Authored by Patrick Balthazor, Paul Dillon, Michelle Hobbs, Mike Schiavo and Michael Wronsky
Last month, GOP congressional leaders and the White House announced the tax reform framework that was agreed to by the “Big Six” negotiators. The Big Six comprises Speaker of the House Paul Ryan, House Ways and Means Committee Chair Kevin Brady, Senate Finance Committee Chair Orrin Hatch, Senate Majority Leader Mitch McConnell, Treasury Secretary Steven Mnuchin and National Economic Council Director Gary Cohn.
This month, the House Ways and Means Committee released its initial draft of a tax reform bill, the Tax Cuts and Jobs Act (TCJA). This legislation is slated to be marked up by the committee the week of Nov. 6 and head to the House floor the week of Nov. 13. This timing may be ambitious as many provisions remain controversial and which revenue raisers to include remain in dispute.
According to a preliminary nonpartisan analysis from the Tax Policy Center, the rate reductions would cost approximately $5.6 trillion over the next two decades, with $2.4 trillion over the first 10 years. Part of this would be paid for by the proposed elimination of the deduction for most state and local taxes. The compromise in the bill is to allow individuals to deduct up to $10,000 of property taxes, but deductions for all state and local income and sales taxes would be eliminated. This could make it difficult to secure votes from House Republicans in higher-taxed states. Such votes are important as few, if any, Democrats are expected to cross the aisle and vote for this legislation.
In addition, if tax reform is enacted via reconciliation (meaning it passes the Senate by a simple majority not subject to the filibuster rules), it must be deficit neutral over the 10-year budget window or it will automatically sunset (similar to the Bush tax cuts). Achieving deficit neutrality may be difficult since more than two-thirds of every federal dollar is considered “mandatory” spending. Items such as Social Security, Medicare and interest on the national debt are considered untouchable. Further complicating matters is the national debt itself. Between 2007 and 2016, the national debt, as a percentage of GDP, more than doubled to 77 percent from 35 percent, according to the nonpartisan Committee for a Responsible Federal Budget. This is the highest debt-to-GDP percentage since 1945 when it was 103 percent. The recently passed budget resolution provides for tax reform to increase the deficit by $1.5 trillion over the next decade, so unless rule changes are made, or additional revenue sources found, rate reductions are likely to sunset.
Rates. The framework provided for a 20 percent corporate tax rate. The TCJA reduces the current corporate rate to 20 percent from 35 percent. The corporate alternative minimum tax (AMT) would be repealed as part of the rate reduction package. Personal service corporations would be subject to a flat 25 percent corporate rate.
A reduced rate of 25 percent will apply to pass-through business entities, which include partnerships, S corporations and sole proprietorships, albeit with restrictions. The limitations are aimed at preventing abuse of the 25 percent rate, namely, high-earning individuals forming themselves into corporations to get a tax cut.
Professional services providers, including doctors, lawyers, accountants and others, generally will not qualify for the reduced rate.
If enacted, this structure will require pass-through entity owners to choose one of two options:
- Classify 70 percent of their income as wages (taxed at the individual tax rate) -- with 30 percent as business income, taxable at the 25 percent rate. This is the default rule.
- Set the ratio of wage income to business income based on the level of their capital investment. That ratio would be based on the federal short-term rate plus 7 percent multiplied by the capital investment in the business. The asset balance/capital investment would be the taxpayer’s adjusted basis of property used in the business as of the end of the year. For this purpose, bonus depreciation and section 179 expensing would be disregarded.
Note that the default capital percentage for owners of the aforementioned professional services firms under the second option above is zero. However, the TCJA would allow these owners to use an alternative capital percentage relative to the business’s capital investment, subject to certain limitations.
Once an election is made to use the alternative ratio, the election would be binding for a five-year period.
The recharacterization applies to active business income – i.e., owners treated as materially participating in a trade or business. The existing material participation rules apply for this purpose. In contrast, business income treated as passive under the passive activity rules would be eligible for the 25 percent rate. Further, capital gains and qualified dividends retain their preferential rates and are not subject to recharacterization.
Corporate AMT. The corporate AMT would be repealed. If a taxpayer has AMT credit carryforwards, the taxpayer would be able to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020 and 2021. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2022. The provision would generally be effective for tax years beginning after 2017.
Deduction for certain foreign dividends. Under current law, U.S. persons are generally taxed on all income, whether earned in the U.S. or abroad. Foreign income earned by a foreign subsidiary of a U.S. corporation generally is not subject to tax until distributed as a dividend to the U.S. corporation. A foreign tax credit is allowed to mitigate the effects of the double taxation.
The bill replaces the current system with a 100 percent deduction for certain dividends received from certain foreign subsidiaries. Under the revised system, a U.S. corporation would receive a 100 percent deduction for the foreign-source portion of dividends received from a foreign corporation in which the U.S. corporation owns 10 percent or more. No foreign tax credit or deduction would be allowed with respect to these dividends.
Repatriation of foreign earnings. U.S. shareholders owning at least 10 percent of a foreign subsidiary generally must include in income for the subsidiary’s last year beginning before 2018 the shareholder’s pro rata share of the net post-1986 earnings and profits (E&P) to the extent the E&P has not previously been subject to U.S. tax. The E&P would be classified as cash or cash equivalents subject to a 12 percent rate with the remainder of the E&P subject to a 5 percent rate. At the election of the taxpayer, the tax liability would be payable over a period of up to eight years, in equal installments.
Foreign tax credit carryforwards would be fully available, and foreign tax credits triggered by the deemed repatriation would be partially available, to offset the U.S. tax.
Business expensing. Taxpayers other than those in real property trades or businesses and certain utilities would be able to fully expense qualified property (tangible personal property with a recovery period of 20 years or less) acquired after Sept. 27, 2017, and before Jan. 1, 2023. In addition, the small business expensing provision under section 179 would be increased to $5 million and the phase-out amount would be increased to $20 million. The increased section 179 provision would be applicable to tax years beginning after 2017 and before 2023.
Business interest. Interest deductions for every business, regardless of entity form, would be subject to disallowance of net interest expense in excess of 30 percent of the business’s adjusted taxable income. Adjusted taxable income is a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses, and depreciation, amortization, and depletion (essentially, EBITDA). For pass-through entities, the disallowance would be determined at the entity level rather than the partner or shareholder level.
This rule will not apply to:
- small businesses with average gross receipts of less than $25 million,
- real property trades or businesses, and
- some utilities.
Disallowed interest expense deductions can be carried forward for five years and deducted on a first-in, first-out basis.
Net operating losses (NOL). Under the TCJA taxpayers could only deduct an NOL carryforward up to 90 percent of their taxable income (determined without regard to the NOL deduction). This change in essence conforms to the AMT rule under current law. Net operating losses arising in a taxable year beginning after Dec. 31, 2017, will be allowed to be carried forward indefinitely. The option to carryback an NOL is no longer available, with few exceptions.
Like-kind exchanges. Tax deferral under like-kind exchanges of personal property would generally be repealed after 2017. Exchanges of real property may still qualify.
Repeal of section 199 deduction. The bill would repeal the current 9 percent deduction for income attributable to domestic production activities.
Repeal of numerous business tax credits. The following would be repealed under the bill:
- New Markets Tax Credits. No new credits would be allotted after 2017. However, credits that have already been allocated may be used over the course of seven years.
- Employer-provided child care credit
- Rehabilitation credit. Under a transition rule, the credit would continue to apply to expenditures during a 24-month period selected by the taxpayer. That period would have to begin within 180 days after Jan. 1, 2018.
- Work Opportunity Tax Credit
Small business accounting method reforms. The bill provides several provisions reforming and simplifying accounting methods for small businesses:
Cash method of accounting. Under current law, a corporation or partnership with a corporate partner may only use the cash method of accounting if its average gross receipts do not exceed $5 million for all prior years (including the prior tax years of any predecessor of the entity). Under the bill, the $5 million threshold for corporations and partnerships with a corporate partner would be increased to $25 million and the requirement that such businesses satisfy the requirement for all prior years would be repealed.
Under current law, farm corporations and farm partnerships with a corporate partner may only use the cash method of accounting if their gross receipts do not exceed $1 million in any year. An exception allows certain family farm corporations to qualify if its gross receipts do not exceed $25 million. The TCJA extends the increased $25 million threshold (above) to farm corporations and farm partnerships with a corporate partner as well as family farm corporations (the average gross receipts test would be indexed for inflation).
Accounting for inventories. The TCJA permits businesses with average gross receipts of $25 million or less to use the cash method of accounting even if the business has inventory. In contrast, under current law, the cash method can only be used for certain small businesses with average gross receipts of not more than $1 million (for businesses in certain industries that have annual gross receipts that do not exceed $10 million). Under the cash method, the business could account for inventory as non-incidental materials and supplies. Under the bill, a business with inventories that qualifies for and uses the cash method would be able to account for its inventories using its method of accounting reflected on its financial statements or its books and records.
Capitalization and inclusion of certain expenses in inventory costs. The bill fully exempts businesses with average gross receipts of $25 million or less from the uniform capitalization (UNICAP) rules. The UNICAP rules generally require certain direct and indirect costs associated with real or tangible personal property manufactured by a business to be included in either inventory or capitalized into the basis of such property. The bill’s exemption would apply to real and personal property acquired or manufactured by such business.
Accounting for long-term contracts. Under current law, an exception from the requirement to use the percentage-of-completion method (PCM) is provided for certain businesses with average annual gross receipts of $10 million or less in the preceding three years. The TCJA increases the $10 million average gross receipts exception to the PCM to $25 million, effective for tax years beginning after 2017. Businesses that meet the increased average gross receipts test would be allowed to use the completed-contract method (CCM) or any other permissible exempt contract method.
Deductibility of FDIC premiums. No deduction would be allowed for a certain percentage of premiums paid by banks for the FDIC for years after 2017. The deduction would be disallowed for taxpayers with consolidated assets of $50 billion or more and limited for small institutions.
Impact on individuals. We analyzed the bill to see how it would affect a family of four at three income levels. The first is a family with $80,000 of adjusted gross income (AGI), the second at $250,000 of AGI and finally one with $1 million of AGI. This analysis assumes income from pass-through business entities, itemized deductions, net investment income (NII) tax and AMT paid based on preliminary 2014 averages published for those income levels by the IRS. Additional assumptions incorporated into this analysis are below. Each taxpayer’s facts are different and no specific inference should be drawn for your particular tax situation.
|Example 1||2017||Proposed 2018||% change|
|Adjusted gross income||80,000||80,000|
|Mortgage interest paid||(7,600)|
|State and local taxes paid|
|Income, sales and other taxes||(6,710)|
|Federal income tax||5,400||6,700||24.1%|
|Child tax credit||(2,000)||(3,200)|
|Example 2||2017||Proposed 2018||% change|
|Adjusted gross income||250,000||250,000|
|Mortgage interest paid||(11,600)|
|State and local taxes paid|
|Income, sales and other taxes||(11,700)|
|Federal income tax||42,500||44,700||5.2%|
|Alternative minimum tax||4,100||-|
|Child tax credit||-||(2,200)|
|Example 3||2017||Proposed 2018||% change|
|Adjusted gross income||1,000,000||1,000,000|
|Mortgage interest paid||(17,800)||(17,800)|
|State and local taxes paid|
|Income, sales and other taxes||(42,070)|
|Federal income tax||314,300||285,700||-9.1%|
|3.8% net investment income tax||10,100||10,100|
|Alternative minimum tax||33,300||-|
- Per preliminary 2014 IRS statistics, 99.8 percent of returns on which the child tax credit was claimed were filed by taxpayers with AGI of $50,000 or less. This calculation assumes a family of four with two qualifying children under section 24. The credit is available to offset both regular tax and the AMT. The TCJA expands upon the child tax credit as further discussed below.
- Assumes taxpayer is a nonprofessional services provider and elects to classify 70 percent of their income as wages (taxed at the individual tax rate) and 30 percent as business income, taxable at the 25 percent rate under the default rule mentioned above.
Rates. The framework would replace the current seven-bracket system with three rates of 12, 25 and 35 percent. The TCJA includes four individual income tax brackets, with the top bracket remaining at 39.6 percent but increasing the applicable income level to $1 million, up from $418,400 for single filers and $470,700 for joint filers.
A fifth bracket is essentially created due to the phaseout of the 12 percent for high-income taxpayers (measured as the difference between what the taxpayer pays and what the taxpayer would have paid had the income subject to the 12 percent bracket instead been subject to the 39.6 percent bracket). The TCJA phases this out at a rate of $6 of tax savings for every $100 of adjusted gross income in excess of $1 million (single filers) or $1.2 million (joint filers).
The individual AMT would be repealed. If a taxpayer has AMT credit carryforwards, the taxpayer would be able to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019, 2020 and 2021. Taxpayers would be able to claim a refund of all remaining credits in the tax year beginning in 2022. The provision would generally be effective for tax years beginning after 2017.
Repeal of self-employment tax exclusion for limited partners. The exclusion from self-employment tax for limited partners would be modified so any partner could have net earnings from self-employment regardless of the individual’s status as a limited partner.
Standard deduction and personal exemptions. The standard deduction would increase to $24,400 for joint filers (and surviving spouses) and $12,200 for individual filers. Single filers with at least one qualifying child would receive an $18,300 standard deduction. However, the bill repeals personal exemptions.
Home mortgage interest. The bill maintains the mortgage interest deduction in its current form, but only for existing mortgages. It reduces the deduction for new mortgages from the current $1 million principal cap to $500,000. The $500,000 limitation also applies to refinancing occurring after Nov. 2, 2017, if the principal amount of the new debt exceeds the principal amount of the debt that is being refinanced. If a taxpayer has a binding contract in effect before Nov. 2, that debt will be treated as incurred before that date and eligible for the $1 million cap. Interest arising from mortgages on secondary residences and home equity lines of credit would no longer be deductible.
Deductions for state and local taxes. Deductions for most state and local taxes are generally eliminated. However, the TCJA allows a deduction of up to $10,000 for property taxes.
Other individual itemized deductions. With the exception of charitable donations, all other itemized deductions, including deductions for medical care, would be repealed.
Alimony. Alimony payments would no longer be deductible by the payor or included in the income of the recipient. This repeal would apply to any divorce or separation decree executed after 2017 as well as any modification to an existing agreement made after 2017 if the modification expressly provides for this section to apply.
Retirement accounts. Changes to the deductibility of contributions to retirement plans, such as 401(k)s, were widely expected. The bill makes no changes to the current deductibility rules. However, changes could be made during markup or in the Senate version of the bill.
Exclusion for gain on sale of a principal residence. The $500,000 exclusion would be retained but modified. The exclusions would be phased out by one dollar for every dollar that a taxpayer’s average modified AGI for a three-year period (including the year of the sale) exceeds $500,000 ($250,000 for single filers). Further, to qualify for the gain exclusion, the residence has to be the taxpayer’s principal residence for five out of eight years, compared to two out of five under current law.
Termination of contributions to medical savings accounts (MSA). Under the bill, no deduction would be allowed for contributions to an Archer MSA. Employer contributions to employee MSAs would no longer be tax-free. Existing MSA balances can be rolled tax-free into an HSA.
Expansion of child tax credit. Under the TCJA, the child tax credit would be increased to $1,600 per qualifying child from $1,000, and the AGI levels at which the credit begins to phase out would be increased to $230,000 from $110,000 and to $115,000 from $75,000 for joint and single filers, respectively.
Additional tax reform considerations
Basic reform of the code. The bill does provide some basic simplification for individual taxation where taxpayers do not have complex returns. However, neither the bill, nor the previously discussed tax reform framework, addresses complexities in the code and regulations that increase the cost of taxpayer compliance. For example, the passive loss rules, anti-churning rules, etc., remain in place without modification. For pass-through entities, additional complexity is added by decisions regarding reasonable compensation and whether to use the 70/30 capital percentage default.
Funding tax reform. The bill has not yet received a score from the Congressional Budget Office. Bridging the gap from a projected $5.6 trillion revenue reduction to a $1.5 trillion deficit means Congress will need to make difficult choices about what deductions to eliminate thereby creating winners and losers under reform. The Senate has yet to release its version of tax reform and may include additional revenue raisers. The following are potential items discussed in the past as either part of the tax reform framework released earlier this year or as part of the “Camp tax reform” proposal from a few years ago. The potential items include:
- Retirement accounts. One possibility is treating 401(k) accounts like Roth individual retirement accounts (IRAs), a process also known as “Rothification.” Rothification would result in IRA and 401(k) contributions losing eligibility to be made on a pre-tax basis. Instead, contributions would be made on a post-tax basis and subsequent earnings of the IRA/401(k) plan would be tax-free when withdrawn.
- While the House chose not to change the rules for retirement accounts, Senate action remains to be seen. This is potentially a large source of revenue.
- Repeal of like-kind exchanges. The tax reform framework proposed repealing all like-kind exchanges. The House bill retains exchanges for real estate, but this could be on the table.
- Change to long-term contracts. The tax reform framework would limit the CCM to small businesses, applying only to contracts estimated to be completed within two years for taxpayers with average gross receipts of $10 million or less over a three-year period. Under current law, taxpayers that produce property under long-term contracts must determine taxable income under the PCM. This rule generally requires the taxpayer to include in gross income the portion of the contract price equal to the percentage of the contract completed during the year. For certain home construction contracts and for small businesses, taxpayers may use the CCM, under which income generally is deferred until the contract is completed.
- The CCM was intended to be a simplified method for small contractors and home builders; however, this exception is not limited to small businesses in the case of home builders.
- Repeal of last-in, first-out. Last-in, first-out (LIFO) inventory method would be eliminated. Income associated with the recapture would likely be spread out over several years.
- Repeal of lower of cost or market. The lower of cost or market (LCM) method would be eliminated and taxpayers on LCM would be required to write up any items remaining in inventory subject to the same schedule as discussed in the repeal of LIFO section above. Under current law, taxpayers using the first-in, first-out (FIFO) method of accounting can write-down the cost of their inventory to market if the inventory declines in value. There is no subsequent requirement to write inventory back up if it recovers.
- Carried interests. Taxation of carried interests has been debated for years. Last month, National Economic Council Director Gary Cohn indicated the White House still supports eliminating this tax break. Under the proposal, certain partnership interests held in connection with the performance of services would be subject to a rule that characterizes a portion of any capital gains as ordinary income. An applicable partnership interest subject to this rule would include any interest transferred, directly or indirectly, to a partner in connection with the performance of services by the partner, if the partnership is engaged in a trade or business conducted on a regular, continuous and substantial basis consisting of: (1) raising or returning capital, (2) identifying, investing in or disposing of other trades or businesses, and (3) developing such trades or businesses. Unlike previous carried interest proposals, the provision would not apply to a partnership engaged in a real property trade or business.
The recharacterization formula generally would treat the service partner’s applicable share of the partnership’s aggregate invested capital as generating ordinary income. The service partner’s applicable share is based on the highest percentage of profits that could be allocated to the service partner in any given year. That amount is then multiplied by a specified rate of return (the federal long-term rate plus 10 percentage points). The recharacterization account balance represents a running total of the amount that can be recharacterized as ordinary income.
The formula is intended to approximate the compensation earned by the service partner for managing the capital of the partnership. If the partnership sells property in the course of a trade or business and generates capital gain, the service partner’s share of the capital gain would be treated as ordinary to the extent of the partner’s cumulative recharacterization account balance. Amounts in excess of the recharacterization account balance would be capital gain. The recharacterization rule also applies to partnership distributions and dispositions of partnership interests.
The bottom line?
If enacted, some taxpayers’ positions will improve as a result of this proposal, others’ will decline and the remainder will fall somewhere in between. While the TCJA’s supporters and opponents present the legislation as a victory for or detriment to taxpayers, respectively, the reality depends on each taxpayer’s particular circumstances, even within the same income bracket. So far, we can identify winners and losers only in broad terms:
- C corporations – rate is reduced to 20 percent from 35 percent
- Businesses with low borrowing needs – current deductibility of interest expense is being limited
- High-income individuals from lower-taxed states – lower tax rates, less exposure to impact of state and local income tax reduction repeal
- Pass-through businesses with high capital investment requirements – a greater portion of income will be eligible for reduced 25 percent rate
- Individuals with taxable estates – estate tax exemption is increased in short term, repealed in long term
- Individuals maximizing retirement plan contributions – no changes currently proposed to 401(k) plans
- Taxpayers who are generally subject to AMT – AMT is repealed
- Businesses with high borrowing costs -- current deductibility of interest expense is being limited
- Pass-through businesses with low capital investment requirements – a greater portion of income will be subject to regular rates rather than reduced 25 percent rate
- Homebuilding industry – mortgage interest limitation and loss of state income tax deduction could lead to a decline in home prices
- Low- to moderate-income individuals with multiple children – personal exemption is eliminated; increased standard deduction will not offset this change for larger families
- Borrowers – increase in deficit of $1.5 trillion over the next decade may lead to higher interest rates
What happens next? The bill heads to markup by the Ways and Means Committee, where it could be revised, then to the House floor for a vote. The Senate will also introduce and debate its own bill during this period.
At the same time, Congress is facing a number of issues not related to tax reform:
- The debt ceiling needs to be addressed by Dec. 8. The September extension was only for three months.
- Current events are a distraction from focusing on reform.
- As we saw with healthcare reform, even though Republicans hold majorities in both houses, intra-party tensions could derail the bill at any time and for any number of reasons.
- Based on the principles of the tax reform bill, there is no reason to expect rates to increase next year; expect inflation adjustments to income tax brackets, exemptions and deductions.
- Numerous members of Congress are likely to oppose this bill due to the $1.5 trillion it would add to the deficit. Bottom line, enactment is still far from certain.
- No provision in the bill has the rate reductions retroactive to Jan. 1, 2017.
- If some type of tax reform is enacted in early 2018, rates will likely go down.
- Time-honored tax advice of “defer, defer, defer” remains an appropriate strategy for most taxpayers.
- Under ASC 740, deferred federal and state (net of federal benefit) tax attributes and liabilities will have to be recalculated to take the lower rates into consideration, if enacted.
- Defer income. For example, cash-basis taxpayers may want to postpone billing clients until January.
- Maximize contributions to 401(k)s and other pre-tax retirement accounts in 2017. If this means saving less in 2018 so the net savings between the two years is the same, the tax savings may be worth it.
- Postpone retirement account withdrawals. If you are retired and withdrawing money from a retirement plan, cash flow permitting, consider suspending any additional withdrawals for 2017 and catching up in 2018.
- Accelerate state tax payments. If you have flexibility in when you can pay your real estate taxes, accelerate the payment — as well as 2017 state income tax payments — into 2017.
- Caution: Accelerating certain deductions into 2017 could trigger the AMT, defeating the purpose of claiming the additional deductions in the first place. We recommend you meet with your tax advisor to run multiyear projections to determine the best strategy for your personal situation.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.