Tax Code Changes: Q1 2022

Several tax changes (new tax provision and lapse of several others) will take effect for the first time in the first quarter of 2022. Because of this, it is imperative for small businesses in charge of tax provisions to be aware of them. A company's income tax provision may be affected by these changes. Whether they should be accounted for separately or through the annual estimated effective tax rate should be considered.

But first things first, what are tax codes?

Tax Codes Defined

A tax code is a document published by the federal government that outlines the procedures businesses and individuals must follow to pay their taxes on time. Tax code changes occur when Congress passes a new tax law or makes a significant change to an existing one. If you’re hoping for financial assistance, these positive developments can help you.

The following are some of the most significant tax code developments:

IRC Sec. 1061 — Carried Interests

Despite the fact that this Tax Cuts and Jobs Act (TCJA) change is not new, it may occur more frequently in 2022 than in the past.

Due to Sec. 1061's three-year minimum holding period for capital gain treatment on the sale or exchange of an applicable partnership interest (API), also known as a profit share or carried interest, most APIs acquired after January 1, 2018, will have just recently reached that milestone and will therefore be subject to this longer holding period.

Sec. 1061, added to the Code by the TCJA, now uses a three-year holding period for long-term capital gain or loss treatment instead of one year to determine the net long-term capital gain on APIs.

For tax purposes, an API refers to any interest of a partnership transferred to a taxpayer in connection with the performance of substantial services in any trade or business of raising capital and investing, disposing of, or developing assets like securities and commodities.

For calendar-year taxpayers and entities, this means tax years beginning after December 31, 2017. Still, taxpayers and entities may have applied the final regulations (T.D. 9945) providing guidance on this change to tax years beginning on or after January 19, 2021 (i.e., in 2022 for calendar-year taxpayers and entities).

IRC Sec. 163(j) — Limitation of Interest Expense- The Base Is Now Limited to Taxable EBIT

With effect from 2022, the IRC Sec. 163(j) interest limitation would not include a benefit of an add-back of depreciation and amortization expenses, as has been planned since the TCJA first limited interest expenses in 2018.

It is anticipated that interest costs will be restricted to 30% of taxable income before interest and taxes (or taxable EBIT). The one piece of good news is that the threshold for the gross receipts test that allows taxpayers to avoid the penalties of Internal Revenue Code Section 163(j) has been increased to $27 million for the year 2022.

The IRC Sec. 163(j) limitation on interest expense creates a deferred tax asset that can be carried forward indefinitely. If a valuation allowance is required, companies will have to determine if this deferred tax asset can be realized.

In addition, businesses with intangible assets with an indefinitely long lifespan and so-called "naked credits" might discover that the added interest expense disallowance has a significant impact on the latter type of credit.

IRC Sec. 174 — Amortization of Research and Experimental (R&E) Expenditures

It used to be possible for a taxpayer who didn't currently expense these costs to defer their recognition for 60 months, starting from when they realized the benefits of such expenditures, under former Sect—174 (b)(1), which applies to tax years before Jan. 1, 2022.

According to Regs. Sec. 1.174-4(a)(3), A tax benefit was realized when a taxpayer first put the expenditures "to income-producing use" by utilizing the "process, formula, invention, or similar property."

Unless an election to capitalize on such costs was made, research and experimental expenses were tax-deductible until 2022. The Tax Cuts and Jobs Act of 2017 (TCJA) mandates that for tax years beginning on or after January 1, 2022, all R&E costs must be capitalized.

It's common to think of R&E as the cost of finding out what you need to know to make a product better. Indirect expenses, such as depreciation and overhead, may also be included. The R&E tax credit may not cover all of the capital expenditures incurred in software development.

Research and development expenses incurred in the United States will be amortized over a five-year period, while those incurred abroad will be deferred for fifteen years. Estimated tax payments, tax expenses, and other tax matters can be affected by the mandatory capitalization of these costs.

In terms of financial reporting and tax provision, a new temporary difference will be recorded to raise the current period's taxable income while creating a new deferred tax asset. Mandatory R&E capitalization has been delayed several times through bipartisan efforts, but none have succeeded in repealing the provision.

In another change, R&E expenditures attributed to "foreign research," as outlined in Sec. 41(d)(4)(F), the amortization period has been increased to 15 years. Increasing research activities is eligible for a tax credit under Section 501 of the Code. Sec. 41 defines "qualified research" expenses as those that can be deducted as business expenses under Sec. 174.

IRC Sec. 163 (h) — Expired Provisions

ARPA's tax relief provisions for 2021 have been the subject of much recent attention, and some of those provisions will be continued in the Build Back Better Act.

As of December 2021, ARPA's monthly advance payments for the child tax credit will no longer be available, and its expansion of the child tax credit. IRS has not said how quickly it can restore payments if the Build Back Better Act is passed, but payments will resume if that provision is renewed for 2022 (as passed by the House).

Some pre-ARPA "extender" provisions also expired in 2021 and those already mentioned. Very few of them apply to a wide range of situations, except for one itemized deduction that is relatively common, as highlighted in section 163(h)(3)(E)(iv).

There have been several re-enactments of this provision since it was first introduced in 2007 (most recently in the Consolidated Appropriations Act (CAA), 2021, P.L. 116-260), some retroactively.

Accounting Standards Update — Leases

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-12 in February 2016, mandating that businesses record all leases on the balance sheet. As a result of the delay due to the pandemic, the adoption will become obligatory for all privately held companies beginning with fiscal years commencing after December 15, 2021.

Since the 15th of December in 2018, publicly traded companies have been bringing themselves into compliance with the standard.

Leases are classified as either operating or finance based on the ASC 842 two-model approach, but the leases are generally reflected on a company's balance sheet. Lease liabilities are recognized on the balance sheet when the lease is first recorded, based on the future value of the due payments.

This creates an asset known as a right of use (ROU). When calculating the present value of a lease, the implicit rate is used as the discount rate.

There has been no change in the accounting rules for tax purposes for leases. Because the ROU asset comprises various components, each of which has its own specific set of tax implications, the traditional change-in-balance method of tracking book-tax differences might no longer be applicable.

The ROU amortization and interest expense are not deductible, while the cash rent paid is deductible under the all-events test. As a result, businesses will probably need to establish deferred tax assets based on lease adoption entries and track the significant parts.

It's also a good idea for companies to consider whether it's necessary to separate the deferred tax assets and liabilities created by the lease liability and the ROU asset and present them separately in the footnote. In some cases, it may be necessary to alter the approach.

Increase in Bonus Depreciation

Taxpayer-friendly provisions of the TCJA included a 50% increase in bonus depreciation for qualifying assets to 100%. Taxpayers will no longer be able to immediately deduct the total value of their qualifying assets after this year (2022).

The rate of bonus depreciation will be reduced to 80% beginning on January 1, 2023, followed by a reduction to 60% in 2024, a decrease to 40% in 2025, and finally to 20% in 2026, at which point the bonus amount would remain unless the law is revised.

That said, furniture and machinery with a modified accelerated cost recovery system (MACRS) recovery phase of fewer than 20 years are eligible for bonus depreciation.

Another provision that seems to have broad support in Congress for an extension but hasn't happened yet is that bonus depreciation can be taken at 100%.

Capital expenditures should be accelerated into 2022 to take advantage of the full expensing. Still, it is also essential to consider the impact of additional depreciation on IRC Sec. 163(j) interest limitation and other limitations.

However, even though the depreciation adjustment is temporary, cash tax implications must be considered when making estimated payments. Taxpayers will also have to keep track of the state's annual conformation to the federal bonus rates.

The Bottom Line

If you own a small business, you know that you only have a few days to ensure that your Q1 tax provision is up to date with the tax law changes mentioned above to avoid surprises and cash flow issues and to verify that the increased data required by the above changes can be met through accounting software now that the Q1 tax season is over.

Prepare for these modifications.

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