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. This method was required for AMT purposes. However, corporate AMT is repealed for tax years beginning after 31 December 2017.
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. Further, 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 can 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, P.L. 115-97 increases the dollar limitation to USD 1 million, while increasing the cost of property subject to the phase-out to USD 2.5 million. The new dollar limitations are indexed for inflation for tax years beginning after 31 December 2018.
In addition, the deduction under this election is limited to the taxable income of the business.
A 50% special first-year depreciation allowance (i.e. bonus depreciation) applies (unless an election out is made) for new (i.e. property with respect to which the original use begins with the taxpayer) MACRS property with a recovery period of 20 years or less, certain computer software, water utility property, and certain leasehold improvements acquired after 31 December 2007. The special allowance applies for regular income tax and AMT purposes. No AMT adjustment is made if the special allowance is used. 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.
P.L. 115-97 replaced 50% bonus depreciation with 100% bonus depreciation for eligible property, and also repealed the original use requirement that now results in used property being eligible for 100% bonus depreciation. Thus, for certain new and used property acquired and placed in service after 27 September 2017 and 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 pre-Act bonus depreciation rules apply. P.L. 115-97 also made additional categories of property eligible for bonus depreciation (e.g. film and used property) if applicable requirements are met.
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 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 in which the trade or business begins.
US manufacturing deduction
Over the last several decades, various tax incentive systems have been enacted in the United States to encourage exports and were later repealed, including the extraterritorial income (ETI) regime, which was repealed as a result of a World Trade Organization (WTO) ruling that the ETI regime favoured US goods and violated the national treatment provisions of the General Agreement on Tariffs and Trade. In response, the United States enacted the American Jobs Creation Act of 2004, which introduced a phase-out repeal of ETI and introduced the domestic production activities deduction under Section 199, seeking to compensate US manufacturers for the loss of ETI benefits.
For tax years beginning before 1 January 2018, Section 199 generally provided taxpayers with a 9% deduction for qualified production activities (QPA) income (subject to a taxable income limitation). The deduction was available to all taxpayers actively engaged in QPA. For most corporate taxpayers, the deduction generally meant a federal income tax rate of 31.85% on QPA income, although certain oil- and gas-related QPA received a less generous reduction that equated to a federal income tax rate of 32.9%. Importantly, the deduction also applied in calculating the AMT.
There was a limit on the amount of the deduction equal to 50% of W-2 wages allocable to domestic production gross receipts (DPGR). The deduction generally was not allowed for taxpayers that incurred a loss from their production activities or had an overall loss (including a carryover loss) from all activities.
A taxpayer's QPA income was calculated using the following formula: DPGR less the sum of cost of goods sold allocable to such receipts and other expenses, losses, or deductions that are properly allocable to such receipts.
P.L. 115-97 repealed Section 199 for tax years beginning after 31 December 2017.
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), new Section 163(j) applies regardless of whether the interest payment is made to a foreign person or a US person, and regardless of whether such person is related or unrelated to the taxpayer. ATI is roughly equivalent to earnings before interest, taxes, depreciation, and amortisation (EBITDA) (similar to prior-law Section 163(j)) for tax years beginning before 1 January 2022. For tax years beginning on or after that date, ATI would be 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 are temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) (P.L. 116-136). P.L. 116-136 amends Section 163(j) for tax years beginning in 2019 and 2020 by generally increasing the percentage of a taxpayer’s ATI from 30% to 50% for purposes of calculating the limitation under Section 163(j). In some cases, it is possible to elect to increase the percentage. In addition, for tax years beginning in 2020, a taxpayer generally may elect to substitute its ATI from its 2019 ATI for its 2020 ATI in performing the calculation.
There are special rules for short tax years and for partnerships. For 2019, the P.L. 116-136 increase of the 30% ATI limitation to 50% does not apply to partnerships; instead, partners may deduct 50% of their distributive share of the partnership’s excess business interest in 2020 without regard to Section 163(j). The provision also allows a taxpayer (including partnerships) to elect to use its 2019 ATI for its 2020 limitation.
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 15 succeeding years, subject to the 10% limitation annually.
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)
Under P.L. 115-97, for tax years beginning after 2017 and before 1 January 2026, new 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 the enactment date of P.L. 115-97 (i.e. before 22 December 2017).
For amounts paid on or after the enactment date of P.L. 115-97 (i.e. 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 such government or entity into the potential violation of any law are non-deductible, unless such payments clearly reflect amounts paid for restitution 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 for a contingent liability until such liability is fixed and determinable.
- Costs incurred for entertainment must meet strict tests to be deductible. The deduction for business meal and entertainment expenses generally is 50% of the expenses paid or incurred before 1 January 2018. Under P.L. 115-97, for amounts paid or incurred after 31 December 2017, this deduction generally is no longer available (note, however, that business meals without entertainment remain 50% deductible). There also are limitations on the deductibility of international and domestic business travel expenses.
- 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 limits.
- Compensation paid by a publicly traded corporation to its CEO, CFO, and three additional 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. 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).
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, for NOLs generated in tax years beginning after 31 December 2017, the NOL deduction is limited to 80% of taxable income (determined without regard to the deduction). P.L. 116-136 included a technical correction regarding the elimination of NOL carrybacks for tax years ending after 31 December 2017 to address the statement in the conference report for P.L. 115-97 that the provision applied to tax years beginning (not ending) after 31 December 2017.
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.
As part of US COVID-19 relief efforts, P.L. 116-136 amended NOL rules that were enacted in 2017 to allow an NOL from tax years beginning in 2018, 2019, or 2020 to be carried back for five years. The provision temporarily removes the current-law taxable income limitation to allow an NOL to fully offset income. The provision also makes a retroactive technical correction to the 2017 tax reform act to allow NOLs arising in a tax year beginning in 2017 and ending in 2018 to be carried back two years.
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.
P.L. 116-136 also includes technical corrections to the 2017 tax reform act clarifying (i) treatment of excess business losses that are carried forward and treated as part of the taxpayer’s NOL, (ii) that excess business losses are determined without regard to any deduction under Sections 172 or 199A, and (iii) that excess business losses are determined without regard to any deductions, gross income, or gains attributable to any trade or business of performing services as an employee (e.g. wages).
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).