On Feb. 26, 2014, the House Ways and Means Committee Chairman David Camp released the Tax Reform Act of 2014 (the proposal). The proposal repeals 228 sections of the existing tax code and, if enacted, would represent the most sweeping change to the income tax code since the Tax Reform Act of 1986. Both Republicans and Democrats have indicated the draft is a starting point for further debate on tax reform.
While it is highly unlikely the proposal will be adopted in the short term or without substantive changes, such discussion drafts generally contain key provisions that ultimately will be included in tax reform. This was the case in 1986. We expect this process to unfold over the balance of the year—it’s possible that actual legislation will move forward after the November election, or that the new Congress will take up a working draft in January. Right now, though, it is too early to say how this process will evolve.
Accordingly, we’ve highlighted some of the important elements of the proposal in this alert. We want to let you know what tax provisions are currently on the table to give you ample time to voice any concerns you may have with your representatives in Congress. As always, we’ll continue to advise you as substantive developments occur.
Changes to rate structure and elimination of the AMT
The existing seven brackets (10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, and 39.6 percent) would be collapsed into two brackets (10 percent and 25 percent), and taxpayers with incomes higher than $400,000 (single) and $450,000 (married filing jointly) would face an additional 10 percent surtax on certain income.
Long-term capital gains would be taxed as ordinary income; however, 40 percent of gains and dividends would be excluded. This proposal basically reverts the taxation of capital gains to pre-1986 law. Nevertheless, capital gains will continue to be subject to the 3.8 percent Medicare tax under the proposal.
The standard deduction increases to $11,000 for individuals and $22,000 for married couples. The additional standard deduction for the elderly and the blind would be eliminated. Phaseout would begin at $20 for every $100 when modified adjusted gross income exceeds $517,500 for joint filers and $358,750 for single filers.
The individual alternative minimum tax would be repealed.
For tax years beginning after Dec. 31, 2018, the maximum corporate tax rate would drop to 25 percent (from the current 35 percent). The maximum rate would be 33 percent for tax years beginning in 2015; 31 percent for tax years beginning in 2016; 29 percent for tax years beginning in 2017; and 27 percent for tax years beginning in 2018. The 25 percent rate, for each of these years, would apply to taxable income less than $75,000.
Personal service corporations would be taxed at the same rates as other corporations.
The corporate alternative minimum tax would be repealed.
Reduced mortgage interest deduction
Under current law, taxpayers may claim an itemized deduction for mortgage interest on up to $1 million in acquisition indebtedness and up to $100,000 in home equity indebtedness.
Under the proposal, taxpayers can still claim the mortgage interest deduction, but the $1 million limitation will be reduced to $500,000. The reduction would be phased in over four years, so that the limitation would be $875,000 for debt incurred in 2015; $750,000 for debt incurred in 2016; $625,000 for debt incurred in 2017; and $500,000 for debt incurred in 2018 and beyond. The provision generally would be effective for interest paid on debt incurred after 2014.
Changes to self-employment income
For tax years beginning after 2014, self-employment tax would be assessed on general and limited partners of a partnership (including limited liability companies) and shareholders of S corporations to the extent of their distributive share of the entity’s income or loss. In determining net earnings from self-employment, partners and shareholders who materially participate in the trade or business of the entity would be allowed to exclude 30 percent of their distributive share from self-employment tax as earnings on invested capital. The remaining 70 percent would be subject to self-employment tax.
Partners and shareholders who do not materially participate in the trade or business would not include any of their distributive share as self-employment income.
Elimination of the state tax deduction
Under current law, individual taxpayers may claim an itemized deduction for state and local government income and property taxes paid. For tax years beginning before 2014, individuals can claim a deduction for state and local sales paid in lieu of the deduction for income taxes.
The act repeals the deduction for state and local income, property, and sales taxes for tax years beginning after Dec. 31, 2014. Under the proposal, individuals would only be allowed a deduction for state and local taxes paid or accrued in carrying on a trade or business or producing income.
The proposal limits the charitable contribution deduction to amounts exceeding 2 percent of adjusted gross income (AGI). It also extends the deadline for making tax deductible donations for a given tax year to April 15 of the following year.
In a significant change, the amount of a deduction for property generally would be limited to the taxpayer’s adjusted basis in the property rather than fair market value (FMV). However, for the following types of property, the deduction would be based on FMV less any ordinary gain, as if the taxpayer had sold the property:
- Tangible property related to the purpose of the tax-exempt organization;
- Any qualified conservation contribution;
- Any qualified inventory contribution;
- Any qualified research property; and
- Publicly traded stock
Roth IRA changes
The proposal reduces the amount employees can contribute to a tax-deferred retirement account (i.e., traditional IRA, 401(k)) to half the maximum annual elective deferral amount ($8,750 from $17,500 for 2014), including catch-up deferral amounts for individuals older than 50. Any contributions in excess of the $8,750 would be dedicated to a Roth-style account, which would be tax-free savings during retirement. Income eligibility requirements to contribute to these accounts are eliminated under the proposal.
In addition, new contributions to traditional IRAs and nondeductible IRAs would be prohibited. (However, taxpayers could still roll over a traditional IRA or 401(k) into a traditional IRA). Finally, the proposal repeals the rule that allows taxpayers to re-characterize a contribution to a traditional IRA as a contribution to a Roth IRA (and vice versa).
Capital contributions as income to corporations
Under current law, the gross income of a corporation generally does not include contributions to its capital by nonowners, such as government entities. In addition, a corporation does not recognize gain or loss on the receipt of money or property in exchange for stock of the corporation, nor does it recognize gain or loss with respect to any lapse or acquisition of an option to buy or sell its stock.
Under the proposal, the gross income of a corporation includes any contributions to its capital to the extent the contribution exceeds the FMV of the stock issued in exchange. Since governmental agencies don’t receive stock for incentive they may provide, this provision would remove a federal tax subsidy for state and local governments to offer incentives within their jurisdictions. Similar rules would apply to contributions to the capital of any noncorporate entity, such as a partnership.
In addition, under the proposal, the tax liability of a corporation would not take into account income, gains, losses, or deductions with regard to a derivative that relates to the corporation’s stock, except for income received with regard to certain forward related contracts. The provision would be effective for contributions made, and transactions entered into, after the date of enactment.
Slower depreciation deductions
Under current law, depreciation for tangible property is determined under the modified accelerated cost recovery system (MACRS). The MACRS recovery periods for most tangible personal property range from three to 25 years, with accelerated depreciation methods in many instances. The recovery periods for real property are 39 years for nonresidential real property and 27.5 years for residential rental property. Real property is depreciated using the straight-line method. In certain situations, property must be depreciated under the alternative depreciation system (ADS), which requires longer recovery periods and straight-line depreciation.
Under the proposal, for property placed in service after Dec. 31, 2016, the current MACRS recovery periods and methods would be repealed and replaced with rules substantially similar to ADS rules. Thus, in general, recovery periods would be longer (for example, 40 years for real property) and depreciation deductions would be determined under the straight-line method. To partially offset this slower cost recovery, the proposal allows taxpayers to take an additional depreciation deduction to account for the effects of inflation on depreciable personal property. The additional deduction would be calculated by multiplying the year-end adjusted basis in the property by the chained CPI rate for the year.
The proposal also repeals a host of other depreciation rules, including bonus depreciation; special rules for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property; the special allowance for second-generation biofuel plant property; the special allowance for certain reuse and recycling property; and the special allowance for qualified disaster assistance property.
Repeal of like-kind exchanges
Effective for transfers after 2014, the proposal repeals the deferral of gain on like-kind exchanges. If a written binding contract is entered into on or before Dec. 31, 2014, the like-kind exchange would be permitted as long as the exchange is completed before Jan. 1, 2017.
Cash method limitation
All businesses, with some exceptions in the farming industry, would be required to use the accrual method of accounting if their average annual gross receipts exceed $10 million. Sole proprietors would be able to continue to use the cash method regardless of the level of their gross receipts. The provision would be effective for tax years beginning after 2014. Assuming there is a positive adjustment to income, the taxpayer would be allowed to include additional income resulting from the change on their tax returns over a four-year period beginning with the first tax year after 2018. The additional income would be included in the following amounts: 10 percent included in the first year (2019); 15 percent in the second year (2020); 25 percent in the third year (2021); and 50 percent in the fourth year (2022). The taxpayer could elect to begin the inclusion of the additional income prior to 2019.
Change to long-term contracts
Taxpayers that produce property under long-term contracts must determine taxable income under the percentage-of-completion method (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 completed-contract method (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. Under current law, however, this exception is not limited to small businesses in the case of home builders. The act 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. The provision also would repeal the special exceptions to the PCM rules for multiunit housing contracts and shipbuilding contracts. The provision would be effective for contracts entered into after 2014.
Repeal of last in, first out
Under the proposal, the last in, first out (LIFO) inventory method would be eliminated. A taxpayer currently using LIFO would recapture their LIFO reserve over a four-year period beginning with its first taxable year after 2018 as follows:
- 10 percent included in 2019
- 15 percent included in 2020
- 25 percent included in 2021
- 50 percent included in 2022
Taxpayers could elect to begin the recapture earlier. Closely held entities, generally those with no more than 100 owners, would be eligible for a reduced 7 percent tax rate on the recapture of their reserves.
Repeal of lower of cost or market
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. Under the proposal, lower of cost or market (LCM) would be eliminated and taxpayer 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.
For tax years beginning after 2014, 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.
Existing provisions that would be repealed under the act, not discussed above, include:
- Personal exemptions
- Deduction for personal casualty losses
- Deduction for tax preparation expenses
- Itemized deduction for medical expenses
- Deduction for alimony payments (and corresponding inclusion in gross income by payee)
- Deduction for moving expenses
- Deduction and exclusions for contributions to medical savings accounts
- 2 percent floor on miscellaneous itemized deductions
- Overall limitation on itemized deductions (Pease limitation)
- Work Opportunity Tax Credit
- Employer-provided child care tax credit
- Energy-efficient appliance credit and home credit
- Credits for biodiesel and renewable diesel used as fuel, production of low sulfur diesel fuels, producing fuel from a nonconventional source
- Energy credit and advanced energy project credit
Provisions modified under the proposal include:
- Increase and expansion of the child tax credit
- Reform of the earned income tax credit
- Corporation, S corporation, and partnership tax return filing due dates
- Penalties for filing certain information returns
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
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.