On December 20, 2017, Congress passed the Tax Cuts and Jobs Act of 2017 (the Act). The Act is largely a win for tech companies and should help spur growth in 2018—but also contains some unwelcome surprises. The biggest benefit, of course, is the lower corporate tax rate of 21%, which keeps more cash on the balance sheets of technology companies. Aside from making distributions to shareholders and increasing employee benefits, expect this money to be used for acquisitions, R&D investments, and talent acquisition. 

The Act delivers another windfall for the tech industry, allowing the five biggest tech firms—Apple, Alphabet, Amazon, Facebook, and Microsoft— who have a combined total of $457 billion of unrepatriated foreign earnings (per a November 2017 Bloomberg report) to bring cash back into the United States at a dramatically reduced tax rate of 15.5%.

Under the new tax regime, tech firms will have less incentive to park their intellectual property (IP) overseas in low-tax countries like Ireland. Why? Because they will be forced to pay more on foreign earnings. “Companies that developed their IP in the U.S. will find that, thanks to tax reform, their IP is now more valuable,” said Joshua Yeargin, a tax partner at CohnReznick and leader of the Firm’s technology practice in Los Angeles. “By contrast, the cost and effort of holding intellectual property abroad will be a less effective strategy moving forward.” 

One negative implication of the new tax law is that, starting in 2022, technology companies will lose out on the ability to immediately expense research and experimentation expenditures. Beginning in 2022, research and experimentation costs will be required to be capitalized and amortized over 5 years. But, with the elimination of the Alternative Minimum Tax (AMT) for corporations, the Research and Experimentation Tax Credit will be more valuable for corporations, because under prior law it was limited by the AMT. Due to the limits on state and local tax, as well as the elimination of itemized deductions, far fewer individuals will be subject to significant amounts of AMT. These changes will also make the credit more valuable for flow-through entities, such as S-Corps and LLC’s, as well. 

The new tax law presents additional challenges for tech companies. For example, the new tax rules limit the deductibility of interest expense to 30% of “adjusted taxable income,” which means that private equity investors will need to consider how to structure the amount of debt carried by portfolio companies post-acquisition, which could ultimately impact valuations of targeted technology sector acquisitions. 

On the other hand, the new tax law does not significantly change the rules around the carried interest, only changing the holding period from one to three years. It also leaves the 100% gains exclusion available on Qualified Small Business Stock untouched. This is very good news for venture capitalists and private equity professionals, as well as for tech companies and founding entrepreneurs.

Unfortunately, the new tax law also takes a large bite out of meals and entertainment deductions, which could have an outsized impact on the tech industry. Previously, companies could write off 50% of business meals and entertainment, and 100% of meals provided in-house to employees. Now, costs related to entertainment activities and facilities are no longer deductible, and in-house meal deductions are capped at 50%. “This change is significant because many tech companies use in-house meals as a perk to attract talent,” said Shaune Scutellaro, senior tax manager at CohnReznick. “Going forward, tech companies must cut those perks or absorb the extra costs as the price of doing business.” 

However, rules governing Net Operating Loss (“NOL”) carry-forwards are significantly changed. NOL carry-forwards arising after January 1, 2018 will be limited to 80% of taxable income, but will no longer be subject to expiration. Pre-2018 NOLs will not be subject to the 80% income limitation and, due to the elimination of the corporate AMT, will no longer be subject to limitations contained in the alternative minimum tax rules. “Expect some creative NOL planning and an increase in the value of NOLs,” said Yeargin.  

Conclusion

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