Depreciation and amortisation
Depreciation deductions are allowances that may be taken for capital outlays for tangible property. For property placed in service after 1986, capital costs must be recovered by using the modified accelerated cost recovery system (MACRS) method. Depending on the type of tangible property, the general cost recovery periods are three, five, seven, ten, 15, 20, 27.5, and 39 years (31.5 years for property placed in service before 13 May 1993). The cost recovery methods and periods are the same for both new and used property. Most tangible personal property is in the three-, five-, or seven-year class. Property placed in the three-, five-, seven-, or ten-year class is depreciated by first applying the 200% declining-balance method and then switching to the straight-line method at such a time as when use of the straight-line method maximises the depreciation deduction. Property in the 15- or 20-year class is depreciated by using the 150% declining-balance method and later switching to the straight-line method. An election may be made to use the alternative depreciation system (basically, the straight-line method over prescribed lives). Residential rental property generally is depreciated by the straight-line method over 27.5 years. Non-residential real property is depreciated by the straight-line method over 39 years (31.5 years for property placed in service before 13 May 1993).
An election to use the straight-line method over the regular recovery period or a longer recovery period also is available. Alternatively, taxpayers may elect to use the 150% declining-balance method over the regular recovery period for all property other than real property.
Special rules apply to automobiles and certain other 'listed' property. Accelerated depreciation deductions can be claimed only if the automobile is used 50% or more for qualified business use as defined in related regulations. For automobiles placed in service after 1986, the allowable yearly depreciation deduction cannot exceed specific dollar limitations.
Separate methods and periods of cost recovery are specified by statute for certain tangible personal and real property used outside the United States.
Rapid amortisation may be allowable for certain pollution control facilities.
Tax depreciation generally does not conform to book depreciation. Tax depreciation generally is subject to recapture on the sale or disposition of certain property, to the extent of gain, which is subject to tax as ordinary income.
The cost of most intangible assets is capitalised and amortisable rateably over 15 years.
Section 179 deduction
Corporations may elect to expense, up to a statutory amount per year, the cost of certain eligible property used in the active conduct of a trade or business. This is commonly referred to as the Section 179 deduction.
Varying amounts and thresholds apply to tax years beginning before 1 January 2018.
For property placed in service in tax years beginning after 31 December 2017, the dollar limitation is USD 1 million and the cost of property subject to the phase-out is USD 2.5 million. These dollar limitations are indexed for inflation for tax years beginning after 31 December 2018.
This deduction is limited to the taxable income of the business.
A 100% special first-year depreciation allowance (i.e. bonus depreciation) applies (unless an election out is made) for property for which the original use begins with the taxpayer (or, under certain circumstances, if the use is new to the taxpayer), MACRS property with a recovery period of 20 years or less, certain computer software, water utility property, and certain leasehold improvements. The special allowance does not apply to property that must be depreciated using the alternative depreciation system or to 'listed property' not used predominantly for business. The special allowance reduces basis before regular depreciation is figured. Additionally, claiming bonus depreciation on automobiles may affect the first-year depreciation limits on such automobiles.
Thus, for certain new and used property acquired and placed in service before 1 January 2023 (with an additional year for certain aircraft and longer production period property), taxpayers may expense immediately the entire cost of such property. For qualified property placed in service in calendar years 2023, 2024, 2025, and 2026 (2024, 2025, 2026, and 2027 for certain aircraft and longer production period property), 100% is reduced to 80%, 60%, 40%, and 20%, respectively. For any property acquired prior to 28 September 2017, the previous bonus depreciation rules apply.
For natural resource properties other than timber and certain oil and gas properties, depletion may be computed on a cost or a percentage basis.
Cost depletion is a method of depletion applied to exhaustible natural resources, including timber, which is based on the adjusted basis of the property. Each year, the adjusted basis of the property is reduced, but not below zero, by the amount of depletion calculated for that year. The current year cost depletion deduction is based on an estimate of the number of units that make up the deposit and the number of units extracted and sold during the year.
Percentage depletion is a method of depletion applied to most minerals and geothermal deposits, and, to a more limited extent, oil and gas. Percentage depletion is deductible at rates varying from 5% to 25% of gross income, depending on the mineral and certain other conditions. Percentage depletion may be deducted even after the total depletion deductions have exceeded the cost basis. However, percentage depletion is limited to 50% (100% for oil and gas properties) of taxable income from the property (computed without allowance for depletion). Generally, percentage depletion is not available for oil or gas wells. However, exceptions exist for natural gas from geopressurised brine and for independent producers of oil and gas.
The cost of goodwill acquired in connection with the acquisition of assets that constitute a trade or business generally is capitalised and amortised rateably over 15 years, beginning in the month the goodwill is acquired.
Generally, start-up expenditures must be amortised over a 15-year period; however, certain taxpayers may elect to deduct a certain amount of start-up expenditures in the tax year the trade or business begins.
Interest expense limitation
Prior-law Section 163(j) was replaced by new Section 163(j) at the end of 2017 with the enactment of P.L. 115-97 (hereafter referred to as current-law Section 163(j) or Section 163(j)). Effective for tax years beginning after 31 December 2017, Section 163(j) generally limits US business interest expense deductions to the sum of business interest income, 30% of ‘adjusted taxable income’ (ATI), and floor plan financing interest of the taxpayer for the tax year.
The current-law Section 163(j) interest limitation broadly applies to the ‘business interest’ of any taxpayer (regardless of form) and regardless of whether the taxpayer is part of an ‘inbound’ group or an ‘outbound’ group. That is, unlike prior-law Section 163(j), current-law Section 163(j) applies regardless of whether the interest payment is made to a foreign person or a US person, and regardless of whether the person is related or unrelated to the taxpayer. ATI is roughly equivalent to earnings before interest, taxes, depreciation, and amortisation (EBITDA) for tax years that began before 1 January 2022. For tax years beginning on or after that date, ATI is roughly equivalent to earnings before interest and taxes (EBIT).
Disallowed business interest expense can be carried forward indefinitely.
The Section 163(j) rules enacted as part of P.L. 115-97 were temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) (P.L. 116-136). P.L. 116-136 amended Section 163(j) for tax years that began in 2019 and 2020 by generally increasing the percentage of a taxpayer’s ATI from 30% to 50% for the purpose of calculating the limitation under Section 163(j).
A taxpayer that is not a partnership (see below regarding partnerships) was permitted to elect for 2019 or 2020 to not increase its ATI percentage from 30% to 50%. Once made, such an election is revocable only with the consent of the IRS.
In the case of a partnership, the change in ATI percentage did not apply to the 2019 tax year. Instead, 50% of any excess business interest expense (EBIE) that the partnership allocated to each partner in 2019 is treated as paid or accrued by the partner in 2020 and not subject to Section 163(j). The remaining 50% of each partner’s 2019 EBIE remains subject to the normal rules of Section 163(j). Each partner was able to elect out of the special rule for 2019. For 2020, the change in ATI percentage applies to partnerships unless the partnership (not the partners) elects out of the rule.
In addition, for tax years that began in 2020, a taxpayer (including a partnership) generally was able to elect to substitute its ATI from 2019 for its 2020 ATI in performing the calculation. There are special rules regarding this election for short tax years.
Bad debt resulting from a trade or business may be deducted in the year the debt becomes worthless. Determining the date the debt becomes worthless may present difficulty.
Taxpayers also may claim a deduction for partially worthless bad debt to the extent they are charged off of the taxpayer’s books.
Deductions for allowable charitable contributions may not exceed 10% of taxable income computed without regard to certain deductions, including charitable contributions themselves. Deductions for contributions so limited may be carried over to the five succeeding years, subject to the 10% limitation annually. Carryovers of qualified conservation contributions may be carried over for 15 years.
An additional deduction may be available to corporations that donate inventory to be used by the donee solely for the care of the ill, the needy, or infants.
Employee benefit plans (pension plans and expenses)
Through the Code, the government provides incentives for employers to provide qualified retirement benefits to workers. Usually, the employer will be allowed a current deduction for contributions made to a trust, and the employee's tax liability will be deferred until the benefit is paid. For-profit, non-government employers generally have two types of available plans, which generally are subject to the reporting and disclosure requirements set forth under the Employee Retirement Income Security Act of 1974 (ERISA). Qualified plans are required to provide benefits for a broad group of employees (and not only executives) and there are annual limits on the amount of benefits that can be earned by the participants.
The first category of tax-qualified retirement plans is a defined benefit plan, or more commonly known as a pension plan, to which an employer contributes money, on an ongoing basis, to cover the amount of retirement income owed to retired employees under the plan (which will vary based on years of service, average salary, age at retirement, and other factors). Any investment gains or losses will not affect the amount of benefits paid to participants but will affect the amount an employer needs to contribute in order to cover its obligation.
The second category of employee benefit plans is the defined contribution plan, or more commonly known in the United States as a '401(k) plan', to which an employee can contribute compensation (up to an annual limit) on a pre-tax basis to an account in the employee’s name. Employers also can contribute amounts to these accounts, such as matching contributions or profit sharing contributions. Investment gains or losses and the history of contributions will affect the value of a participant's account at retirement but will not affect an employer's contributions since the employer is not obligated to ensure any specified level of benefit in the plan. Small employers have similar options available but may be subject to different requirements.
Non-profits, including churches and government entities, have similar employee benefit plans, except different requirements apply. Self-employed individuals also may set up retirement plans, but these are subject to separate requirements.
Foreign-derived intangible income (FDII)
For tax years beginning after 2017 and before 1 January 2026, Section 250 allows as a deduction an amount equal to 37.5% of a domestic corporation’s FDII plus 50% of the GILTI amount included in gross income of the domestic corporation under new Section 951A (discussed in the Income determination section). For tax years beginning after 31 December 2025, the deduction is reduced to 21.875% and 37.5%, respectively. If, in any tax year, the domestic corporation’s taxable income is less than the sum of its FDII and GILTI amounts, then the 37.5% FDII deduction and the 50% GILTI deduction are reduced proportionally by the amount of the difference.
FDII is determined by subtracting a deemed 10% return on the domestic corporation’s tangible assets from its deduction-eligible income (DEI), which comprises its total net income (apart from certain specified categories, such as Subpart F and GILTI inclusion income, foreign branch income, and CFC dividends). This net amount is then multiplied by a fraction, the denominator of which is the corporation’s DEI and the numerator of which is its net income from sales of property to foreign persons for foreign use or from services provided to persons, or with respect to property, located outside the United States. Thus, despite its name, FDII is not limited to sales or licenses of intangible property, or services provided using intangible property.
Research and experimental (R&E) expenditures
For tax years beginning before 1 January 2022, corporations can continue to elect under Section 174 to expense all R&E expenditures that are paid or incurred during the tax year or to defer the expenses for 60 months. Taxpayers also can make a special election under Section 59(e) to amortise their research expenditures over 120 months. A portion of the research expenditures may qualify for a research tax credit, which is described in the Tax credits and incentives section.
For tax years beginning after 2021, P.L. 115-97 repealed expensing of R&E expenditures, including software development costs, under Section 174 and required such expenditures to be capitalised and amortised over a five-year period, beginning with the midpoint of the tax year in which the specified R&E expenditures were paid or incurred. R&E expenditures that are attributable to research that is conducted outside the United States will have to be capitalised and amortised over a period of 15 years.
Bribes, kickbacks, and illegal payments
An amount paid, directly or indirectly, to any person that is a bribe, kickback, or other illegal payment is not deductible.
Fines and penalties
No deduction generally is allowed for fines or penalties paid to the government for violation of any law for amounts paid or incurred before 22 December 2017.
For amounts paid on or after 22 December 2017, all payments to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by a government or entity into the potential violation of any law are non-deductible, unless the payments are for restitution, remediation, or to come into compliance with the law and are identified as such in the underlying agreement.
State and municipal taxes imposed on businesses are deductible expenses for federal income tax purposes.
Other significant items
- No deduction generally is allowed to an accrual-method taxpayer for a contingent liability. A liability must be fixed and the amount must be reasonably determinable, and economic performance must have occurred.
- Costs incurred for entertainment before 2018 must meet strict tests to be deductible and generally are limited to 50% of the expenses paid or incurred. For amounts paid or incurred after 31 December 2017, entertainment expenses are 100% disallowed unless an exception applies. Expenses for meals, including meals associated with entertainment (if separately invoiced), are 50% deductible unless an exception applies. The cost of providing food and beverages that qualify as a de minimis fringe benefit is no longer an exception to the 50% disallowance after 2018. For 2021 and 2022, expenses for food and beverages provided by a restaurant are 100% deductible (if otherwise qualified as a business expense). After 2022, the 2018 deduction rules apply again. The deductibility of international and domestic business travel expenses is subject to a number of limitations and disallowances.
- Royalty payments, circulation costs, mine exploration and development costs, and other miscellaneous costs of carrying on a business are deductible, subject to certain conditions and limitations.
- Compensation paid by a publicly traded corporation to its CEO, CFO, and three additional SEC executive officers is generally subject to a USD 1 million per-year deduction limit. P.L. 115-97 eliminated the prior-law exception for performance-based compensation and extended the deduction limit to all compensation payments, including payments after termination of employment. Because the deduction limitation applies to payments after separation, there may be more than five employees that are subject to the limitation in a given tax year. The limitation now also applies to certain privately held corporations that have public debt and foreign corporations that trade on US exchanges through American Depository Receipts (ADRs). Effective for tax years beginning after 31 December 2026, the highest paid five employees will be subject to the USD 1 million deduction limit.
Net operating losses (NOLs)
An NOL is generated when business deductions exceed gross income in a particular tax year. NOLs generated in tax years ending before 1 January 2018 may be carried back to offset past income and possibly obtain a refund or carried forward to offset future income. Generally, a loss generated in tax years ending before 1 January 2018 may be carried back two years and, if not fully used, carried forward 20 years.
Special rules regarding NOLs generated in tax years ending before 1 January 2018 may apply (i) to specified liability losses or (ii) if a taxpayer is located in a qualified disaster area.
NOLs generated in tax years ending after 31 December 2017 generally may not be carried back and must instead be carried forward indefinitely. However, the deduction for these NOLs is limited to 80% of taxable income (determined without regard to the deduction).
Complex rules may limit the use of NOLs after a re-organisation or other change in corporate ownership. Generally, if the ownership of more than 50% in value of the stock of a loss corporation changes, a limit is placed on the amount of future income that may be offset by losses carried forward.
An NOL limitation applicable to pass-through businesses and sole proprietors is modified to permit utilisation of excess business losses for tax years beginning before 1 January 2021.
Payments to foreign affiliates
Subject to certain limitations, a US corporation generally may claim a deduction for royalties, management service fees, interest charges, and other items paid to foreign affiliates, to the extent the amounts are actually paid and are not in excess of what it would pay an unrelated entity (i.e. they are at arm's length). US tax, collected through withholding, on these payments generally is required. Under certain circumstances, however, such payments may give rise to a BEAT liability for the US payer (as discussed in the Taxes on corporate income section).