PATH Act, State Laws Bring Significant Change to 2016 Taxes
By Brian McCuller and Andrew Hill
The flurry of activity by state and federal legislators in 2015 brought many significant tax changes to be aware of as you prepare 2016 taxes. There is much welcome news for Tennessee businesses on both the state and federal tax fronts with new relief in some areas, and in other areas, permanent or long term assurances for tax breaks that previously received short-term extensions.
The federal changes resulted from the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) that was signed into law in the closing days of December, while the state changes were enacted by the Tennessee legislature as a part of the sweeping reforms in the Revenue Modernization Act and the untitled tax incentives bill supported by the Tennessee Department of Economic and Community Development and enshrined as 2015 Public Chapter 504.
The relief comes on a variety of issues important to business, from credits for job creation and R&D, to depreciation and the expensing of certain capital expenses, and more.
Here is a rundown of key tax changes to consider as you prepare 2016 taxes and plan for 2017 and beyond:
Purchase of machinery and equipment for research and development
A much wider array of companies now qualify for the industrial machinery tax credit and sales and use tax exemption for certain equipment expenditures thanks to a newly expanded definition of "industrial machinery" in Tennessee's tax code. 2015 Public Chapter 504 added an additional provision to the chapter definitions found in Tennessee's sales and use tax statute, Tenn. Code Ann. § 67-6-102, for research and development machinery and equipment. Those chapter definitions are referenced throughout the tax code, including in the franchise and excise tax credits provision found in Tenn. Code Ann. § 67-4-2009. As of July 1, 2015, qualified research and development expenditures for equipment and related expenses are eligible for tax credits and exemptions.
Previously, these industrial machinery tax credits and sales and use tax exemptions were reserved for the purchase of machinery used in the "fabrication or processing of tangible personal property" or some other related manufacturing activities and therefore were only available to a narrow segment of businesses.
Under the change in the law, the definition of eligible industrial machinery is extended to include "machinery, apparatus, and equipment" including parts, repairs, and installation, "that is necessary to, and primarily for, the purpose of research and development." This expanded definition is not just limited to those businesses engaged in traditional manufacturing activities and applies broadly to any business conducting research and development.
These tax credits apply to franchise and excise taxes and can offset as much as 50 percent of a company's obligation, with a carry-forward for as long as 15 years. The sales and use tax exemption covers the entire sales and use tax obligation.
While the credit is expanded for manufacturers, it is now also available to non-manufacturing companies that buy equipment for research and development. For example, a software company that buys equipment, pays for installation, or has repair costs, in conducting R&D in conjunction with creating new software products would be able to deduct a certain percentage of those expenses from its franchise and excise taxes. Another example of a newly qualifying expenditure is equipment purchases made by a pharmaceutical company in connection with the development of new drugs.
Naturally, these costs must be segregated, but the credit applies for any purchases made after July 1 of last year.
Companies eligible for the new R&D category of the industrial machinery tax credit have the opportunity for additional savings because industrial machinery purchases are also exempt from sales and use taxes. Companies that have already paid sales and use tax on those purchases could qualify for a refund.
The statute does not define "research and development" and the Department of Revenue has yet to release formal rules or guidance on the scope of the new definition and the procedures for qualifying. However, it is anticipated that the qualifying research and development activities under the Tennessee statute will be similar to the research and development activities found in the federal Research and Experimentation Tax Credit, I.R.C. § 41, namely, scientific and technical research, the improvement of an existing product or development of a new product whether or not the product is ever offered for sale, and the design of prototypes. Non-qualifying activities are expected to be ordinary testing and inspection, social science or humanities research, advertising and marketing, and surveys.
While no formal procedures are currently in place, it is also anticipated that businesses will be required to apply for approval with the Tennessee Department of Revenue prior to the purchase of qualifying research and development equipment. Businesses making purchases of qualifying research and development equipment after the July 1, 2015, and prior to the promulgation of the formal application procedure will be allowed to apply for credits and exemptions retroactively. Once the Department of Revenue's process is in place, retroactive approval will be more difficult.
Nearly any business engaged in product development or improvement should qualify for these new credits and exemptions.
The Tennessee tax credit bill also expanded credits in another category, although it will likely benefit fewer companies than the new R&D credit. The change relates to credits for the cost of moving back-office functions to the state. Previously the headquarters tax credit was restricted to construction and relocation costs that came with moving a headquarters to Tennessee. Now the headquarters can still remain elsewhere, so long as a call center, accounting center or other similar function is moved to the state.
These credits generally require a baseline level of job creation and investment and will often qualify businesses for other credits such as the Tennessee Jobs Credit. Businesses wishing to take advantage of these incentives must register a business plan with the Tennessee Department of Economic and Community Development to get the process started.
One area where taxes are being expanded is in the state's approach to levying sales taxes on software and video games. The Revenue Modernization Act sought to address a perceived shortfall in the way remote-access software was being treated from a sales tax perspective. Previously, sales tax was levied only if you purchased software at a store, or downloaded it over the Internet. Software wasn't taxed if you purchased the software or subscription and used it over the Internet.
This new approach recognizes the huge growth in cloud-based software offerings. This software is remotely hosted and is usually accessed through a web browser. An example would be TurboTax Online.
This change brings the tax code in line with the reality that people are accessing software remotely much more than downloading it, which had been eliminating the payment of a sales tax.
There is some ambiguity around whether certain software is considered a product or a service. This distinction impacts an entire market segment known as software-as-a-service. A good example for business might include customer relationship management software, like Salesforce, which can be accessed remotely.
While the state's sales and use tax is imposed on the sale of products, services are generally not taxed. If software-as-a-service is defined as a product, it would be taxed. Defined as a service, not so. If the primary purpose of the transaction is the provision of a service, rather than the underlying software product, it will be treated as a service.
Another change in the Revenue Modernization Act may help make Tennessee-based businesses more competitive with their out-of-state counterparts, although it does not directly impact their tax obligations. Out-of-state companies are now required to pay franchise and excise taxes and business taxes if they have "economic nexus" of more than $500,000 in sales or $50,000 in property or payroll in Tennessee.
Out-of-state retailers are now also required to collect sales and use tax when paying an in-state party a fee or commission to route customers to their website. This is commonly referred to as "click-through nexus," and Tennessee joins 14 other states doing this.
Research and development credit
The PATH Act made the popular Research and Experimentation Tax Credit (R&D Credit) permanent. This credit generally can be applied to income tax, alternative minimum tax and payroll tax. Historically, the R&D Credit has been used disproportionately by large businesses, when in fact, businesses of all sizes can use the benefit. Significant changes to the R&D credit will help small businesses and startups in new ways for tax years beginning after Dec. 31, 2015.
The federal R&D tax credit is primarily a wage-based credit, as opposed to Tennessee's R&D tax credit which only applies to R&D equipment. Eligible expenses for the federal credit include wages, supplies, contract research and basic research payments to qualified non-profit organizations and institutions. There are several ways to calculate the credit, but the Alternative Simplified Credit base amount is 14% of qualified expenses that exceed a calculated base amount.
Businesses can take an expense deduction for up to $500,000 in capital investment -- rather than having to depreciate it -- for certain property under Section 179 of the tax code. The break phases out for asset purchases above $2 million, although there is no limitation on real estate. Under the law passed last year, air conditioning and heating units have been added to the list of eligible property for tax years beginning after December 31, 2015.
The 15-year straight-line cost recovery period for qualified leasehold improvement property, restaurant property and retail improvement property is now permanent for property placed in service after December 31, 2014.
Taxpayers, other than corporations, may exclude from income 100% of the gain from the sale of small business stock acquired when originally issued and held for at least five years, with some limitations. The exclusion has been made permanent for purchases of qualifying stock on and after January 1, 2015.
In addition to making permanent enhanced deductions for charitable contributions of food inventory for the care of the ill, the needy, or infants, the law raised the limit on the amount of the deduction from 10 to 15 percent of the taxpayer's taxable income (if a taxable corporation) and to 15 percent of adjusted gross income for all other taxpayers beginning in 2016.
Provisions on contributions of conservation easements and the IRA charitable rollover were also made permanent.
An S corporation that previously was a C corporation is required to pay corporate tax on certain dispositions of assets that were appreciated in the hands of the C corporation at the time the S corporation status became effective. The time period that the corporate tax was applied had temporarily been reduced to five years and now that time period is permanent.
In addition, the law made permanent a provision affecting the tax basis of S corporation shareholders who receive a deduction when the S corporation makes a charitable donation.
Bonus depreciation was extended for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation is 50 percent for property placed in service during 2015, 2016, and 2017. It goes down to 40 percent in 2018, and 30 percent in 2019.
Taxpayers can also choose to accelerate the use of alternative minimum tax credits in lieu of bonus depreciation under special rules for property placed in service during 2015. The provision also increases the amount of unused AMT credits that may be claimed instead of bonus depreciation beginning in 2016.
The law also allows additional first-year depreciation for qualified improvement property after 2015 regardless of whether the improvements are on leased property, and no longer requires that the improvements be placed in service more than three years after the building was first placed in service.
Work Opportunity Tax Credit
The PATH Act extended the Work Opportunity Tax Credit through December 31, 2019, including 2015 retroactively. This has provided a level of certainty for a lucrative tax credit that had previously been extended only on a year to year basis, usually retroactively. In the past, companies may have declined to put processes in place to reap this credit due to the annual uncertainty of its continued existence. With this long-term extension, businesses should take steps to take advantage of this tax benefit.
In addition, for tax years beginning after Dec. 31, 2015, the law adds a new target group to the list of those allowing an employer to claim the credit: long-term unemployed individuals (27 or more consecutive weeks unemployed). The Work Opportunity Tax Credit applies to employers who hire people from eligible target groups who have significant barriers to employment. Other target groups are certain individuals with disabilities, those receiving Temporary Assistance for Needy Families, food stamp recipients, veterans, ex-felons, summer youth employees, people living in certain designated HUD zones, and those receiving supplemental security income benefits.
The credit can reduce an employer's federal income tax liability from between $2,400 and $9,600 per qualified employee hired, depending on which group the individual belongs to. There is no limit to the number of people employers can hire to claim the credits.
Generally, businesses have 28 days from the hiring date to file the necessary paperwork. The IRS has yet to outline the process for claiming 2015 credits outside of the 28 day window, but in prior years, the entire year's worth of new hires were eligible.
New Markets Tax Credit
The goal of the New Markets Tax Credit is to incentivize investment in low-income and impoverished communities, and allows a credit for qualified equity investments in community development entities that invest in these low-income communities. The credit is 39% of the qualifying investment, and is claimed over seven years. The credit was retroactively extended for 2015 through 2019. There is a $3.5 million cap on investments with a carry-forward through the 2024 tax year for amounts over the cap.
Federal Taxes - 2-year extensions
Energy efficient commercial buildings deduction
The credit for certain energy efficient commercial building property was extended through Dec. 31, 2016, up to a per-building maximum of $1.80 per square foot.
Credits for biodiesel and renewable diesel used as a fuel, and the credit for alcohol fuel, biodiesel, and alternative mixtures were extended to December 31, 2016.
The law adds two years to the moratorium on the 2.3 percent tax on sales of medical devices (except certain devices sold at retail). The moratorium was placed in effect as part of the Affordable Care Act in 2010 and was intended to apply to device sales beginning on January 1, 2013. The moratorium now extends through Dec. 31, 2017.
Brian McCuller is partner-in-charge of the State and Local Tax practice at LBMC, a premiere Tennessee-based professional services firm. Contact him at firstname.lastname@example.org or 615-690-1971. Andrew Hill is a senior in the Credits and Incentives practice at LBMC. Contact him at email@example.com or 615-309-2685.
 Tenn. Code Ann. § 67-6-102(44).
 Tenn. Code Ann. § 67-6-102(44)(O).