by Don Susswein and Rob Alinsky
RSM is an IMA member accountant…
On Nov. 2, the House Ways and Means Committee unveiled their long-awaited tax reform bill, the Tax Cuts and Jobs Act.
While there have been several previous releases from both Congressional Republican leaders and the White House, this bill marks the first proposed tax legislation to be released, and represents a major step in the tax reform process.
The Tax Cuts and Jobs Act (TC&J Act) largely conforms to the general principles laid out in the Unified Framework released in September, which generally called for cuts to the individual and business tax rates, elimination of many itemized deductions, exemptions and credits, limitations on the deductibility of interest expense and a switch to a territorial system of international taxation. The TC&J Act, however, goes on to provide the fine print that recent previous releases have lacked.
Most notably, the bill proposes to:
- Condense the number of individual tax brackets from the seven under current law to four, including 12, 25, 35 and 39.6 percent brackets. In addition, the bill proposes to repeal the personal exemption as well as increase the standard deduction to $12,000 for individuals and $24,000 for married couples ($12,200 and $24,400, respectively when adjusted for inflation for the 2018 tax year).
- Eliminate a significant number of itemized deductions, but preserve the deduction for charitable contributions, and retain, in part, the itemized deductions for state and local taxes. Notably, while the bill proposes to continue to allow a deduction of up to $10,000 for state and local property taxes, it eliminates the itemized deduction for state and local incomeand sales taxes.
- Limit the home mortgage interest deduction for newly purchased residences to interest on $500,000 of indebtedness, while grandfathering existing mortgages.
- Double the current estate tax exemption to approximately $11 million, effective Jan. 1, 2018, with complete repeal of the estate tax occurring in six years.
- Quite notably, despite the bill’s proposed repeal of the estate tax, it retains the step-up in basis for inherited property.
Other notable provisions of the bill affecting individuals include:
- The complete repeal of the Alternative Minimum Tax (AMT).
- Enhancements to the child tax credit, which include increasing the credit from $1,000 to $1,600, along with adding a $300 credit for non-child dependents.
- Retention of the current rules that apply to certain deferred tax retirement plans, such as the limit for pre-tax contributions to 401(k) plans.
On the business front, the bill proposes to:
- Reduce the federal corporate income tax rate to a flat 20 percent for tax years beginning after 2017. It would replace the current corporate tax brackets, which now have a top rate of 35 percent. Personal service corporations would be subject to a flat 25 percent rate, and would not be eligible for the 20 percent general corporate rate.
- In addition, the bill proposes to introduce a new tax rate of “not more than 25 percent” for certain pass-through business income.
- In conjunction with reducing the rate for pass-through business income, the bill introduces new rules to preclude personal service income from being taxed at the lower rates. Under the bill, business owners would have the option to either elect to have 30 percent of certain business income passing through to them taxed at the 25 percent rate, or determine the amount of income eligible to be taxed at the 25 percent rate based on their capital investment in the pass-through entity, and a statutory assumed rate of return on that capital, approximately seven percentage points higher than Treasury short-term borrowing rates. In the case of certain professions and service businesses, the 30 percent rule would not apply and the reduced rate would only apply to the extent the taxpayer demonstrated a substantial capital investment, and only to the extent of that statutory assumed rate of return on that investment.
- The bill also limits the deductibility of interest expense for all businesses with average gross receipts in excess of $25 million, regardless of their form, to 30 percent of “adjusted taxable income.” Adjusted taxable income would include business income only, excluding amortization, depletion, depreciation, interest and net operating loss deductions. Businesses with average gross receipts of less than $25 million, along with certain regulated public utilities and real property trade or businesses, would be exempt from this limitation. For tax years beginning after 2017, this rule would apply both to entities subject to corporate level income tax and to owners of pass-through entities such as partnerships and S corporations. Disallowed interest would be carried forward by the business up to five years for potential future use. A similar five-year carryforward would apply to another interest deduction limitation proposed by the bill, which would apply to certain multinational groups having annual revenue in excess of $100 million.
- In addition, the bill provides for the immediate expensing of qualified property placed in service between a five-year span of Sept. 27, 2017 and Jan. 1, 2023. Under the provisions of the bill, however, regulated public utilities and real estate trade or businesses would not qualify for immediate expensing.
- The bill proposes changes to the net operating loss (NOL) deduction rules, which generally would be effective for NOLs arising in tax years beginning after 2017. NOL carrybacks generally would be prohibited, except that a one-year carryback would be permitted for eligible disaster losses. The NOL carryforward period would be extended indefinitely, so NOLs incurred in tax years beginning after 2017 would not expire. The NOL deduction amount, however, would be limited to 90 percent of the taxpayer’s taxable income (determined without regard to the NOL deduction). NOLs carryforwards attributable to NOLs arising in tax years beginning after 2017 generally would be increased by an annual interest factor of the applicable federal rate plus 4 percent.
- The bill would repeal the AMT, as mentioned above, and would repeal the Domestic Production Activities Deduction (DPAD) for tax years beginning after 2017, as well as simplify the method certain businesses with average gross receipts of less $25 million are required to use to account for certain items, such as inventory under uniform capitalization (UNICAP) rules and long term contracts.
- The bill also repeals several tax credits, including the historic building rehabilitation credit and the work opportunity tax credit. Certain types of renewable energy projects eligible for the investment tax credit allowed to expire after 2017, have been reinstated with the same phase-out schedule as solar energy projects.
- The bill also notably repeals the performance-based exception to the $1 million deduction limitation for certain covered employees of public companies, and imposes tax on deferred compensation when it is no longer subject to a substantial risk of forfeiture.
- The bill contains several significant international tax proposals. First, it proposes to replace the existing worldwide system of international taxation with a territorial system. To implement this, the bill would exempt 100 percent of the foreign source portion of dividends paid by a foreign corporation to a greater than 10 percent U.S. shareholder. This territorial approach would apply to all payments made after 2017.
- As part of the transition to this international tax new system, the bill provides for a one-time tax on the repatriation of accumulated offshore earnings at rates of 5 or 12 percent, depending on whether the earnings are held as cash and cash equivalents or as non-cash assets. The tax would be payable over an 8-year period upon election.
- Additionally, the bill calls for measures to prevent base erosion and profit shifting (BEPS), including a measure that would subject 50 percent of a U.S. parent’s returns on foreign investment deemed to be in excess of a certain threshold to a U.S. taxation.
- In a somewhat expected turn, the bill would also impose a 20 percent excise tax on payments made by U.S. corporations to foreign related corporations where such payments are otherwise deductible, includible in costs of goods sold or includible in the basis of an asset, unless the foreign payee elects to be taxed on a net basis. An exception would apply for intercompany services provided on a cost basis. The proposal would apply to international groups where payments from U.S. corporations to foreign affiliates total at least $100 million annually and would be effective for tax years beginning after 2018.
While this bill represents a major step for tax reform, there is still a long road ahead for the ultimate passage of any tax reform legislation. The TC&J Act, in its current form, is likely only the opening bid in the overall tax reform process, with adjustments (many of which could be substantial) almost certain to come as it moves through the legislative process in the House. In addition, the Senate Finance Committee is expected to release their tax reform bill soon, which could introduce new or varying positions regarding tax reform that may conflict with those of the TC&J Act in its current form. To compound the uncertainty, the positions of the House, Senate and the White House may still be subject to change, particularly in response to constituent concerns, and input from trade associations or lobbyists that may view particular proposals as problematic for their industries or interests, or disruptive to the economy.
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