Late last week, House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady announced the release of the Ways & Means Committee's tax reform bill, the "Tax Cuts and Jobs Act" (H.R. 1).
The legislation calls for significant changes to the individual tax rules, the business tax rules, the international tax rules, and rules affecting employers and employees. The following is a general summary of the key proposals in each category.
Rates, Standard Deduction, and Exemptions
H.R. 1 would create individual income tax brackets of 12%, 25%, and 35%, and retain the 39.6% bracket for income in excess of $1 million. The 25% threshold would begin at $90,000 for taxpayers filing jointly and $45,000 for individuals. The 35% bracket threshold would begin at $260,000 for joint filers and $200,000 for individuals. The benefit of the 12% rate bracket would be phased out for taxpayers with adjusted gross income (AGI) in excess of $1 million ($1.2 million for joint filers).
The standard deduction would be nearly doubled to $12,000 for single individuals and $24,000 for joint filers. H.R. 1 repeals the deduction for personal exemptions.
Tax Credits and Savings Incentives
H.R. 1 preserves the Earned Income Tax Credit and raises the child tax credit to $1,600. H.R. would not modify popular retirement savings options, like 401(k)s and IRAs.
The legislation consolidates the higher education tax credits into an enhanced American Opportunity Tax Credit.
H.R. 1 repeals the overall limit on itemized deductions. The home mortgage interest deduction for existing mortgages would be preserved, but the mortgage interest deduction for newly purchased homes would be limited to $500,000 (and would no longer be applicable to second homes). Refinancings of debt incurred prior to November 2, 2017, are treated as having been incurred as of the date of the original mortgage.
The legislation limits the deduction for the cost of state and local property taxes to $10,000 and eliminates the deduction for state and local income or sales taxes. The legislation also repeals many traditional deductions, like those for alimony payments, medical expenses, and moving expenses.
H.R. 1 retains (unchanged) the itemized deduction for charitable contributions.
AMT and Estate Tax
H.R. 1 calls for the repeal of the Alternative Minimum Tax on individuals. A taxpayer with AMT credit carryforwards can claim a refund of 50% of the remaining credits to the extent they exceed regular tax for a year, in the tax years beginning in 2019, 2020, and 2021. The bill doubles the Estate, Gift, and GST tax exemption amount (to $10,000,000) until the tax is repealed in 2023. Effective 2024, the top gift tax rate would be lowered to 35%.
Capital Gains and Carried Interest
H.R. 1 does not modify the current preferential treatment of long-term capital gains and qualified dividends (currently subject to a top rate of 23.8%). Nor does the legislation modify the tax treatment of "carried interest" as applicable to investment fund managers.
Exclusions and Taxable Compensation
Under current law, a taxpayer may exclude up to $500,000 of the sale of a principal residence from AGI as long as the property was used as the principal residence for 2 of the past 5 years. H.R. 1 requires the property to have been used as the principal residence for 5 of the past 8 years to qualify for the exclusion, and would be phased out (at a dollar-for-dollar rate) for taxpayers with AGI in excess of $500,000 ($250,000 for single filers).
Corporate Rate and Corporate AMT
Under H.R. 1, the corporate tax rate would be cut, immediately and permanently, to 20%. Personal service corporations would be taxed at a 25% rate. The corporate AMT is slated for elimination.
Pass-through business income would be taxed at a 25% rate. The 25% tax rate applies fully to all passive activity income (as currently defined in the Code). All other activities would be bifurcated between business income and regular income. Taxpayers could elect to use a default capital percentage of 30%, or a capital percentage based on a rate of return (the federal short-term rate plus 7%) multiplied by the capital investments in the business. Businesses that provide services in the fields of law, accounting, consulting, engineering, financial services, or the performing arts may only use the capital percentage formula.
Expensing and Business Interest Deduction
Taxpayers would be able to fully and immediately expense 100% of qualified property acquired after the release of the tax reform Framework (September 27, 2017). This proposal sunsets at the end of 2022.
H.R. 1 would limit the deduction for net business interest to 30% of adjusted taxable income. (The "adjusted taxable income" concept comes from the current earnings-stripping rules and is similar to an EBITDA measure). Disallowed interest expense could be carried forward for 5 years. Businesses with average gross receipts of $25 million or less, certain regulated public utilities, and real estate companies are not subject to this limitation.
Net Operating Loss Deductions (NOLs)
The legislation would limit NOLs to 90% of taxable income, with any disallowed NOLs carried forward indefinitely. Carrybacks are generally eliminated.
Current law allows the deferral of gain from an exchange of qualifying "like kind" property (that is used in a business or held for investment). While H.R. 1 retains the current rule for real property, it would repeal the rule for all other property.
H.R. 1 calls for the adoption of a territorial system of taxation where foreign business income would be exempt from U.S. taxation. This would be accomplished by exempting 100% of the foreign-source portion of dividends paid by a foreign corporation to a 10% U.S. corporate shareholder. No foreign tax credit would be allowed for any foreign taxes paid with respect to the dividend, and no deductions would be allowed for expenses properly allocable to the dividend.
The legislation subjects the previously untaxed earnings and profits of a 10% foreign subsidiary to immediate tax at a rate of 12% for cash (and cash equivalents) and 5% for other assets. The resulting tax liability would be payable ratably over a period of up to 8 years. Foreign tax credits triggered by the deemed repatriation would be partially available (depending on whether the foreign tax credits are attributable to cash and cash equivalents or to other assets).
Base Erosion Prevention
H.R. 1 imposes a global minimum tax on a U.S. multinational's foreign source income. Specifically, the proposal would subject 50% of a foreign subsidiary's "foreign high returns" to current U.S. tax (yielding an effective rate of 10% for such income). The calculation of "foreign high returns" is determined as the excess of the foreign subsidiary's aggregate net income over a routine return (calculated as the federal short-term rate plus +7%) on the subsidiary's aggregate adjusted bases in depreciable tangible property.
H.R. 1 makes permanent the "look-through" rule relating to controlled foreign corporations. The rule gives a U.S parent the ability to avoid triggering tax on distributions between foreign subsidiaries.
Payments from Domestic to Foreign Corporations
H.R. 1 includes a new proposal of significant consequence – as it would affect many cross-border payments (other than interest payments) between related companies. Specifically, all related-party cross-border payments that are (i) deductible payments, (ii) includible in costs of goods sold, or (iii) includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax. This proposal applies to any international financial reporting group with cross-border payments (from the U.S. entity) of at least $100 million per year. A U.S. taxpayer can avoid the excise tax by electing to treat such payments as "effectively connected income" (under which the foreign subsidiary pays U.S. income tax on its net income attributable to the relevant product line). If the election is made, no credit would be permitted for foreign taxes paid on the effectively connected income. The excise tax would not be deductible.
Interest Deduction of a Domestic Corporation in an International Financial Reporting Group
H.R. 1 would limit the deduction of interest paid by a domestic corporation that is a member of an international financial reporting group to the extent the domestic corporation's share of the global net interest expense exceeds 110% of the domestic corporation's share of the global EBIDTA (i.e., the domestic corporation can have 10% more leverage than the global group). Disallowed interest expense would be carried forward for 5 years.
Employer Employee-Related Proposals
H.R. 1 includes a number of proposals that affect employers and employees. Some of these changes include
- Repealing the employee deduction for moving expenses,
- Repealing the itemized deduction for expenses attributable to the trade or business of performing services as an employee,
- Limiting the exclusion for housing provided for employers and employees of educational institutions to $50,000 (with a phase-out for high earners)
- Modifying the credit for social security taxes on employee tips paid by the employer,
- Repealing the work opportunity credit (WOTC),
- Disallowing the deduction for entertainment, amusement, recreational activities or facilities, or certain membership dues,
- Repealing the deduction for transportation fringe benefits or other amenities,
- Modifying the rules regarding the deductions for expenses related to meals and entertainment,
- Repealing the exclusion for qualified moving expense reimbursements, and
- Repealing the exclusion for the value of employer-provided child and dependent care assistance programs.
H.R. 1 would make significant changes to executive compensation rules. Subject to various grandfather and transition provisions, deferred compensation, including stock options and other forms of equity compensation, provided by for-profit entities would be taxed when vested rather than when paid or made available. All compensation paid by publicly traded entities to covered executives would be subject to the $1,000,000 deduction limit; no exceptions would apply. Nonprofit entities would be subject to a 20% excise tax on any annual compensation payments to key executives in excess of $1,000,000 or which constitute excessive severance, and would no longer be able to establish Section 457(b) deferred compensation plans.
Today, the House Ways and Means Committee began its consideration of the legislation (with a markup of the legislation) – and its deliberation is expected to continue for much of this week (concluding by this Friday). If all goes as scheduled, the House of Representatives could be considering H.R. 1 as early as next week.
Tax reform activity is not limited to the House. The Senate Finance Committee may be releasing its own tax reform package as early as late this week.
If you have any questions on the contents of this alert, please reach out to the authors or any member of Venable's Tax and Wealth Planning Group.