The Senate passed the final version of the bill introduced as the Tax Cuts and Jobs Act (TCJA) in the early hours of December 20, with the House of Representatives voting again the same day to pass the reconciled tax reform bill. President Trump signed the tax reform bill into law December 22, bringing home a major campaign promise. Due to a violation of Senate procedural rules, the bill’s name reverted to the more ungainly title, "To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018." We will refer to it merely as the tax reform bill, for ease of reference. As passed, the bill includes elements of both the House version and the Senate version of the tax reform bill.
The Senate parliamentarian identified two other procedural violations in an earlier version of the tax reform bill: a provision expanding Section 529 savings accounts to home school expenses, and a college endowment excise tax exemption for schools with fewer than 500 tuition-paying students. With those elements removed, the tax reform bill quickly passed both chambers.
Overview of the Final Bill
The tax reform bill generally affects tax years beginning in 2018, with some exceptions. Provisions in the reconciled tax reform bill include a variety of changes from earlier versions of the tax reform plan, as well as some similarities. Highlights include:
- A permanent 21 percent corporate tax rate effective in 2018, representing a 40 percent decrease over the current rate of 35 percent
- A trimmed back 20 percent deduction for qualifying pass-through income from partnerships and S corporations
- Unlimited capital expensing of qualifying tangible assets, with increased Section 179 expensing
- Limitations on business and personal net operating losses, and business interest deductions
- Repeal of the corporate alternative minimum tax (AMT), but retention of the individual AMT with increased exemption amounts
- The survival of most business credits, but repeal of DPAD
- Permanent repeal of the individual mandate to buy health insurance coverage after 2018
- Doubling of estate and gift tax exemptions through 2025 (approximately $11 million individual and $22 million for couples) with no decrease in rates, and return to current exemption amounts thereafter
The following individual tax provisions expire at the end of 2025:
- Decreases in individual tax rates with seven brackets and a maximum rate of 37 percent
- Doubling of the standard deduction but repeal of personal exemptions
- $10,000 combined limit to state and local income and property tax deductions
- All other itemized deductions repealed except improved charitable contributions and medical
- Increased child care credit of $2,000, of which up to $1,400 is refundable
The tax reform bill also repeals the deduction for alimony for the spouse making the payment and the corollary inclusion in income for the spouse receiving the payment for any divorce or separation instrument executed after Dec. 31, 2018 (with modification exceptions).
Our analysis is separated into three sections to facilitate the ability to focus on provisions of the most interest to readers: Business provisions; Individual, Estate, Trust, and Gift Provisions; and International Provisions.
Part 1: Business Provisions
If the goal for the tax reform bill was simplification, the TJCA appears to fall short. If the goal was simply to cut taxes, there are winners and losers. The principal provisions of this compromise tax reform bill are effective starting in 2018, with a few provisions being effective for the last few months of 2017 or after 2018. The primary beneficiaries of the tax reform bill will be businesses and their owners, regardless of how the business is structured and regardless of how the owner holds his or her interest.
Corporate Tax Provisions
For businesses and their owners, the highlights of the reconciled tax reform bill include a 21 percent corporate tax rate. This is an increase from the draft legislation’s 20 percent rate, but still a 40 percent reduction from the current 35 percent rate. The corporate rate increase allowed Congress to eliminate some of the previously proposed revenue raisers.
Most analysts predict that the lower corporate rate will result in increased dividend distributions and stock redemptions that will benefit corporate shareholders. The rate will be effective in 2018 instead of the Senate’s proposed delay to 2019. Further, fiscal year businesses having a period that straddles Jan. 1, 2018 will be subject to a blended rate that will effectively subject income earned after Dec. 31, 2017 to the lower rate.
Personal service corporations will also be able to claim the 21 percent rate, whereas the House bill called for a 25 percent rate. Another win for corporations is the repeal of the corporate AMT. The corporate AMT was briefly revived in the final Senate bill, but its implementation would have negatively affected other corporate tax benefits, such as the research and development credit and the new international territorial tax system.
Pass-Through Business Tax Provisions
Another business friendly provision is the adoption of a new 20 percent deduction for qualified business income received from a pass-through entity. This provision was modified from the Senate proposal, which originally called for a 23 percent deduction. Therefore, an individual taxed at the committee’s maximum proposed rate of 37 percent would pay an effective rate of 29.6 percent on income subject to the 20 percent deduction.
Qualified business income is defined as business income from domestic sources (including Puerto Rico) from a qualified trade or business, excluding investment income (investment interest income, most dividends, capital gains, commodities gains, and foreign currency gains). Qualified business income does not include any amount paid by an S corporation as reasonable compensation to an owner/shareholder, or any amount that is a guaranteed payment for services from a partnership. A qualified trade or business means any trade or business other than a “specified service trade or business” and other than the trade or business of being an employee. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities, respectively.
Notably, engineering and architectural services are not included as a specified service, leaving those industries among qualified trades or businesses that are eligible for the deduction. On the other hand, inclusion of the somewhat ambiguous category “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” has already caused concern, particularly within the small business community.
The availability of the deduction is limited in several ways. The Senate had proposed a wage limitation that would have limited the deduction to the lesser of 20 percent of qualified business income or 50 percent of W-2 wages (wages including bonuses, elective deferrals, and deferred compensation). Under the final tax reform bill, the deduction is limited to the greater of (a) 50 percent of W-2 wages, or (b) 25 percent of W-2 wages plus 2.5 percent of qualified property. For purposes of the limitation, W-2 wages do not include amounts that are not properly allocable to qualified business income. The provision would appear to exclude guaranteed payments from a partnership and compensation paid to an S corporation shareholder/owner from the definition of W-2 wages, however, explanatory comments in the chairman's mark of the earlier Senate version of the tax reform bill (as well as other professional commentators) indicate that compensation paid to an S corporation shareholder/owner is included as W-2 wages.
For example, assume an S corporation that is a qualified pass-through business has one shareholder, $1 million in qualified business income, one employee who was paid $200,000 in W-2 wages, and machinery with an unadjusted basis immediately after acquisition of $5 million. The shareholder would first compute her 20 percent deduction ($200,000). Then the shareholder would compute each wage limitation. The 50 percent limit would be $100,000. For the other wage limitation, the limit would be $175,000 (25 percent of the $200,000 wages + 2.5 percent of the $5 million dollar asset). Because this is larger than the 50 percent wage limit, but smaller than 20 percent of qualified business income, the deduction would be limited to $175,000.
There are some additional restrictions that apply when computing the wage and property limits. As mentioned, W-2 wages do not include guaranteed payments paid to partners and appear to also exclude compensation to S corporation shareholder/owners. Second, eligible W-2 wages are allocated to shareholders and partners in the same proportion as the original deduction for such wages. Third, qualifying property is limited to tangible property held by, and available for use in, a qualifying pass-through trade or business. The property can be included in this calculation each year until its depreciation period has ended (a special 10-year minimum depreciation period is deemed to exist solely for this purpose when the MACRS period ends earlier than such a 10-year period). If the property is no longer held by, or available for use in, the qualifying trade or business (for example it is sold during the year), it cannot be used in determining the wage plus property limitation. Furthermore, the combined tax reform bill calls for the IRS to develop anti-abuse regulations in the case of related party transactions and sale-leaseback transactions.
As an incentive for lower income taxpayers, the 50 percent wage limitation and the wage plus property limitation do not apply. As a further incentive for such taxpayers, the exclusion from the definition of a qualified business for specified service trades or businesses also does not apply. The threshold amount of taxable income for such taxpayers is $157,500 ($315,000 for joint returns), indexed for inflation. There is also range over which relief from these limits will be phased out, with the limits being fully applicable for taxpayers whose income exceeds $207,500 ($415,000 for joint returns).
The final version of the pass-through deduction is a marked difference from the provisions of the House bill. The House bill favored passive investors and passive investments over active business owners who benefit more under the Senate bill. Under the House bill only passive investors would have fully benefitted from their proposed 25 percent tax rate. Active owners would have only been able to use the 25 percent rate for 30 percent of their pass-through income, (an effective rate of 35.2 percent using the House bill’s maximum individual rate of 39.6 percent) unless such owners used a complicated allocation formula based on capital invested. Also, under the House bill, service businesses were completely ineligible to use the reduced rate.
Capital Investment Provisions
The 50 percent allowance for bonus depreciation is increased to 100 percent for most property placed in service after Sept. 27, 2017, and before Jan. 1, 2023, and will apply to used property as well as new property. The bonus deprecation percentage will phase down 20 percent per year starting in 2023, until it is phased out in 2027. As a result of the pre-2018 bonus depreciation incentive (which is deductible at the higher 2017 corporate tax rates), corporations should take advantage of this provision before the deduction becomes less valuable in 2018 at the lower corporate tax rates.
The expensing election under Code Section 179 is also increased to $1 million per year and will begin to phase out for qualifying purchases exceeding $2.5 million. Furthermore, property eligible for section 179 expensing would be enhanced to include nonresidential real property improvements such as roofs, HVACs, fire protection and alarm systems, and security systems. As a result of the bonus depreciation provisions, the Section 179 provisions are made largely irrelevant; however, certain real property improvements not eligible for bonus depreciation are eligible under Section 179 (under the current law definition of qualified improvement property, together with the new types of qualifying property stated previously).
Business Interest Provisions
For any type of entity, business interest deductions will be limited to the sum of business interest income plus 30 percent of adjusted taxable income (computed without regard to deductions allowable for interest, depreciation, amortization, depletion, net operating losses, and the pass-through entity deduction), with additional benefits for auto dealerships. Businesses with average annual gross receipts for the prior three taxable years that do not exceed $25 million are exempt.
Unused business interest expense can be carried forward indefinitely. At the taxpayer’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation would not apply. A similar election is available for any farming business.
Other Business Provisions
In most cases, net operating losses can no longer be carried back two years, but may be carried forward indefinitely. The carryforward deduction is limited, however, to 80 percent of taxable income (determined without regard to the deduction) for losses arising in taxable years beginning after Dec. 31, 2017. Furthermore, business losses for non-corporate taxpayers (such as individuals) are limited to $250,000 per year ($500,000 for joint returns) for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. The limitation applies to the aggregate of all personal and pass-through losses for the year. As a result, this provision effectively prevents individuals from deducting losses from partnerships and S corporations in excess of these levels. Disallowed losses are added to the individual’s net operating loss carryforward. In most cases, individual net operating losses may be applied against 90 percent of taxable income.
Numerous other changes for businesses survived or were dropped from prior bills:
- Technical terminations of partnerships, which can occur when more than 50 percent of a partnership’s interest are transferred and can allow the partnership to “restart” its depreciation, has been repealed.
- Tax deferred treatment of like-kind exchanges completed after Dec. 31, 2017 is limited to real property that is not held primarily for sale for exchange.
- The cash method of accounting will be available to more taxpayers, as the gross receipts threshold for qualifying taxpayers is increased to $25 million for the three prior tax-year periods.
- The Domestic Production Activities Deduction (DPAD) is repealed for taxable years beginning after Dec. 31, 2017.
- Carried interests will only be eligible for long term capital gains treatment if held for more than three years.
- Accrual basis taxpayers with qualifying financial statements must include income no later than the time it is included on their financial statements.
- Proposals to make contributions to the capital of corporations taxable were scaled back and will generally only apply to any contribution in aid of construction or any other contribution as a customer or potential customer.
- Deductions for business entertainment, club dues and qualified employee transportation fringe benefits were curtailed or eliminated. Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).
- The Work Opportunity Tax Credit (WOTC) and the New Markets Tax Credit were retained, as was the ability to use municipal bonds for stadium financing.
Part 2: Individual, Estate, Trust, and Gift Provisions
The tax reform bill includes significant changes to the taxation of individuals, as well as changes impacting estates, trusts, and gifts. For individuals, it is more difficult to state that these changes will provide significant tax benefits, particularly for low and middle-class workers, and especially if the tax reform bill’s temporary provisions are allowed to expire. Although there are few provisions directly affecting the taxation of trusts, it is clear that fewer individuals will be burdened with estate and gift taxes due to increased exemption amounts.
Individual Tax Rates
The first major change on the individual side is a reduction in tax rates, though these new rates are set to expire after 2025. For taxable years beginning after Dec. 31, 2017, the new rates and brackets for married couples and single individuals are:
Married Filing Jointly and Surviving Spouses:
10% (Taxable income not over $19,050)
10% (Taxable income not over $9,525)
12% (Over $19,050 but not over $77,400)
12% (Over $9,525 but not over $38,700)
22% (Over $77,400 but not over $165,000)
22% (Over $38,700 but not over $82,500)
24% (Over $165,000 but not over $315,000)
24% (Over $82,500 but not over $157,500)
32% (Over $315,000 but not over $400,000)
32% (Over $157,500 but not over $200,000)
35% (Over $400,000 but not over 600,000)
35% (Over $200,000 but not over $500,000)
37% (over $600,000)
37% (Over $500,000)
There are also categories for married filing separately and head of household. These rates and brackets are:
Married Filing Separately
Head of Household:
10% (Taxable income not over $9,525)
10% (Taxable income not over $13,600)
12% (Over $9,525 but not over $38,700)
12% (Over $13,600 but not over $51,800)
22% (Over $38,700 but not over $82,500)
22% (Over $51,800 but not over $82,500)
24% (Over $82,500 but not over $157,500)
24% (Over $82,500 but not over $157,500)
32% (Over $157,500 but not over $200,000)
32% (Over $157,500 but not over $200,000)
35% (Over $200,000 but not over $300,000)
35% (Over $200,000 but not over $500,000)
37% (Over $300,000)
37% (Over $500,000)
These rate and bracket charts also show shifting priorities as the legislation emerged from the conference committee. The final tax bracket structure does not embrace the simplification efforts that were first championed by Speaker of the House Paul Ryan (R-WI), where the conference report keeps the current number of tax brackets. Also, the merged TCJA contains a significant marriage penalty for wealthy individuals, with the highest 37 percent rate bracket for single individuals beginning at $500,000, but beginning only slightly higher at $600,000 for married couples filing joint returns. Finally, the House’s plan to phase-out the benefit of certain lower rate brackets for wealthy individuals was eliminated. The capital gains rates under current law will remain at 0 percent, 15 percent, and 25 percent, and the Net Investment Income tax together with the 0.9 percent Additional Medicare Surcharge will remain as well. The capital gain thresholds for single filers will be $38,600 ($77,200 for married couples) for the 15 percent rate, and for single filers will be $425,800 ($479,000 for married couples) for the 20 percent rate.
One critical item concerning these rate brackets is a change in the measure of inflation to be used for the income thresholds, from traditional CPI to chained CPI. Previously, traditional CPI was used to make inflation adjustments year to year. The traditional inflation rate from 2000 through 2014 for urban consumers was 2.26 percent. The Congressional Budget Office calculated that chained CPI on average grows at a rate that is roughly .25 percentage points less, and the chained CPI inflation rate for this same period grew at 1.99 percent. Using these averages in 2025 (the last year of these reduced rates), it is possible to project an estimate of how the difference in these rates will affect the tax brackets. A single filer’s $500,000 tax bracket threshold (subject to the 37 percent rate) would increase to $597,883 under traditional CPI modeling, whereas chained CPI modeling would drop this threshold to $585,370; a decrease of over $10,000. Most estimates predict that this will cause most individuals to actually see tax increases (over prospective application of present law) as soon as 2026, because chained CPI will still be used after 2025 and will not compare to traditional CPI if the tax rate cuts are allowed to expire after 2025.
Individual Deductions and Child Tax Credit
The increased standard deduction amounts from the earlier Senate bill were adopted. For taxable years beginning after Dec. 31, 2017, the new amounts are therefore set at $24,000 for married individuals filing jointly, $18,000 for head of household and $12,000 for single individuals. The enhanced standard deductions for the elderly and the blind are also preserved. Again, chained CPI will be used as the inflation measure for these amounts. These increases expire after 2025, though the chained CPI inflation adjustment will remain.
Personal exemptions for individuals are eliminated, as was proposed in both bills previously. An increased child tax credit instead is provided in their place. The new credit amount is $2,000, of which up to $1,400 is refundable. The credit will begin to phase out at an income threshold of $400,000 for married couples filing joint returns ($200,000 for all other taxpayers). This threshold is not adjusted for inflation. Taxpayers will be able to claim a $500 nonrefundable credit for each non-child dependent. All of these provisions will expire with the individual tax cuts in 2025.
The individual state and local income and sales tax deduction was retained, despite high profile debates on the topic. However, a combined limitation covering state and local property taxes as well as income/sales taxes now applies in the amount of $10,000. Also, a provision was added to specifically prohibit a deduction for the prepayment of future state and local income taxes in 2017. Presumably, this limitation was added to prevent taxpayers from attempting to avoid the $10,000 limit in 2018.
The itemized deduction for medical expenses was preserved, with a decrease in the AGI threshold used to determine the amount of deductible medical expenses, from 10 percent to 7.5 percent in 2017 and 2018. All deductions for miscellaneous itemized deductions subject to the 2 percent floor are repealed for taxable years beginning after Dec. 31, 2017 and before Jan 1, 2026. This results in the elimination of the deductions for employee business expenses, tax preparation fees, and attorney fees, among others.
The overall limitation for itemized deductions (the “Pease” limitation), however, is suspended for 2018 through 2025. This will allow higher income individuals to claim itemized deductions, in contrast to current law which limits itemized deductions once an individual’s income exceeds certain thresholds.
Other Individual Provisions
The conference report generally preserved the other existing credits and deductions for individuals, though there are notable changes to these provisions. The following credits, deductions, and exclusions were wholly unchanged:
- Adoption credit
- Educator expense deduction
- Education credits (American Opportunity and Lifetime Learning credits)
- Earned Income Credit
- Employer provided housing exclusion
- Exclusion for adoption assistance programs
The Alternative Minimum Tax (AMT) for individuals is retained in the reconciled act, and features increases from the current exemption amounts. For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the AMT exemption amount is increased to $109,400 for married taxpayers filing a joint return ($70,300 for single filers), with a phase out threshold of $1,000,000 for married taxpayers filing a joint return ($500,000 for single filers).
The deduction for qualified moving expenses is also suspended for taxable years 2018 through 2025 for all taxpayers other than active duty members of the military, who must still meet the rules for military moves.
Other provisions that were changed in one or both chambers’ bill that made it into the conference report are:
- The current law treatment for exclusion of gain on the sale of a principal residence was preserved, where the House bill would have allowed a reduced exclusion, but the ownership and use tests would have been extended from two of the last five years to five of the last eight years. The House bill also would have limited the exclusion to once every five years. The Senate bill mostly followed the House bill, but the final act does not include either provision.
- For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the mortgage interest deduction limitation is reduced to $750,000 for loans originating after Dec. 14, 2017, and through 2025. The deduction for interest on home equity indebtedness is suspended for the taxable years 2018 through 2025 as well.
- The penalty for failing to maintain minimum essential health insurance coverage (the individual mandate) was reduced to $0 for months beginning after Dec. 31, 2018, effectively eliminating it.
- The deduction for the living expenses of members of Congress is also eliminated.
- The AGI limit for charitable deductions is increased from 50 percent to 60 percent until 2026. However, the 80 percent charitable contribution deduction for contributions made for university athletic seating rights has been eliminated.
- The deduction for personal casualty losses has been significantly limited. The deduction is generally allowed only if the loss was the result of a federally-declared disaster. For instance, a taxpayer whose home was destroyed by flooding from a burst water pipe would not be allowed a deduction, whereas a taxpayer whose home was flooded as a result of Hurricane Irma would be allowed a deduction. Although eliminated in the House version, the deduction for theft losses appears to have survived.
- The limitation for gambling losses is expanded to include (in the definition of losses) all deductions incurred in carrying out wagering transactions (for example travel expenses).
- The alimony expense deduction and corresponding inclusion in income for the recipient spouse is repealed for separation instruments executed after Dec. 31, 2018.
- Elementary and high school expenses are now qualifying expenses for Section 529 plans, though a provision to allow contributions on behalf of unborn children was dropped as it did not comply with the budget reconciliation rules.
- The Sinai Peninsula has been added to the list of areas eligible for the combat zone pay exclusion, for qualifying pay received for duty performed subject to hostile fire or imminent danger. The military has refused to designate the Peninsula as a combat zone for a number of years.
- Discharge of indebtedness income from a student loan received as a result of the death or total permanent disability of the student will no longer be included in income.
- The contribution limits for ABLE accounts are increased in specific situations, and the designated beneficiary can claim the saver’s credit for amounts contributed to ABLE accounts, and further, rollovers from 529 plans to ABLE accounts will be permitted in some situations.
Estates, Trusts, and Gifts
The changes to the estate, trust, and gift taxes are much less extensive than the individual tax changes, but are nevertheless significant. Elimination of the estate tax was ultimately abandoned due to the potential effect on deficit restrictions under the budget reconciliation rules. Instead, the estate tax exemption was doubled to approximately $11 million for individuals and $22 million for couples, indexed for inflation, for decedents dying and gifts made after Dec. 31, 2017. This is paired with an identical increase in the exclusion for the generation skipping transfer tax for transfers after Dec. 31, 2017. Because the estate tax exclusion is unified with the gift tax exclusion, the gift tax will also affect fewer individuals. The doubling of the exemption expires at the end of 2025, with many of the other individual tax changes. On the other hand, the annual exclusion amounts remain unchanged as does the estate tax rate.
In a change from the Senate bill, the 20 percent deduction for pass-through income will be allowed for trusts and estates. This clarifies some of the confusion regarding the deduction for beneficiaries of certain trusts that accompanied the Senate’s exclusion of estates and trusts from the deduction. The change will primarily affect certain family-owned businesses.
Part 3: International and Not-for-Profit Provisions
The tax reform bill also include substantial changes to the tax law for international business, designed to address some of the policy concerns that have been debated for many years. There are also some provisions in the tax reform bill impacting the not-for-profit sector.
International Provisions Overview
Among the massive changes to the tax code under the tax reform bill are many that extend to business conducted beyond the borders of the United States. In addition to a new one-time tax on all of the accumulated earnings of foreign subsidiaries, radical changes are made to certain U.S. base erosion payments made to related foreign parties, the current taxation of offshore earnings under a new category of global intangible low-taxed income (GILTI), and foreign-source dividends received from specified foreign corporations. Before discussing these international provisions, it is important to recap briefly the previous system for taxing income from outside the U.S., and some of the flaws inherent in that system.
Under the law prior to enactment of the tax reform bill, U.S. individuals and businesses were taxed on their worldwide income, but with an important caveat. Active business income earned by foreign subsidiaries was generally not subject to U.S. tax until such income was actually repatriated to its U.S. shareholders as dividends. Thus, some multinational businesses were able to combine foreign tax planning strategies (aimed to reduce foreign tax liabilities) with U.S. tax planning strategies designed to migrate offshore earnings to lower-taxed foreign subsidiaries, and thereby defer U.S. tax on those foreign earnings. Estimates vary, but U.S. companies have approximately $2 trillion of earnings held in cash, cash equivalents, and illiquid assets overseas that have not been subject to U.S. tax.
One-Time Repatriation Tax on Accumulated Foreign Earnings
As part of the effort to address this situation, the tax reform bill imposes a one-time tax on a 10 percent or greater U.S. shareholder’s share of the accumulated and previously untaxed foreign earnings and profits of “specified foreign corporations.” Specified foreign corporations are defined as controlled foreign corporations and other foreign corporations having a domestic corporate shareholder with at least 10 percent ownership. Thus, under the bill, the post-1986 accumulated earnings of all specified foreign corporations will be treated as Subpart F income and mandatorily deemed repatriated to their 10 percent U.S. shareholders (which include U.S. corporations, individuals and partnerships), regardless of whether such profits actually repatriated. Repatriated earnings held in cash and cash equivalents will be taxed at a 15.5 percent rate, and the remaining amount of earnings held in illiquid assets will be taxed at an 8 percent rate. For 10 percent U.S. corporate shareholders, a partial foreign tax credit is allowed in proportion to the taxable amount of the repatriated earnings.
The repatriation tax is subject to rates that are much lower than the regular corporate or individual tax rates, making it a tax holiday of sorts. In fact, a similar one-time repatriation holiday for U.S. corporate shareholders was included in the Bush administration’s tax cuts in the early 2000’s. While there were certain restrictions on the use of the repatriated funds under this previously repatriation holiday (which is not the case under the tax reform bill), the bulk of the repatriated funds were actually used by multinational businesses to increase dividends and to make stock repurchases. However, that repatriation holiday was voluntary and subject to an even lower tax rate.
The amount of accumulated foreign earnings and profits subject to mandatory repatriation will be determined as of Nov. 2, 2017, or Dec. 31, 2017, whichever is greater. The aggregate foreign earnings of specified foreign corporations attributable to cash and cash equivalents is the greater of (1) the cash position of specified foreign corporations as of the close of their last taxable year beginning before Jan. 1, 2018, or (2) the average of the cash positions of those corporations on the last day of each of their two taxable years ending immediately preceding Nov. 9, 2017. For calendar-year specified foreign corporations, this would refer to their cash positions on Dec. 31, 2017, or if greater, the average of such amounts on Dec. 31, 2015 and Dec. 31, 2016.
Shareholders of specified foreign corporations – typically the U.S. parent corporation, but also individuals and partnerships – may elect to pay this one-time tax in installments over a period of eight years. The payment schedule under this election is 8 percent of the liability each of the first five years, 15 percent in the sixth year, 20 percent in the seventh year, and 25 percent in the eighth year.
Importantly, the first installment (or the entire amount) is due by the original due date of the tax return filed for the last tax year beginning before Jan. 1, 2018, without regard to extensions. For calendar-year filers, this would be the tax year beginning Jan. 1, 2017 and ending Dec. 31, 2017, which means that the first installment (or the entire amount) is due April 15, 2018.
For S corporations subject to the deemed repatriation tax, there is a special provision that defers the tax until the S corporation sells substantially all of its assets, ceases to conduct business, changes its tax status, or the electing shareholder transfers its stock. But for all U.S. shareholders of specified foreign corporations, routine calculations of earnings and profits (or a comprehensive E&P study) will be necessary to determine the amount of earnings and profits subject to the tax. Further complicating matters is that this tax is based on the greater of the accumulated foreign earnings and profits determined on Nov. 2, 2017 or Dec. 31, 2017 (as noted above), which leaves U.S. shareholders businesses with a short period of time before the payment due date to determine the proper amount.
U.S. Base Erosion Provisions
This one-time repatriation tax alone would not fundamentally change the incentives for multinational businesses to accumulate earnings offshore. As a result, policymakers have taken a winding path to arrive at changes in the U.S. tax system that address this issue. These changes include various provisions designed to prevent erosion of the U.S. tax base by increasing the tax cost associated with shifting profits overseas to avoid or substantially delay U.S. taxation.
The new base erosion anti-abuse tax (BEAT) is one such provision. The BEAT is an alternative minimum tax on corporations that have annual gross receipts for the three prior years of at least $500 million and that make certain “base erosion” payments to foreign related parties in excess of a threshold amount. Base erosion payments include amounts paid or accrued to a foreign related party that are deductible against U.S. taxes, such as interest, royalties, and service fees (but does not include costs of goods sold). The BEAT tax rate is 5 percent for tax years beginning in 2018, 10 percent for tax years 2019 through 2025, and 12.5 percent for tax years beginning after 2025.
Another base erosion provision is designed to address perceived abuses involving the transfer of intangible property to foreign corporations. Under the bill, the outbound transfer of goodwill, going concern value, or in-place workforce to a foreign corporation in an otherwise tax-free transaction will be subject to U.S. taxation (either through current gain recognition or deemed annual royalties). In addition, the bill authorizes the IRS to value intangible property transferred offshore on an aggregate basis (rather than asset-by-asset), if such valuation achieves a more reliable result.
A further base erosion provision also applies to deny a deduction for certain payments of interest and royalties to related parties either pursuant to a hybrid transaction, whereby the characterization of the payment differs between U.S. and foreign tax law, or by or to a hybrid entity (a foreign disregarded entity) where the payment is not included in income by the related party. And finally, the base erosion provisions are modified to clarify that dividends received by an individual from a surrogate foreign corporation as a result of an inversion transaction are not qualified dividends, and thus not eligible for the lower qualified dividend rates.
Global Intangible Low-Taxed Income
Along the same lines as the base erosion rules is a new provision designed to reduce a multinational business’ incentive to shift U.S. profits abroad, by currently taxing the global intangible low-taxed income (GILTI) of controlled foreign corporations (CFCs). As described below, the effect of the GILTI provision is to subject U.S. shareholders of CFCs to current taxation on the aggregate net income of its CFCs over a routine return. The GILTI provision applies to the tax years of a CFC that begin after Dec. 31, 2017, and to U.S. shareholders of such CFC in which or with which such tax years of the CFC end.
Under the tax reform bill, a U.S. shareholder (corporation, partnership or individual) of a CFC includes in current income its share of the GILTI earned by the CFC. For this purpose, GILTI is defined as the excess of the U.S. shareholder’s “net CFC-tested income” over the shareholder’s “net deemed tangible income” return. The net CFC-tested income is the excess of (1) the aggregate of the U.S. shareholder’s pro rata share of tested income over (2) the aggregate of the U.S. shareholder’s pro rata share of tested loss of each CFC owned by the U.S. shareholder. Tested income (or loss) for a CFC equals the difference between of all of the CFC’s gross income and the CFC’s properly allocable deductions (including taxes) to such gross income. For this purpose, the tested income excludes:
- Income which is effectively connected with a U.S. trade or business (which is already generally taxable)
- Subpart F gross income (which is already generally taxable)
- Certain excluded foreign base company income or insurance income
- Foreign related-party dividends
- Foreign oil and gas extraction income
The net deemed tangible income return (the second part of the main equation in determining a CFC’s GILTI) is the excess of (a) 10 percent of the U.S. shareholder’s pro rata “qualified business asset investment” of each CFC over (b) the U.S. shareholder’s interest expense taken into account previously in measuring tested income (but only to the extent interest income associated with the expense is not part of tested income).
U.S. corporate shareholders of CFCs (but not individuals, partnerships or S corporations) are allowed to deduct 50 percent of GILTI income for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, and 37.5 percent of GILTI after 2026. U.S. corporate shareholders of CFCs can also claim a foreign tax credit with respect to included GILTI amounts, but such credit is limited to 80 percent of the foreign tax paid, and any unused foreign tax credits cannot be carried forward or carried back to other tax years.
Foreign-Derived Intangible Income
As an incentive to keep intangible assets in the U.S. and also encourage U.S. export activity, the bill allows a U.S. corporation to deduct 37.5 percent of its foreign-derived intangible income (FDII) for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026. For taxable years beginning after Dec. 31, 2026, the FDII deduction is reduced to 21.875 percent.
FDII of a U.S. corporation is generally the excess of its gross income over deductions properly allocable to such income, to the extent such income is derived in connection with the sale of property to a non-U.S. person for a foreign use, or services provided to any person (or with respect to property) located in the U.S. FDII does not include:
- Subpart F income
- Any GILTI of the corporation
- CFC dividends
- Financial services income
- Domestic oil and gas extraction income
- Any foreign branch income.
The GILTI and other base erosion provisions are the primary means by which multinational businesses are dissuaded from shifting profits outside of the U.S. These measures are critical because, as a fundamental change from prior law, U.S. corporations will no longer be taxed on worldwide income per se. Under the new territorial system contained in the tax reform bill, a U.S. corporation that owns 10 percent or more of a foreign corporation (other than a passive foreign investment company that is not also a CFC) is entitled to a 100 percent deduction for the foreign-source portion of dividends received from such corporation. In a set of related rules, constructive dividends arising from a U.S. corporation’s sale or exchange of stock in a foreign subsidiary (held for more than one year) will be treated as a dividend for purposes of the 100 percent dividends-received deduction.
As a part of this change, any foreign taxes attributable to the income that give rise to the dividend will not be eligible for the foreign tax credit or deduction. There is also a holding period requirement that must be met in order for the dividend to be eligible for the deduction, where the foreign corporation stock must be held for more than 365 days during the 731-day period beginning 365 days before the ex-dividend date. Another important caveat is that the deduction is only available to C corporations that are not regulated investment companies (RICs) or real estate investment trusts (REITs). Thus, an individual, partnership or S corporation shareholder in a foreign corporation will not be eligible for the deduction, even if the 10 percent ownership threshold is met.
All amounts that are eligible for the 100 percent dividends-received deduction will reduce the U.S. corporation’s basis in the stock of the foreign corporation for purposes of determining loss on the eventual sale of such stock.
Foreign Tax Credit Changes
Another part of the reforms to the international tax system is a new set of limitations on the foreign tax credit. These include a repeal of the Section 902 deemed-paid foreign tax credit on dividends received from foreign subsidiaries, and the creation of separate baskets for foreign branch income and GILTI. Also, the tax reform bill changes the current law 50/50 sourcing rule (with respect to income from the sale of inventory produced partly in and partly outside the U.S.) by allocating and apportioning such income solely on the basis of production of that inventory. Thus, inventory produced entirely in the U.S. will be 100 percent U.S. source income for foreign tax credit purposes, even if title to such inventory is outside the U.S.
A new election is also made available for foreign tax credit purposes. Generally under current law, in situations where a taxpayer incurs a loss and is limited as to claiming a foreign tax credit, U.S. source income can be re-characterized as foreign source income in subsequent years in an amount equal to the lesser of (a) the entire amount of such loss that is not carried back, or (b) 50 percent of the taxpayer’s U.S. source taxable income for the succeeding year. For taxable years beginning after Dec. 31, 2017 and before Jan. 1, 2018, taxpayers may elect to compute the percentage-based amount in a different manner if it results in a higher amount.
Other International Changes
The tax reform bill makes numerous other changes to rules applicable to multinational businesses, including:
- Repeal of provisions requiring inclusion of foreign base company oil-related income as a category of foreign base company income;
- Repeal of provisions requiring inclusion of foreign base company shipping operations income when investments in CFCs decrease;
- A change to the CFC attribution rules such that, in certain situations, stock held in a foreign corporation by a foreign person can be attributed to a U.S. person for purposes of determining CFC status of a corporation;
- A change to the definition of a U.S. shareholder to now include any U.S. person who owns 10 percent or more of the total value of shares of all classes of stock of a foreign corporation, in addition to the current 10 percent voting stock rule; and
- A change to eliminate the 30-day minimum holding period for determining whether a U.S. shareholder must include the CFC’s Subpart F income
On the not-for-profit front, there are some smaller shifts in tax law as a result of the tax reform bill. These shifts include new inclusion amounts for unrelated business taxable income (UBTI) purposes, and a new excise tax on certain college or university endowment income. Other changes in the tax reform bill have indirect application to the not-for-profit sector. For instance, the corporate rate reduction from 35 percent to 21 percent will also apply to the UBTI of a tax-exempt organization, as will changes to business net operating loss deduction rules that limit the deduction to 80 percent of current year taxable income.
Excise Tax on Endowment Income
The headline provision is the new tax on the investment income of some private colleges and universities, for tax years beginning after Dec. 31, 2017. State colleges and universities are not subject to the tax. The provision adds a new 1.4 percent excise tax on the net investment income of private colleges and universities that have more than 500 students and assets of at least $500,000 per full-time student. Such per-student assets do not include those used directly in carrying out the exempt purpose of the college or university. But, such assets (and the net investment income) of certain related organizations must be included for these purposes.
The reconciled conference report originally indicated that “tuition paying” students be those used for this purpose, but this provision was determined to be a violation of the Byrd rule (a subset of the Senate’s budget reconciliation rules), and was thus removed from the final legislation. The 1.4 percent rate was also in the House bill as part of a plan to simplify the excise tax on certain private foundations, but the attempt did not make it into the final tax reform bill.
Unrelated Business Taxable Income
In addition to the endowment tax, there were other changes impacting UBTI for the not-for-profit sector. One such provision involves payments of certain fringe benefits by the organization to its employees. Qualified transportation fringe benefits, parking facility benefits, and on-premises athletic facility benefits paid or incurred are included in UBTI, effective for amounts paid or incurred after Dec. 31, 2017.
Another such provision now requires organizations to separately calculate UBTI for each trade or business (when more than one is involved), where a net operating loss deduction is allowed only with respect to a trade or business from which the loss arose. A net operating loss incurred in taxable years beginning before Jan. 1, 2018 is not subject to the requirement for separate determination. As a result of this new rule, an exempt organization will no longer be able to offset income from one activity with losses from another for years beginning after Dec. 31, 2017.
One provision involving a potential change to include income from the licensing of an organization’s name or logo in UBTI did not survive in the final version of the tax reform bill, leaving current law treatment of these items in effect.
Other Not-for-Profit Changes
There is also a new excise tax on executive compensation paid by tax-exempt employers (including related organizations) to covered employees, for tax years beginning after Dec. 31, 2017. The tax is levied at a rate of 21 percent on compensation in excess of $1 million that is paid to the organization’s five highest-paid employees (including to employees who were covered employees in a prior year). The tax will also apply to excess parachute payments made to these employees. The tax spares licensed medical professionals (including veterinarians) from its purview. For purposes of calculating compensation, deferred compensation will be included only when it is no longer subject to a substantial risk of forfeiture.
One controversial provision that was removed prior to the conference report’s finalization was a repeal of the Johnson amendment. The Johnson amendment, which the President has directed the IRS “to exercise maximum enforcement discretion,” prohibits 501(c)(3) organizations from participating in political activities that favor or oppose a candidate for office. The potential repeal of the Johnson amendment was dropped from the final tax reform bill, as it was determined to violate the Senate’s Byrd rule.
These changes to the international and not-for-profit provisions round out the major provisions of the tax reform bill. There are some additional provisions affecting specific industries, particularly the craft beer and wine industries which will generally see lower excise taxes. As our publications series on the tax reform bill concludes, be sure to stay tuned for future coverage of this bill and its regulatory guidance from the IRS. The scope of the changes and the speed at which this legislation was drafted will nearly guarantee that that additional changes, IRS guidance through regulations and notices, technical corrections, and continued debate will ensure for the months and years to come.
For more information on the tax reform bill and its application to you and your business, please contact your local CBIZ MHM tax advisor.
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