Tax Alert: Sweeping Tax Reform Proposals Unveiled
As the end of 2017 is fast approaching, Congress is moving quickly to try and enact tax reform laws. On November 2, 2017, the House Ways and Means Committee began the formal process by releasing a massive tax reform draft bill called the "Tax Cuts and Jobs Act" (hereinafter the "House Bill"). The House Bill is over 400 pages and has already been amended twice. In addition, on November 9, 2017, the Senate proposed its own version of the "Tax Cuts and Jobs Act" (the "Senate Bill") and this proposal will also go through numerous changes before the two bills are reconciled in conference.
The House Bill proposes sweeping changes to the existing tax law rules that would drastically impact individuals, businesses (both operating domestically and internationally), tax exempt organizations, life insurance companies, energy industry, as well as pension and retirement planning and executive compensation planning. This Alert will not cover all aspects of the proposals contained within the House Bill and its amendments, but it will discuss some of the major proposals that affect the following areas:
- Individual Taxation
- Corporate Taxation
- Taxation of Pass-Throughs
- Tax Exempt Organizations
- International Operations
We will also indicate in bold text where the Senate Bill substantially differs from the House Bill in the relevant areas.
The House Bill makes major changes that affect how individuals are taxed. The House Bill would reduce the number of tax brackets and also changes the tax rates starting with a 12% lowest rate but continue to maintain a 39.6% top rate. The House Bill would repeal personal exemptions while raising the standard deduction amount. The Senate Bill would also change the tax brackets and tax rates for individuals. However, unlike the House Bill, which would only have four tax brackets, the Senate Bill would have seven tax brackets starting with a 10% lowest rate and topping out at 38.6%. Both the House Bill and Senate Bill would also eliminate the alternative minimum tax. Although the House Bill would increase the eligibility for individuals to claim charitable contribution deductions from 50% of their adjusted gross income to 60% of their adjusted gross income as well as eliminate the Pease limitation on itemized deductions, it would do so at the expense of reducing or eliminating many of the previously allowed itemized deductions that individuals could claim. The House Bill would eliminate the deduction for medical expenses, casualty losses, tax preparation expenses, and moving expenses. The Senate Bill, however, would retain the deduction for medical expenses.
Moreover, the House Bill would eliminate the state and local tax deduction completely, limit eligibility to claim the mortgage interest deduction for debt entered into after November 2, 2017 with respect to a principal home having a principal mortgage amount of $500,000, remove the interest deduction for second homes or home equity lines of credit completely as well as cap the state property tax deduction to $10,000. The Senate Bill would repeal the mortgage interest deduction with respect to interest on home equity indebtedness but would retain the current deduction with respect to interest on acquisition indebtedness of up to $1,000,000. In addition, the Senate Bill would only allow a deduction for state and local taxes paid or accrued in carrying on a trade or business. Further, the Senate Bill would only allow state and local property taxes assessed on business assets to be written off.
The home sale exclusion would be modified and phased out at higher income levels. The ownership period for the exclusion of gain from the sale of a principal residence would be extended from two out of the previous five years to five out of the previous eight years. The exclusion would only be available once every five years and would phase out for single filers with adjusted gross income over $250,000 and married filers with adjusted gross income over $500,000. The Senate Bill would have a similar home sale exclusion but would provide for exceptions to the timing requirement for taxpayers who change their places of employment, have health issues, or have unforeseen circumstances.
The House Bill would also affect income taxation of individuals who are in the process of seeking a divorce. Under the proposal, alimony payments would no longer be deductible by the payor or includible in the income of the payee. The provision would be effective for any divorce decree or separation agreement executed after 2017 and to any modification after 2017 if expressly provided for by such modification. The Senate Bill does not raise this issue within its tax reform plan.
Finally, the House Bill would also seek to make changes to the estate and gift tax provisions. Under the House Bill the estate, gift, and generation-skipping taxes initially would be retained with a doubled $11.2 million basic exclusion for 2018 (adjusted for inflation), and the estate and generation-skipping taxes would be repealed after 2023 (with a stepped-up basis in property) and the top rate on the gift tax would be reduced to 35%. The Senate Bill would simply increase the exclusion amount to $10,000,000 (with inflation adjustments from 2011) and would continue to provide for an estate tax and generation-skipping tax.
Pursuant to the House Bill, the corporate tax rate would become a flat 20% rate with personal services corporations being subject to a flat 25% corporate tax rate. A personal service corporation is a corporation the principal activity of which is the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and such services are substantially performed by the employee-owners. The Senate Bill would provide for a 20% flat corporate tax rate beginning in 2019 but would not provide for a special tax rate for personal service corporations.
The House Bill would allow for qualified property to be fully and immediately expensed at 100% if placed in service after September 27, 2017 and before January 1, 2023. Property would be eligible for this immediate expensing if it is the taxpayer's first use, repealing the existing requirement that the original use of the property begin with the taxpayer.
Small businesses would be allowed to claim higher expenses by increasing the $500,000 limit to $5 million with the phase-out amount being increased to $20 million from the existing $2 million. The Senate Bill would increase the limitation to $15 million.
The House Bill would also change the use of net operating losses ("NOLs") by allowing for an indefinite carry forward of NOLs arising in tax years beginning after December 31, 2017. The proposal would repeal the allowance of carrybacks (with certain limited exceptions) for losses that are generated in tax years beginning after December 31, 2017, as well as limit the amount of an NOL that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction) for tax years beginning after December 31, 2017. NOLs occurring in tax years beginning after 2017 and carried forward would be increased by an interest factor to preserve the NOLs' value. Although the allowance of an indefinite carryforward of NOLs with interest preserves the value of the NOL deduction for future years, it results in the creation of tax by limiting the use of the NOL to offset only 90% of the taxpayer's taxable income rather than be able to have the taxable income completely absorbed by the NOL.
The House Bill would modify interest deduction eligibility for businesses. Businesses with average gross receipts of $25 million or less would not be subject to the interest deduction limitation rules. Other businesses would be subject to a disallowance of a deduction for net interest expense in excess of 30% of the business's adjusted taxable income.
The House Bill would expand gross income of a corporation to include contributions to its capital, to the extent the amount of money and fair market value of property contributed to the corporation exceeds the fair market value of any stock that is issued in exchange for such money or property. This is significant change as contributions to capital were previously excluded from income.
Under the House Bill, availability to use the cash method of accounting for corporations and partnerships with corporate partners would be expanded from the $5 million average gross receipts threshold to $25 million (indexed for inflation). The requirement that such businesses satisfy the requirement for all prior years would be repealed. The Senate Bill would also increase the amount but only to $15 million (indexed for inflation). Unlike the House Bill, the Senate Bill would require the businesses to satisfy the threshold for the three prior taxable-year period.
Currently, taxpayers with average gross receipts of less than $10 million ($1 million in certain industries) are permitted to account for inventories as materials and supplies that are not incidental. The House Bill would increase the average gross receipts threshold from $10 million to $25 million (indexed for inflation), regardless of industry, and allow such taxpayers to either treat inventories as materials and supplies that are not incidental or conform to the taxpayer's financial accounting treatment. The Senate Bill would also make accounting changes to inventories but taxpayers that meet a $15 million (indexed for inflation) gross receipts test would not be required to account for inventories. Those taxpayers could use a method of accounting for inventories that either: (1) treats inventories as non-incidental materials and supplies or (2) conforms to the taxpayer's financial accounting treatment of inventories.
Although not an issue raised in the House Bill, the Senate Bill would require a taxpayer to recognize income no later than the taxable year in which such income is taken into account as income on an applicable financial statement, but would provide an exception for long-term contract income. The Senate Bill would allow taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.
On the deduction side, the House Bill would eliminate deductions for entertainment, amusement or recreation activities, facilities, or membership dues relating to such activities or other social purposes. The House Bill would also eliminate many credits such as Rehabilitation Tax Credit for old and/or historic buildings; Work Opportunity Tax Credit; Certain unused business credits; and New Markets Tax Credit, which could result in businesses deciding to not pursue activities to restore or preserve historic buildings or hire certain workers from specific disadvantaged groups as there is no longer a tax benefit.
Taxation of Pass-Through Entities
The House Bill would create a new maximum income tax rate of 25% for individuals on certain net income from pass-through entities, which include partnerships and S corporations. The 25% tax rate would apply to qualified business income ("QBI"), after the exclusion of net capital gain. QBI generally is 100% of "net business income" derived from a "passive business activity" and 30% of any "net business income" derived from an "active business activity." This provision would add an extra level of complexity that already exists to partnership taxation rules. It would now require taxpayers to determine the extent to which they are active or passive in a trade or business using the provisions found in the passive activity limitation rules of Section 469 of the Internal Revenue Code, which were primarily enacted to limit the ability of taxpayers to use losses from passive activities to reduce their active income.
In addition, taxpayers receiving income from an active business income would determine their business income by reference to their "capital percentage" of net income. The proposal would allow taxpayers to elect to apply a capital percentage of 30% to net business income from an active business income to determine the business income eligible for the 25% rate. However, the taxpayers could alternatively apply a formula based on facts and circumstances to determine a capital percentage of greater than 30%. An election to use this formula would be binding for five years. Of particular note, the House Bill specifically creates a zero percent capital percentage for "specified services", which would include any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. As a result, under the House Bill's proposal, these taxpayers would not be eligible for the 25% rate but would have to pay tax at their ordinary income tax rate.
The Senate Bill would provide for a deduction for pass-through entities rather than provide for a 25% tax rate. The Senate Bill would allow for an individual taxpayer to deduct 17.4% of domestic qualified business income from a partnership, S corporation, or sole proprietorship. Qualified business income would not include from certain services which would basically include the services enumerated under the definition of "specified services" in the House Bill.
The House Bill also includes a provision that would repeal the exclusion from self-employment tax for limited partners. This repeal would increase the number of partners treated as having net earnings from self-employment which would likely result in the limited partner who takes on a passive role from having to include its distributive share of partnership income as self-employment.
The issue of taxation on "carried interest" has been a hot issue for years. "Carried interest" refers to the share of profits or gains from investment received by a manager of a private equity fund, hedge fund, or similar investment vehicle, which is typically unrelated to any capital investment by the manager. Currently, carried interest is generally taxed at favorable long-term capital gain rates. Under the proposal, there would be a 3-year holding period requirement for certain partnership interests received in connection with the performance of services to be taxed as long term capital gain rather than ordinary income. There would also be an anti-abuse rule which would tax as ordinary income transfers of applicable partnership interests to certain related persons within the 3-year holding period. This issue was not raised in the Senate Bill.
Similar to corporations, the House Bill would no longer have contributions to capital be completely tax-free, to the extent the amount of money and fair market value of property contributed to the partnership exceeds the fair market value of any units that is issued in exchange for such money or property.
Tax Exempt Organizations
The House Bill would treat exempt organizations in a similar manner to public C corporations with respect to compensation paid in excess of $1 million to certain employees. The House Bill would impose a 20% excise tax on all compensation in excess of $1 million paid to any of its five highest paid employees for the tax year ("covered employees"). For purposes of the excise tax, compensation from related organizations would also be included.
In addition, the House Bill would impose a similar excise tax on "golden parachute payments." "Parachute payments" are payments that are contingent upon the covered employee's separation from the tax exempt organization and have an aggregate present value that equals or exceeds three times the base amount. For this purpose, the "base amount" is determined by applying the current rules of section 280G, which generally provide that a covered employee's base amount is the individual's average annual taxable income from the organization over the five-year period immediately preceding the year in which the separation from service occurs (or any shorter period of service with the organization if less than five years).
The House Bill would make excise tax changes to private foundations. The House Bill would change the excise tax rate on private foundation net investment income to a standard 1.4%. The House Bill would also provide for an exemption on certain private foundations from the current 10% excise tax on the value of a private foundation holding a more than 20% interest in other for-profit businesses provided that: (a) the foundation owned all of the for-profit business's voting stock and did not acquire its ownership interest by purchase, (b) the for-profit business distributed all of its net operating income for the tax year to the private foundation within 120 days of the close of that tax year, and (c) the for-profit business's directors and executives are not substantial contributors to the private foundation or are not a majority of the private foundation's board of directors. This latter provision was adopted to benefit Newman's Own.
The House Bill would also repeal the "Johnson Amendment" which prohibits section 501(c)(3) organizations from engaging in political activities. Political speech would be permitted so long as the organization's preparation and presentation of the political content occurred in the ordinary course of the organization's carrying out of its exempt purpose and the associated costs to the organization of including the political content are de minimis.
The House Bill would replace the current system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when those earnings are distributed with a dividend-exemption system. Under the new proposed system, 100% of the foreign-source portion of any dividend received from a specified 10%-owned foreign corporation by a domestic corporation that is a U.S. shareholder of that foreign corporation would be exempt from U.S. taxation. There would be no foreign tax credit or deduction allowed for any foreign taxes paid or accrued with respect to any exempt dividend. The hope is that this change would encourage U.S. companies to repatriate their foreign earnings back into the U.S.
In addition, the House Bill would eliminate tax on reinvestments in the United States for foreign corporations. The proposal would create an incentive for reinvesting foreign earnings in the United States. Moreover, since the proposal would provide a 100% exemption for the foreign-source portion of dividends from the foreign subsidiary of a U.S. corporate shareholder, there would be no U.S. tax.
Under current law, a U.S. parent of a controlled foreign corporation ("CFC") is subject to current U.S. tax on its pro rata share of the CFC's subpart F income. A foreign subsidiary is a CFC if it is more than 50% owned by one or more U.S. persons, each of which owns at least 10% of the foreign subsidiary. The House Bill would expand the constructive ownership rules to treat a U.S. corporation as constructively owning stock held by its foreign shareholder. In addition, the House Bill would remove the minimum 30-day requirement that U.S. parent owns stock in the foreign subsidiary in order for the U.S. parent of a CFC to be subject to U.S. tax on its pro rata share of the CFC's subpart F income.
The House Bill would impose a tax on a U.S. parent that has one or more foreign subsidiaries on 50% of the U.S. parent's foreign high returns. Foreign high returns would be the excess of the U.S. parent's foreign subsidiaries' aggregate net income over a routine return (7% plus the Federal short-term rate) on the foreign subsidiaries' aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include, among other things, income effectively connected with a U.S. trade or business and subpart F income.
The House Bill and Senate Bill have many proposals but are a long way from becoming law and it remains to be seen whether, or how much, the proposals will be altered. We will continue to monitor the progress of the proposals and prepare an Alert when tax reform legislation is officially enacted. If you have any particular area of interest or concern regarding the proposals in the House Bill or the Senate Bill or how it impacts you or your business, please feel free to contact our tax attorneys, Cheryl Johnson at [email protected]or Jen Green at [email protected].
This communication is intended for general information purposes and as a service to clients and friends of Verrill Dana, LLP. This publication, which may be considered advertising under the ethical rules of certain jurisdictions, should not be construed as legal advice or a legal opinion on any specific facts or circumstances, nor does it create attorney-client privilege.