On November 2, 2017, the House Ways and Means Committee unveiled the Tax Cuts and Jobs Act (the "Bill"). The Bill could dramatically alter the U.S. approach to domestic and international taxation. Although the possibility of tax reform has been the subject of much discussion since the election of President Donald Trump, many past proposals have been light on details. The Bill represents the first potential legislative language. House Ways & Means Committee Chairman Kevin Brady (R-Texas) released an amendment to the Bill on November 6, 2017 (the "Amendment").1 The committee is marking up the Bill this week with a vote expected Thursday. Republican leaders in the House hope for a full vote the week of November 13th.2
The Bill proposes dramatic changes to existing U.S. tax rules. For individuals, the Bill reduces the amount of home mortgage indebtedness on which interest payments are deductible and repeals the itemized deduction for state and local income taxes. For businesses, the Bill permanently reduces the corporate income tax rate to 20% and allows taxpayers to fully and immediately expense 100% of the cost of certain qualified property. For multinational groups, the Bill moves the United States toward a territorial system coupled with anti-base erosion measures intended to shore-up the U.S. tax base. The Bill also proposes a one-time transition tax on currently deferred foreign earnings.
The following is a brief summary of the key provisions in the Bill:
- Reduces the number of tax brackets from seven to four: 12%, 25%, 35%, and 39.6%. Significantly lowers the taxable income threshold of the 35% bracket and significantly raises the application of the 39.6% bracket; the benefit of the 12% bracket is lost as a taxpayer's income exceeds $1,200,000 (married filing jointly) or $1,000,000 (single). (The effect of these shifts (without regard to other changes that tend to increase taxable income) is to cause married taxpayers at the top of current 35% bracket ($480,050 of taxable income) to experience the lowest percentage reduction in effective tax rate under the proposed rate revisions (a 0.82% reduction). The percentage reduction thereafter climbs to a maximum percentage reduction of 2.78% at $1,000,000 of taxable income.) The maximum dollar amount of reduction in tax liability is $27,844, reached at $1,000,000 of taxable income (without regard to the new 25% preferential rate discussed below).
- Doubles standard deduction to $24,000 but eliminates personal exemptions. (The effect of the elimination of the personal exemption more than offsets the increased standard deduction for taxpayers claiming more than two exemptions, but under some circumstances for low-income taxpayers, the net reduction for such taxpayers may be offset by an increase in credits for dependents.)
- Creates a new preferential 25% rate for income from a "business activity." All of business income from passive activities qualifies for the 25% maximum rate, while the amount of business income from activities in which the taxpayer materially participates depends on a taxpayer's "capital percentage" for the relevant activity (that is, the portion of the income not considered to be attributable to services provided by the taxpayer). The default capital percentage is 30%, but taxpayers may elect instead to determine their percentage using a formula in the statute. Relies heavily on existing passive/active business activity rules (Section3 469) to determine which income qualifies for the 25% maximum rate and which is subject to ordinary individual income tax rates. The 25% maximum rate does not apply to income from "specified service activities," which include "any activity involving the performance of services described in Section 1202(e)(3)(A), including investing, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2))." The 25% maximum rate also does not apply to "investment-related items," which include capital gain, dividend and dividend-equivalent income, interest income not allocable to a trade or business, and certain other categories of passive income.
- Applies the maximum 25% business activity rate to real estate investment trust ("REIT") dividends that are currently treated as ordinary income.
- Determines self-employment income from flow-through businesses by reference to a "labor percentage." The labor percentage is the inverse of the capital percentage computed for that business (discussed above). The exclusion for distributive shares of partnership income allocated to limited partners would be repealed.
- Repeals the so-called "Pease limitation," which generally limits itemized deductions for high-income taxpayers.
- Reduces the amount of home mortgage indebtedness on which interest payments are deductible. Under current law, taxpayers may deduct interest on up to $1,000,000 in acquisition indebtedness.4 Under the Bill, with respect to debt incurred after November 2, 2017, this would be reduced to $500,000. The $1,000,000 limit would be retained for debt incurred on or before November 2, 2017 (including refinancing of such grandfathered debt), and debt incurred under a binding contract exception. The deduction for interest paid on home equity indebtedness would be eliminated.
- Limits the exclusion of gains from sale of a principal residence by (i) requiring that the taxpayer have used the residence for 5 of the previous 8 years (instead of 2 of the previous 5 years under current law), (ii) limiting the ability to use the exclusion to once every 5 years (instead of once every 2 years under current
- law), and (iii) phasing out the exclusion for taxpayers with a 3-year average adjusted gross income exceeding $500,000 (for joint filers), determined without regard to inclusion of gains attributable to the phase-out.
- Repeals the itemized deduction for state and local income taxes. Limits state and local property tax deduction to $10,000.
- Limits gambling deductions to the extent of gambling winnings. Under current law, gambling losses are limited to gambling winnings, but other expenses connected to gambling (when conducted as a trade or business) are not so limited.
- Increases the limitation on charitable contributions to 60% of adjusted gross income (up from 50% under current law).
- Repeals deductions from gross income for alimony payments, moving expenses, and itemized deductions for tax preparation expenses and medical expenses and expenses attributable to the trade or business of being an employee.
- Eliminates the ability of taxpayers to recharacterize IRA contributions as Roth IRA contributions (and vice-versa).
- Increases the exemption from estate, gift, and generation-skipping transfer tax from $5,000,000 to $10,000,000, and beginning 2023, repeals the estate and generation-skipping transfer taxes.
- Repeals the alternative minimum tax ("AMT") beginning in 2018. Taxpayers may claim a refund for AMT credit carryforwards beginning in 2019.
- Permanently reduces the general corporate tax rate from a maximum graduated rate of 35% to a flat 20%.5 Similarly, reduces the tax rate for qualified personal service corporations6 from a flat 35% to a flat 25%.
- Allows taxpayers to fully and immediately expense 100% of the cost of certain qualified property (e.g., certain tangible personal property, certain computer software, water utility property, etc.). Repeals the current requirement that the original use of the property must begin with the taxpayer taking the depreciation deduction. Instead, under the Bill, a taxpayer is generally eligible for the depreciation deduction if it is such taxpayer's first use of the property.
- Permits the use of the cash method of accounting for tax purposes by entities taxed as corporations (and partnerships with a corporate partner) whose 3-year average annual gross receipts (determined as of the
- end of the immediately preceding taxable year) did not exceed $25,000,000. Under current law, use of the cash method is limited to corporations whose 3-year average annual gross-receipts did not exceed $5,000,000 for any prior year.
- Restricts business interest expense deduction by providing that no business, regardless of form, may deduct interest expense in excess of 30% of such business's adjusted taxable income (that is, taxable income allocable to the trade or business without regard to the interest deduction, loss carryovers, and certain other items). Interest deductions by businesses whose 3-year average annual gross receipts for the immediately preceding year did not exceed $25,000,000 would not be subject to this limitation. The provision also would not apply to real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trades or businesses.
- Modifies the rules for carrying back net operating losses ("NOLs") for corporations by eliminating the existing general 2-year carryback and permitting an unlimited NOL carryforward period (rather than the current maximum of 20 years). In addition, the unused NOL carryforwards will be increased by an interest factor for the period that they remain unused. Similar to the existing alternative minimum tax rules, not more than 90% of the taxpayer's current year's taxable income can be offset by otherwise available NOL carryovers.
- Limits like-kind exchange non-recognition treatment to exchange of real property only. Under current law, qualifying personal property may also qualify for preferred like-kind exchange treatment if certain conditions are satisfied.
- Under current law, insured depository institutions may deduct FDIC assessments as a trade or business expense. The Bill phases out these deductions for financial institutions that have consolidated assets between $10,000,000 and $40,000,000.
- Restricts the potential tax benefit of carried interest by limiting the availability of long-term capital gain rates. In general, under new Section 1061, a taxpayer that performs substantial services for an investment business and receives a partnership interest in exchange must use a 3-year holding period to determine long-term capital gain with respect to that partnership interest. Amounts that are disqualified because of the 3-year rule are treated as short-term capital gain. The 3-year rule does not apply where a partnership interest generates a capital loss, rather than capital gain, for a tax year. It also does not apply to partnership interests held directly or indirectly by a corporation or certain capital interests in partnerships.7
1 Chairman Brady also released a mark-up with some technical changes on Friday, November 3, 2017.
2 On the Senate side, the Senate Finance version will be released later this week
3 References to "Sections" throughout this Client Alert are to the currently effective version of the Internal Revenue Code of 1986, as amended, unless otherwise specified.
4 In addition to "acquisition indebtedness," current law also permits taxpayers to deduct interest on up to $100,000 of "home equity indebtedness."
5 Currently the rate is 15% for taxable income up to $50,000; 25% for taxable income between $50,000 and $75,000; 34% for taxable income between $75,000 and $10,000,000; and 35% for taxable income above $10,000,000.
6 Section 448(d)(2) generally defines a "personal service corporation" as a corporation that performs services (i.e. health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting). Currently Section 11(b)(2) provides that qualified personal service corporations are subject to a flat rate of 35%.
7 If enacted, new Section 1061 could raise potential conflicts between investment managers (such as private equity and venture capital sponsors) on one hand and their investors on the other.
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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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