service firms, particularly those using debt to finance expansions or acquisitions. Firms facing a cap on their interest deduction may have opportunities to instead allocate interest expense to the research and development, production, construction or acquisition of a wide range of tangible and intangible property. Once recharacterized to another asset, the interest becomes part of the cost of that asset and is recovered using the accounting method applicable to that item. For example, if interest is recharacterized to a fixed asset, it would be recovered through depreciation deductions. For a more detailed discussion, see Strategic considerations for the newly restrictive 163(j).

Section 174 might be the more important issue, especially for service firms developing software, which must generally be capitalized under Section 174. The IRS released important guidance on how to apply these rules just days or weeks before returns were due for many calendar-year taxpayers. The guidance offered important insight into how the IRS views the scope of what’s included in software development, but some uncertainty remains. The IRS might offer additional rules to help taxpayers identify and segregate software costs that are still deductible as maintenance rather than an upgrade or enhancement.

For now, taxpayers should analyze the new rules, which are proposed to be applicable for tax years beginning after September 8, 2023. Some of the rules provide favorable results, while others could present challenges and compliance burdens.

With bonus depreciation shrinking to 80% this year and 60% next, it’s worth looking at opportunities to accelerate deductions for fixed assets. This will be most important for firms expanding their physical footprint. An analysis to identify costs that can be considered repairs has always been valuable when looking at structural property that doesn’t qualify for bonus depreciation. With bonus depreciation at 60% next year, this repairs analysis could also now significantly accelerate the cost recovery of other types of property. Firms can also consider a broader cost segregation analysis, which identifies costs eligible for recovery as property with a shorter depreciable period. This effort can be paired with Section 163(j) planning to accelerate the recovery of any related interest expense.

State and local taxes

State and local taxes can be as important as federal taxes for many professional services firms. States looking for new revenue sources are aggressively targeting service providers.

As we move farther from the 2018 decision in South Dakota v. Wayfair, states continue to push the envelope with economic nexus provisions requiring sales and use taxes on services and licensing. Sales and use taxes are growing increasingly complex with the interplay between various states and evolving nexus rules. Consider performing a sales and use tax “reverse audit” to review your purchase records over the past several years and identify potential missed exemptions, misapplied rates and overpayments. The reviews can often generate significant refunds, as well as identify areas of exposure.

Many states are also looking at applying economic nexus concepts and unique sourcing rules to income and gross receipts taxes. In certain cases, such laws could require service providers to recognize revenue based on where the production costs for the services take place. This is a particularly relevant issue as hybrid and remote work arrangements become a permanent part of the workforce relationship.

SALT deduction workaround

Professional service firms organized as partnerships or S corporations have a unique opportunity to provide owners with relief from the $10,000 cap on the federal state and local tax (SALT) deduction. To date, 36 states and one locality have enacted regimes that allow pass-through businesses to deduct SALT taxes at the entity level in exchange for a credit or exemption from state tax on the pass-through income of owners. This allows a business to fully deduct state tax for federal purposes against the distributive share of owner income, rather than having owners pay tax and take a limited SALT deduction at the individual level. Another three states have proposed similar rules.

The explosion in state pass-through entity (PTE) tax regimes over the last two years came partly in response to IRS guidance (Notice 2020-75) confirming the viability of the entity-level deductions. Although these regimes can offer significant benefits to pass-through business owners, there are potential drawbacks. There are a variety of factors in the complex determination of whether it makes sense to elect into a pass-through entity (PTE) tax.

The lack of uniformity among state laws presents challenges. State rules vary on when taxpayers can make an election to shift tax to the entity level. The timing of an entity-level deduction may depend both on when the election is made and when the entity makes payments for the tax. State laws also vary (and are not always clear) on whether PTE taxes paid in one state are creditable against other PTE regimes or personal income tax liability in other states.

It’s also important to understand that PTE tax elections may benefit certain partners more than others, particularly for partnerships operating across many states or with partners residing in different states. These pass-through businesses should weigh the burdens of paying the entity-level tax against the benefits of passing the entity-level deduction to partners, and consider whether the partnership agreement will permit any necessary adjustments to allocations or distributions. States are still updating their laws to address technical considerations. Professional service businesses considering the election should carefully analyze the most current state laws and fully assess the potential implications.

Selling services abroad

Firms providing services abroad should consider the deduction for foreign-derived intangible income. It is an annual and permanent benefit that provides cash tax savings. It applies more broadly than the name implies. The benefit was ostensibly designed to target income derived from intangible assets, but its formula-driven approach means that its reach often extends beyond this type of income. Your organization may qualify if it provides services to any person or with respect to any property that is located outside of the U.S. However, it is only available for a domestic C corporation.

The benefit is also reduced by a routine return, which is calculated as a percentage of tangible assets. This often results in a substantial reduction in the benefit for many asset-intensive industries. However, most service companies typically have minimal tangible assets, allowing a larger portion of the benefit to hit the bottom line.

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The professional services industry should expect elevated scrutiny from the IRS over the next few years. The Inflation Reduction Act provided the IRS with $80 billion in additional funding, and over 50% is earmarked for enforcement. The debt limit deal included a handshake agreement to reallocate $20 billion of that money to other spending priorities, but $60 billion is still a staggering sum compared to normal IRS funding. It represents more than four years of annual appropriations based on recent IRS funding levels, and it comes on top of regular annual funding with no restrictions on when it can be spent.

The increased enforcement may come more quickly than some taxpayers expect. In the last two year, the IRS has significantly expanded its workforce and is actively recruiting 3,700 new auditors. Much of the activity will be focused on partnerships, which have seen a dramatic decrease in audit rates over the last several years. 

Capital account management

We are now three years into rules for partnerships to report the tax basis of capital accounts of partners, and transition relief has fully expired.

Capital accounts involve the economic relationship of the partners, so capital account maintenance is important, not just for tax reporting, but for many other reasons. The computational work in maintaining capital accounts involves potentially significant compliance burdens that entail collecting information from partners and reviewing partnership agreements, debt agreements and compensatory award documents. While there are software solutions that can help with this computational work, the economic arrangement between partners can be very complex and a deep analysis of documents and tax rules may be needed.

International reporting

The IRS might be done changing the new international reporting requirement for partnerships that first took effect for 2021 returns. The rules generally require partnerships to report a variety of information on new Schedules K-2 and K-3. There is limited ability for professional services partnerships to escape these requirements even if they have little international investment.

The domestic filing exception only applies for partnerships with certain types of partners, and requires the partnership to perform notification and request procedures. The partnership also must also either have “no foreign activity” or “limited foreign activity.” For partnerships that do need to report, the rules may require businesses to make changes to their current systems and processes to track and provide the required information in a different way, collect additional information from partners or shareholders, or modify agreements to facilitate information sharing. Automation and other software solutions can help to reduce lead times, improve the efficiency of data gathering and offer more partner-investor communications.

Self-employment and NII tax

Professional service partnerships should consider how partners are treated for self-employment taxes. The IRS has launched an audit campaign and is actively litigating the issue. The treatment of income for employment and investment taxes for limited partners may hinge on three cases in the Tax Court involving investment management funds (Denham Capital Management LP v. Commissioner, Point72 Asset Management LP v. Commissioner, both pending, and Soroban Capital Partners LP v. Commissioner, partial summary judgment in November 2023).

The issue revolves around an exception from self-employment tax under Section 1402(a)(13) for the distributive share of partnership of income of a “limited partner.” Partners can potentially avoid self-employment tax on their distributive share of partnership income if they can establish that they are limited partners. But for this position to benefit the partners, they would also need to exclude the income from the net investment income (NII) tax. The NII tax under Section 1411 generally imposes an equivalent 3.8% tax on partnership income (if the partner income exceeds certain thresholds) unless partners can establish that they are not passive in the underlying trade or business.