Tax Cuts and Jobs Act (H.R. 1) – A Summary of the Proposed Changes
Beginning with the House Blueprint, released in the summer of 2016, and continuing with a number of other announcements from members of Congress and the White House, we have been provided with several plans for significant tax overhaul. However, until now, the plans were merely summaries. They contained broad descriptions and guiding principles, but lacked sufficient details that would allow any sort of analysis of how the changes would impact someone with a specific set of facts. Even simple questions like “at what income levels do the proposed tax brackets begin?” or “will this increase, or decrease my taxes?” were left unanswered. This prevented any sort of meaningful analysis, and tax practitioners have been waiting for a document containing proposed legislative language that would, for once, answer more questions than it created. With yesterday’s release of the Tax Cuts and Jobs Act, we finally have something meaningful to work with.
The actual proposed text of the Act (429 pages) may be found here. The Ways and Means Committee’s summary of their plan (82 pages) may be found here, and it contains a useful index. Given the sheer volume of material and its status as proposed legislation, we will not go into significant analysis here. What follows is a (much shorter than 82 pages) summary of key domestic features of the plan (a separate analysis of the international tax features will follow in a few days). Our discussion will be accompanied by page references to the 82-page House summary for those of you who would like to dig deeper.
Status of the tax plan
Let’s put this in context, though, before we get too carried away with its contents. While the Tax Cuts and Jobs Act is very significant in its provision of previously nonexistent detail, it faces a very formidable gauntlet before it passes in any form, and odds are high that it will undergo meaningful changes if it survives at all. The steps for passage are as follows:
- Procedurally, legislation begins with the Ways and Means Committee.
- If recommended by the Ways & Means Committee, is then introduced to the full House to vote.
- The Senate, through its Finance Committee, uses the House version as a starting point but modifies the bill (often substantially) before introducing it to the full Senate. (The Senate often works on its own bill simultaneously, as we understand is the present case.)
- The Senate votes on the House bill.
- In the rare event that the House version survives the Senate unscathed, it heads to the President.
- More often, a Conference Committee is formed with members of the House and the Senate to iron out the differences before it advances back through the House and Senate (Steps 2 – 5 above) and ultimately the President.
We now stand at Step 1, in receipt of a document that the Ways and Means Committee has not yet even introduced to the House. While the GOP deliberately structured this bill to require only a simple majority vote that is immune from Democrat filibuster, the GOP has proven repeatedly that its internal factions are capable of derailing its own efforts. So while we are happy to break down its details for you below, please do not lose sight of the fact that our foot barely left the starting block.
INDIVIDUAL INCOME TAX
Tax rates and brackets are described on page 1 of the summary. Rates of 12%, 25%, 35% and 39.6% are proposed, with most single or married-filing-separately brackets beginning at half of the married-filing-jointly levels, and most head of household brackets placed at the midpoint of those two. These brackets are indexed for inflation and apply beginning after 2017.
The standard deduction is increased, but personal exemptions will no longer exist following 2017. (This could adversely impact large families, but its impact will be tempered by an expanded child credit, discussed later.) The standard deduction is $12,000 for individual filers, $18,000 for single filers with at least one qualifying child, and $24,000 for joint filers. This is described on page 2 of the summary.
The child credit currently is $1,000 per child, applicable only for children under the age of 17, and phases out at certain income levels. Under the new plan, the credit increases to $1,600 per child, with the age 17 limit intact. However, an additional credit is created for “dependents,” that allows a credit of $300 for other members of the household under the care of the filer. A portion of the $1,600 may be refundable (paid out even if no tax exists), but not so with the $300 credit. This change takes place beginning after 2017, and is described on pages 6-8 of the summary.
Some itemized deductions will survive as an alternative to the enhanced standard deduction, but significant changes are proposed. Many other changes are proposed to above-the-line deductions.
The phase-out of overall itemized deductions (based on income) will be eliminated beginning after 2017.
Mortgage interest currently is deductible for up to $1,000,000 in acquisition indebtedness on a primary and secondary home, plus $100,000 of home equity indebtedness. The Act eliminates interest deductions for home equity loans, and reduces the $1,000,000 cap to $500,000. It further limits deductions to those applicable only to the filer’s primary residence. The $500,000 cap is applicable for debt incurred after November 2, 2017, but subsequent refinancing of debt incurred prior to that will be grandfathered and thereby qualify for the current limit of $1,000,000. This is discussed on pages 12-13 of the summary.
State and local income taxes will no longer qualify as an itemized deduction after 2017, except for certain taxes attributable to carrying on a trade or business (page 13).
Observation: This “feature” has significant opposition from Republican representatives in high-tax states like New Jersey, because its loss as a deduction will disproportionately drive up the federal taxes of its residents.
Real estate taxes will remain qualified as an itemized deduction, but generally cannot exceed $10,000 after 2017 (page 13).
Personal casualty losses will no longer qualify as an itemized deduction (page 14).
Charitable contributions will remain part of itemized deductions, subject to some changes. The 50%-of-AGI cap for cash contributions to public charities will be increased to 60%. The 5-year carryover of unused contribution deductions will survive. The deduction for charitable mileage will be indexed for inflation. These changes take place after 2017 (pages 14-16).
Medical expenses and fees for tax preparation services will no longer qualify as itemized deductions after 2017 (page 16).
The tax treatment of alimony payments will change dramatically for divorce agreements executed after 2017 and certain agreements modified after 2017. The change will cause payments to be nondeductible by the payer and nontaxable to the recipient (pages 16-17).
Moving expenses and most employee business expenses will no longer qualify as deductions after 2017 (pages 17-18).
The exclusion from income for employer-provided housing will be limited after 2017 to $50,000, and will be phased out for highly compensated employees (page 19).
The exclusion of gain from sale of a principal residence will survive but undergo significant limitations. Currently qualifying homes must be owned and used as principal residence for two out of the prior five years. This will be increased to five out of the prior eight years. It will be available once every five years instead of two. The cap (gain of $500,000 for married filers and $250,000 for single filers) will remain in place, but the amount excluded from income will be phased out dollar-by-dollar for income exceeding those same amounts. These changes apply for sales occurring after 2017 (pages 19-20).
Exclusion from income for a number of benefits will be repealed after 2017, causing such benefits to be taxable to the recipient. They include employee achievement awards, dependent care assistance programs, moving expense reimbursements, and adoption assistance programs (pages 20-21).
The alternative minimum tax (“AMT”) will be repealed, effective after 2017.
Energy efficient property received a boost under the proposed rules. Under current law, a 30% credit for qualified electric and solar water heating property (other than equipment used for hot tubs and swimming pools), geothermal heat pumps, and wind and fuel cell equipment expired at the end of 2016. Certain solar electric property continues to qualify for a credit of 26% through 2020 and 22% through 2021. The Act brings all of these types of property back into the fold, eligible for the 26% and 22% credits described above, beginning with property placed in service after 2016.
Interest earned on municipal bonds generally is not subject to federal tax. Exceptions exist for private activity bonds, the funds for which are deemed to have benefited private, rather than public interests. Some municipalities have successfully characterized professional sports stadiums as eligible for tax-free status under these murky rules, but the Act removes that ability from them. Under the proposed rules, interest related to construction or related expenditures on a professional sports stadium (which is defined as one used for at least 5 days a year for training, exhibitions, or games) is subject to federal tax. This will be effective for bonds issued after the date of introduction.
The existing American Opportunity Tax Credit (“AOTC”), Hope Scholarship Credit, and Lifetime Learning Credits will be rolled into one enhanced AOTC that shares most of the favorable specs as the AOTC, and covers an additional year of education. The change begins after 2017 (pages 8-9). Coverdell accounts will be prohibited after 2017, but may be rolled into Section 529 Plans (pages 9-10). Discharge of student loan debt due to disability or death will be excluded from income (page 10).
Several other education-related deductions or exclusions from income will be repealed after 2017, including the deduction of tuition and related expenses, and the exclusion from income of qualified tuition reductions and certain types of employer-provided education assistance (pages 10-11).
One of the most significant changes involves business income. Currently C-corporations are subject to tax rates ranging from 15% to 35%. Personal service corporations are subject to a flat 35% tax, without benefit of the lower brackets. Income of pass-through entities (partnerships, LLCs and S-corporations) is taxed at the owner level, rather than the entity level, and with the exception of allocations of long-term capital gain, the income is taxed at whatever individual tax rates apply to the owner, based on overall income level and applicable brackets.
Under the proposed rules, C-corporations will be taxed at flat rate of 20%, and personal service corporations will be subject to a flat rate of 25%, beginning after 2017.
The proposed changes to taxation of pass-through entities are much more complex, as Congress attempts to implement two goals: Treat all business income in a roughly similar manner, but separate the compensation component from an owner-operator’s overall income from a pass-through entity. (Note: This portion of the discussion assumes the reader is somewhat familiar with pass-through income.)
To accomplish its goals, the Act proposes to view pass-through income in two pieces, both of which will remain taxed at the individual level, rather than assessed on the business entity itself. A new “business income” portion of a recipient’s pass-through income will be subject to a maximum rate of 25%, and the remainder will be viewed more like compensation, which will be subject to whatever tax rates apply to that individual. The proposed legislation introduces the concept of a “capital percentage” to help determine the appropriate “ordinary vs. business” mix of income, with the option to use a shortcut method that assumes 30% of pass-through income qualifies as business income taxed at the lower rate, with the remaining 70% subject to ordinary (and potentially higher) rates. Interestingly, active owners of certain personal service businesses (law, accounting, consulting, engineering, financial services or performing arts) will not qualify for the 25% rate at all; its remuneration will be viewed as ordinary compensation instead of business income.
In any case, other preferable categories of pass-through income, such as long-term capital gains and qualifying dividends, will remain eligible for the lower rates that currently apply and will continue to apply to those categories.
These changes apply beginning after 2017 (pages 3-5 of the summary).
Currently so-called “bonus depreciation” and the Section 179 expensing election allow immediate full or partial write-off of the cost of qualified property acquisitions. Bonus depreciation allows 50% of qualifying costs to be deducted immediately, reduced to 40% and 30% in 2018 and 2019, respectively. Section 179 allows immediate expensing of up to $500,000 in costs, with a phaseout that begins at costs exceeding $2,000,000.
The proposed law retains bonus depreciation through 2022, and provides one of the few retroactive components of the Act by allowing deduction of 100% of qualifying costs for property placed in service after September 27, 2017. It removes the requirement that the taxpayer’s use represents the initial use of the property, but it eliminates its deduction by real property trades or businesses. The proposal also greatly expands the Section 179 deduction by allowing expensing of $5,000,000, with a phaseout that begins at costs exceeding $20,000,000. Both amounts will be indexed for inflation. Air conditioners and energy-efficient heaters will qualify for Section 179 expensing permanently beginning with assets placed in service after November 2, 2017.
Business interest expense
Speculation was made based on earlier proposals that taxpayers would have to choose between write-off of business assets (Sec. 179/bonus) and interest expense. The Act retains that trade off – in part.
The proposal calls for a limit on net interest deductions. Every business will limit its interest deduction to the sum of two amounts: (1) business interest income, plus (2) 30% of the business’ “adjusted taxable income,” which is basically EBITDA on the tax basis, excluding use of any net operating loss or business interest income. For pass-through entities, the limitation will be computed at the entity level, and any disallowed portion may be carried forward for up to 5 years.
Observation: The proposal draws an important distinction between “business” interest income and “investment” interest income. This distinction should result in very few limitations at all for banks and other financial service endeavors, who are in the business of generating interest income. The limitation will be far more common with other industries, who will find a new tax disincentive for being highly leveraged. Like other characteristics in the Act, this is consistent with how many other nations structure their tax rules.
These rules apply after 2017, but real property trades and business, and entities with average gross receipts of $25,000,000 or less are exempt.
Net operating losses
Generally, net operating losses (“NOLs”) currently may be carried back 2 years and forward 20, potentially offsetting all income in those years. The Act would cause the NOL to only offset 90% of the taxable income of the year to which it is carried, and eliminate carrybacks in most cases. These rules generally will apply for losses generated after 2017, but carryback of losses generated in 2017 will be limited somewhat if the loss includes 2017 bonus depreciation resulting from the Act (the assets placed in service after September 27, 2017 that are eligible for 100% rather than 50% write-off). This is explained on page 34 of the summary.
Observation: AMT is being repealed under the Act, but the new NOL rules inherit its 90%-of-income limitation. This move to partial use of NOLs is consistent with many other countries, and undoubtedly is part of Congress’ goal to cause U.S. business taxation to be consistent with that of other countries.
Gain can be deferred when property is exchanged under current rules if property of a “like kind” is received instead of cash. This rule currently applies to both real and personal property under the right conditions, but the Act will limit like-kind exchanges to transactions involving real property (page 35). The change generally will apply to transfers taking place after 2017.
“DPAD” (the domestic production activities deduction) will disappear after 2017 (page 36).
Meals and entertainment
The Act generally makes a distinction between meals and entertainment, both of which generally are 50% deductible under current law. It proposes elimination of all deduction for entertainment activities, as well as meals that are not directly related to business. Business-related meals will remain deductible at 50% of cost.
Unless treated as compensation to the recipient, deductions for transportation, gyms and similar fringe benefits will be nondeductible. In an attempt to achieve parity between taxable and tax-exempt employers, the Act characterizes the value of certain fringe benefits provided to employees of tax-exempt entities as unrelated business taxable income (pages 37-38).
Technical termination of partnerships
Under current law, if ownership of 50% of a partnership or LLC changes hands in a 12-month period, the partnership or LLC is deemed to be terminated, with a new entity being “formed” as of that date. Certain elections are made at that time, which in turn unleash specially-allocated deductions benefiting the new owner(s). Under the Act, the partnership will be treated as continuing instead of terminating, and elections will not be needed or allowed (page 40).
Cash methods of accounting
The accrual method of accounting is generally required under current law for most taxpayers whose average gross receipts exceed $5,000,000. Below that, the cash method may be used. The Act increases that threshold to $25,000,000 after 2017, indexed for inflation (pages 30-31).
An inventory method of accounting generally must be used by an entity whose average receipts exceed $1,000,000. The Act increases that threshold to $25,000,000 after 2017 (pages 30-31).
Sec. 263A “UNICAP”
Direct and indirect costs under current law must be included in inventory costs rather than expensed by certain entities with $10,000,000 or more in average receipts. The Act increases this threshold to $25,000,000 after 2017 (page 31).
Long-term contract accounting
Long-term contracts must be accounted for under current law using the percentage of completion method, except for businesses with average receipts of $10,000,000 or less. The Act increases this threshold to $25,000,000 after 2017 (page 31).
Nonqualified deferred compensation
Under current rules, an employee generally does not include nonqualified deferred compensation in income until the funds are received. The Act will remove that deferral, and cause the income to be taxable by the employee as soon as there is no risk of forfeiture (generally whenever its receipt has already been earned, and is not dependent on future services). This will be effective for services performed after 2017, but deferrals earned prior to 2018 will become taxable in the year 2025.
Observation: This could be hideous for the recipient, as it could leave him or her out of pocket for the tax effect of the deferral. Informed parties will be aware of this when planning any such arrangements going forward, but the impact on existing plans could present employees with a significant amount of income in 2025 – prior to receiving the underlying cash.
ESTATE AND GIFT TAX
Although prior plans consistently called for repeal of the estate tax, the Act softens this approach significantly. The amount excludable from a decedent’s taxable estate will be roughly doubled to $10,000,000 (indexed for inflation) beginning in 2018. The estate tax and generation-skipping tax would be repealed beginning in 2024, but the ability of beneficiaries to receive a stepped-up basis would remain intact. The gift tax would remain in place but receive a top rate of 25% and an exclusion amount of $10,000,000. The annual exclusion amount would remain at $14,000, indexed for inflation.
Observation: The elimination of the estate tax, combined with the survival of the gift tax, produces an odd result. Historically those taxes generally have been joined at the hip, and the proposed arrangement will discourage significant gifting during a donor’s lifetime. Also, prior plans called for an estate tax replacement of sorts, in the form of a tax on built-in capital gains, to take the place of the estate tax at the time of death. The Act has no mention of that.
The Tax Cuts and Job Act contains a lot of what we expected, including decreased rates and elimination of deductions. It has no mention of reduced deductions for retirement plan contributions, which were discussed in recent days as a way to pay for the other cuts, but was widely unpopular and ultimately succumbed to death by presidential tweet. The Act provides answers to questions that have been asked since the House Blueprint was rolled out over a year ago, such as a means for determining how much of a recipient’s pass-through income qualifies for the reduced rate.
The Act adds subjectivity and complexity to parts of the Internal Revenue Code (especially those that impact entities), but offers more simplicity to most 1040s by eliminating many itemized and other deductions in favor of an increased standard deduction. In its current form, it likely will allow more people to prepare their own 1040s, although business tax returns and the 1040s filed by many of their owners will become more complex than before.
The Act is not a massive scrapping of the Internal Revenue Code, or any sort of “starting over” rewrite. (Those who were hoping for a pocket version of the Code and Regulations will be sorely disappointed!) It instead contains selective scrapping of rules and exceptions that have built up over the years, combined with creation of some new ones. Many states base their own tax structure on federal tax laws, and any change this significant will create the need for states to update their own rules to accommodate (or reject) them – individual and business rules alike.
We now have enough detail to run some comparison scenarios. However, whether or not a taxpayer will come out ahead with the proposed rules will be highly dependent on his or her particular set of facts, and at this stage of the negotiating and approval game, comparisons may be of very little value.
Look for our summary of the changes impacting foreign income in the following days, and do not hesitate to contact me, or your BNN tax professional, with any questions.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.