The House of Representatives released draft legislation on November 2 for the highly anticipated tax reform bill. This first attempt will be revised, perhaps extensively, by the House committees before a vote, which House GOP leaders want by Thanksgiving. Lawmakers and President Trump are signaling they want the passage of a reconciled bill by Christmas; however, the Senate plans to release its own tax bill the week of November 13, where significant areas of concern from moderate and conservative groups must be reconciled.
While all tax legislation must originate in the House under the Constitution, the Senate’s tax bill may serve as the real basis for any changes to the tax code. This is a result of the current balance of power. Republicans hold a slimmer majority in the Senate than in the House, which will likely require some extent of capitulation from House Republicans to proposed Senate changes in order to appease any potential defectors.
That being said, there are some major changes from previous plans and pitfalls that stand out among the many changes to the tax code called for in the Tax Cuts and Jobs Act. And while some of these were outlined in previous GOP plans, the ones highlighted here gained additional clarity as part of the bill’s release.
Business Tax Provisions
C corporations would be subject to a flat 20 percent tax rate, with personal service corporations subject to a flat 25 percent tax rate. These provisions would be made permanent.
Owners of pass-through entities (partnerships and S corporations) would be subject to a maximum 25 percent tax rate on profits. For passive investors (to be determined using the current passive activity rules), all income from the pass-through entity would be presumed to be from the business and taxed at the reduced rate. For active participants in the business, the default rule would be that 30 percent of income from the business is eligible for the special rate, with the remaining 70 percent taxed as ordinary income to the owner (e.g., the tax rates otherwise applicable for individuals).
Professional service businesses (such as those of accountants, architects, and doctors) would be ineligible to use the default rule, but could use an alternative capital investment calculation. Also, pass-through business owners would be able to elect to use a different formula based upon facts and circumstances, potentially lowering the percentage to be taxed as ordinary income.
Most businesses would be able to deduct 100 percent of the cost of qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2023. This provision would generally conform with current principles for bonus depreciation, except this new provision would not require “original use” by a business, and would instead require only that it be the business’ “first use” (i.e., used property would qualify). However, property used by a regulated public utility company or any property used in a real property trade or business would not qualify for the 100 percent cost recovery provision.
There are new limits on the deductibility of certain types of executive compensation over $1 million. Tax-exempt bonds will not be permitted for the construction of professional sports stadiums. The bill also specifically identifies the elimination of other tax breaks, where industry groups now have visibility into the particular items they may want to fight to protect. Among the items to be eliminated are the rehabilitation credit, the Work Opportunity Tax Credit, the New Markets Tax Credit, and the tax credit for employer-provided child care. Contributions to capital would be taxable to corporations except to the extent of the value of stock received in exchange, and the Section 199 Domestic Production Activities Deduction would be repealed.
Businesses would also have enhanced access to the cash method of accounting, as long as they have average annual gross receipts of up to $25 million for three prior years, even if they maintain inventories. These businesses would also be exempt from uniform capitalization rules for inventory.
For businesses that have average gross receipts in excess of $25 million, the deduction for interest expense will be limited. Hence, the limitation is targeted toward larger businesses, but every type of business in excess of this threshold would be subject to this limitation. For applicable businesses, the deduction would not be allowed for the net interest expense in excess of 30 percent of the business’s adjusted taxable income. Disallowed interest expense deductions could be carried forward for a maximum of five years.
Net operating loss deductions would be limited to 90 percent of the corporation’s taxable income (making the current-law rule for alternative minimum tax purposes applicable for “regular” tax purposes under the new law). The carryforward period for unused net operating losses would expand from 20 years to unlimited, and carrybacks generally would be repealed. Additionally, the corporate alternative minimum tax would be repealed.
On the international front, previously untaxed foreign earnings of foreign subsidiaries will be deemed repatriated and subject to a bifurcated tax rate. This one-time repatriation tax would be calculated at 12 percent for earnings held in cash and cash equivalents and 5 percent for earnings held in noncash assets. An election would be made available to pay the one-time tax over eight years. Foreign tax credit carryforwards would be fully available, and foreign tax credits triggered by the redeemed repatriation would be partially available to offset the resulting U.S. tax.
The bill calls for a new 10 percent tax on the ongoing foreign-source “high-profit” returns earned by the foreign subsidiaries of a U.S. business. Amounts subject to this new tax would be 50 percent of the excess net income over a “routine return.” A routine return generally would be an amount of net income that is 7 percent plus the federal short-term rate, based on the investment that the foreign subsidiaries have in depreciable tangible property, less interest expense.
Notwithstanding this new 10 percent tax, the bill otherwise eliminates taxes on active overseas profits, and allows for a 100 percent dividend exemption on foreign-source dividends paid to U.S. corporate shareholders (who own at least 10 percent of the foreign subsidiary). The bill imposes a 20 percent excise tax on deductible payments made by a U.S. corporation (other than interest) to a related foreign corporation, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset, unless the foreign corporation elected to treat the payments as effectively connected income subject to U.S. tax or there is no markup with respect to payments for intercompany services.
Individual Tax Provisions
For individuals, many of the bill’s provisions remain unchanged from the Tax Reform Framework; however, there are some notable differences. The head of household filing status would be preserved. The tax rates and brackets would be as follows:
- A 12 percent rate would apply for incomes up to $45,000 ($90,000 for married couples);
- A 25 percent rate would apply for incomes up to $200,000 ($260,000 for married couples);
- A 35 percent rate would apply for incomes up to $500,000 ($1 million for married couples); and
- A 39.6 percent would apply for incomes in excess of $500,000 ($1 million for married couples).
When it comes to calculating the tax bill for those in the top rates, there is an additional wrinkle in that such individuals will have to recalculate their tax liability in such a way that they will essentially lose the benefit of the 12 percent bracket.
The 3.8 percent net investment income tax remains unchanged. Also, despite calls from President Trump, the November 2 bill would preserve the prefential tax treatment for "carried interest," commonly utilized by investment fund managers and certain real estate investors.
The standard deduction would be nearly doubled, up to $12,000 for single filers ($24,000 for married couples). While these amounts are higher, personal exemptions would be eliminated, together with secondary deductions for certain individuals, which detracts from the initial luster of this provision. Also, the bill specifically outlines that the itemized deduction for medical expenses, the student loan interest deduction, the moving expense deduction, the alimony payment deduction, and the adoption credit are slated for elimination. These provisions have their own special interest groups that will seek to protect them and aside from the changes for homeowners.
The mortgage interest deduction would be preserved, but the indebtedness limitation would be lowered to $500,000 versus the previous $1 million limit. This change would be effective immediately. The ability to exclude gain on the sale of a residence (up to certain limits) remains unchanged, but the principal place of abode requirement expands from two of the last five years to five of the last eight.
The hotly debated deduction for state and local taxes would be repealed, except for a limited amount of property taxes. Property tax deductions would be retained up to $10,000 per year. The elimination of the state and local income tax deduction and the new limitations for mortgage interest appear to be the most likely points of resistance on the individual side.
The bill eliminates the alternative minimum tax (AMT), but spares retirement savings rules or the capital gains rates from major alterations. The AMT repeal appears to be a result of the simplification efforts, where it would have otherwise faced a reduced footprint with the elimination of the state and local income tax deduction (a major driver of AMT). Additionally, the child tax credit would be increased to $1,600, with an additional $300 credit for each non-child dependent or parent.
Other Tax Provisions
The estate tax and generation-skipping taxes would eventually be repealed. The lifetime exclusion amount would first be increased to $10 million per person (indexed for inflation with a catch up to current increases), along with a tax rate reduction from 40 percent to 35 percent. Thereafter, the estate tax and generation-skipping taxes would be repealed, for years beginning after 2023. The stepped-up basis on assets received from an estate will be retained.
Not-for-profits, frequently overlooked in tax reform discussions, will also see some changes in limited circumstances. First, private universities with large endowments (over $100,000 per student) would be subject to a new 1.4 percent excise tax on their endowments. This rate, which will be opposed by many of the nation’s top colleges, would also be applied to certain private foundations that were previously subject to a higher rate under the net investment income excise tax. The legislation also calls for a rollback of the Johnson amendment, permitting 501(c)(3) organizations to endorse candidates if the endorsement was part of the ordinary course of their business, and permitting them to spend de minimis amounts on political speech.
Overall, the November 2 bill appears to provide fewer benefits for wealthy individuals than previous tax plans. This appears to be in response to persuasion from Republican moderates and Democrats. However, there are many other points of opposition that the bill will have to overcome. The National Federation of Independent Businesses does not support the bill due to its perception that the bill does not go far enough to help small businesses. The National Association of Realtors also signaled their initial concerns about the new limits on benefits for homeowners. Deficit hawks, such as the Committee for a Responsible Federal Budget, stated that the projections of an increase in the deficit of $1.5 trillion over ten years may be low, and that the $1.5 trillion figure already amounts to nearly $12,000 per household.
Senator Jeff Flake (R-AZ), who has recently become a vocal critic of President Trump, also echoed concerns about the deficit stating that, “we have been hearing a lot about cuts, cuts, cuts. If we are going to do cuts, cuts, cuts, we have got to do wholesale reform. We cannot simply rely on rosy economic assumptions, rosy growth rates to fill in the gap. We have got to make tough decisions.”
On the other hand, large businesses rallied behind the provisions of the proposals, in anticipation of substantially higher profits.
The initial opposition from these groups and Senator Flake highlight the difficult path ahead as each industry will seek to preserve their preferred tax breaks while Republican leaders navigate the Senate’s restrictive reconciliation rules.
For more information on the November 2 House tax bill, please contact your local CBIZ MHM tax professional.
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