On November 2, the Ways and Means Committee released its long-awaited version of tax reform, entitled the “Tax Cuts and Jobs Act.” The bill proposes significant changes to many key areas of federal tax law. This alert highlights some of the changes that could significantly impact your business and/or your family’s wealth and succession planning strategies.
The tax reform process has begun in earnest. Developments can now be expected to move quickly, especially relative to the months of anticipation leading up to the bill’s release since the presidential election.
As far as immediate next steps, the Ways and Means Committee has begun its review of the bill. If this committee review process, known as “markup,” is completed this week, the bill can be expected to move to the House floor for a vote next week. The Senate is also expected to release its own tax reform bill later this week.
President Trump has indicated that he wants to sign a tax bill by Christmas. This sets a very aggressive timetable. The last major tax overhaul in 1986 began with a bill released by the Ways and Means Committee in November 1985 and ended with an act signed by President Reagan in October 1986, nearly a year later.
It is important to keep in mind that the procedure going forward is still largely uncertain, including whether or not legislation will ultimately be enacted. If legislation is passed, it appears likely that the final version will differ (possibly significantly) from the bill initially released by the Ways and Means Committee.
The tax professionals at Buchanan Ingersoll & Rooney are closely monitoring the legislative process so that we will be poised to counsel our clients when greater clarity returns to the tax landscape. In addition, our government relations (GR) team is working on Capitol Hill for those clients who want to advocate for a particular position with respect to tax reform. Please give your Buchanan contact a call if we can be of help to you.
Highlights of Proposed Changes (Note: This list reflects the Chairman’s amendment released on November 3, 2017)
The following is certainly not an exhaustive list of proposed changes to the Tax Code (e.g., the bill includes many revisions applicable to the computation of individual income tax liability, including the reduction of the number of tax brackets, an increased standard deduction, the elimination of many deductions and exclusions, the elimination of alternative minimum tax, and changes to tax credits), but the highlighted changes may end up being the most impactful for many of our clients.
Effective Date of Proposed Changes: Tax years beginning after 2017, unless otherwise indicated.
- New Rate on Business Income. 25% maximum tax rate on portion of pass-through net income treated as qualified business income. All net income derived from a passive business activity would be treated as qualified business income, which essentially means that passive investment will generate income taxed at 25%. Pass-through owners or shareholders who receive income allocations from active business activities may elect to: (1) treat 30% as qualified business income and 70% as wage income, or (2) determine the ratio of qualified business income to wage income based on capital investment.
- Income subject to preferential rates (e.g., net capital gains and qualified dividend income) would not be eligible to be recharacterized as qualified business income. Interest income properly allocable to a trade or business would be eligible to be recharacterized as qualified business income.
- The new 25% rate on qualified business income would generally not apply to services businesses including legal, accounting, consulting, engineering, financial services, or performing arts.
- The 25% rate on qualified business income would apply to sole proprietorships, partnerships, LLCs taxed as partnerships and S corporations.
- Corporate Tax Rate. The current 35% top corporate rate would be reduced to 20% and a 25% rate would apply to personal service corporations.
- Cost Recovery – Increased Expensing. Taxpayer would be able to fully/immediately deduct the entire cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (plus an additional year for certain qualified property with a longer production period).
- Requirement that the original use of the property begin with the taxpayer would be repealed, but it must be the taxpayer’s first use of the property to qualify for immediate expensing.
- Qualified property would not include any property used by a regulated public utility company or any property used in a real property trade or business.
- Cost Recovery – Expansion of Section 179 Expensing. The small business expensing limitation would be increased to $5,000,000 and phase out amount increased to $20,000,000 (adjusted for inflation).
- Definition of Section 179 property would be expanded to include qualified energy efficient heating and air-conditioning property.
- Cash Method of Accounting. $5,000,000 average gross receipts threshold for corporations and partnerships with corporate partners that are not allowed to use the cash method of accounting increased to $25,000,000 (indexed for inflation). $10,000,000 average gross receipts exception to requirement for use of percentage-of-completion accounting method for long-term contracts increased to $25,000,000.
- Interest Expense. The deduction for net interest expenses in excess of 30% of adjusted taxable income would be eliminated.
- This limitation would not be applicable to real property trades or businesses but those businesses are not eligible for full expensing.
- Businesses with average gross receipts of $25,000,000 or less would be exempt from this interest limitation.
- Like-Kind Exchanges. The rule allowing deferral of gain on like-kind exchanges would be modified to allow for like-kind exchanges only with respect to real property. There would be a transition rule that allows like-kind exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before December 31, 2017.
- Carried Interest. The bill would impose a three-year holding period requirement for qualification as long-term capital gain with respect to certain partnership interests received in connection with the performance of services.
- Private Activity Bonds. Under the bills, interest on newly issued private activity bonds would be included in income and, therefore, subject to tax. This change would be effective for bonds issued after 2017.
- Business Credits. The following credits would be repealed: (i) 50% credit for clinical testing expenses for certain drugs and rare diseases; (ii) employer-provided child care credit; (iii) rehabilitation tax credit; (iv) work opportunity credit; (v) deduction for unused business credits; (vi) new markets tax credit; and (vii) credit for expenditures to provide access to disabled individuals
- Energy Credits. The current 30% investment tax credit – for solar, fiber optic solar, fuel cell, and small wind energy producers – would be eliminated for any such facility constructed after 2021. A permanent 10% investment tax credit specifically for solar energy and geothermal energy producers will be completely eliminated for facilities constructed after 2027. In addition, the inflation adjustment for the production tax credit would be repealed for electricity produced at qualifying facilities, reverting back to the base rate of 1.5 cents/kW. This reduction would be effective for all electricity and coal produced at facilities, the construction of which begins after November 2, 2017.
- Alternative Minimum Tax. Alternative minimum tax would be repealed.
- Dividend Exemption System. The bill establishes a 100% dividend exemption for foreign-source dividends paid by foreign corporations to U.S. corporate shareholders owning at least 10% of the foreign entity. The provision disallows a foreign tax credit and a deduction would not be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend. In addition, no deductions for expenses allocable to an exempt dividend would be allowed.
- Offshore Repatriation. Repatriated accumulated foreign earnings held as cash or cash equivalent will face a one-time 12% tax; noncash assets would be taxed at 5%, payable over eight years at the election of the taxpayer.
- Base Erosion Prevention. There would be a new category of inclusion for 10% U.S. shareholders (both corporate and individual) equal to 50% of their CFCs’ “foreign high return amount” – which is net income from most types of active businesses to the extent such net income exceeded a return (equal to the short term AFR for the year + 7 percentage points) on the CFC’s assets used in producing such income (measured by the adjusted bases of those assets). Foreign high returns would be allowed 80% foreign tax credits, which could not be carried forward or backward to that tax year. Certain exceptions for active financing and extraction activities would apply.
- The deductible net interest expense of a U.S. corporation that is a member of an “international financial reporting group” (IFRP) would be limited to the extent of the U.S. corporation’s percentage of the reporting group’s EBITDA.
- An excise tax of 20% would be imposed on certain payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in cost of goods sold, or includible in the basis of a depreciable or amortizable asset, unless the U.S. corporation elects to treat the payments as income effectively connected with the conduct of a U.S. trade or business. The provision provides for certain specific deductions, exceptions and allowances for limited foreign tax credits. The provision is effective for tax years beginning after 2018.
- Subpart F. CFC “look-through” rule for related corporations would be made permanent beginning after 2019. Stock attribution rules for determining “CFC” status would be revised such that a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder and a requirement that a corporation must be controlled for an uninterrupted period of 30-days before it can be subject to U.S. tax on the CFC’s Subpart F income would be eliminated.
Estate, Gift and Generation-Skipping Transfer (GST) Taxes
- Increased Exclusion Amount. The applicable exclusion amount for the Federal estate and gift tax as well as Federal GST tax would be increased to $10,000,000 adjusted for inflation (i.e., $11,200,000 in 2018). Currently, only 0.02% of taxpayers pay estate tax and, with an increase in the exemption, that percentage will decrease further; thereby, setting the stage for eventual repeal.
- Eventual Repeal of Estate and GST. Federal estate tax and GST tax would be repealed in 2024; however, the step up in basis would be retained.
- Eventual Reduction of Rate for Gift Tax. In contrast to the estate and GST taxes, the gift tax would remain in 2024 but with a reduced tax rate (from 40% to 35%).
- Changes in Investment Tax. The private foundation investment tax has been simplified into a single 1.4% rate, rather than the alternate 1% or 2% rates. This 1.4% tax would also be collected from many private colleges and universities on their investment income.
- Increased Reporting for Donor Advised Funds. Donor advised funds would be subject to additional reporting requirements regarding inactive donor advised funds and the average amount of grants made from their donor advised funds.