On November 2, the House Ways and Means Committee released a highly anticipated tax bill, the Tax Cuts and Jobs Act of 2017 (TCJA). The bill incorporates many of the provisions provided in the Unified Framework for Fixing Our Broken Tax Code (Framework) released September 27 by the Big Six while filling in many details left open in the Framework. See our previous alert to learn more about the Big Six and a summary of the key business and individual proposals from the Framework.
It’s important to keep in mind the legislation is only in proposed form at this point, and its release marks the first in a number of steps necessary under the legislative process for it to become law. In addition, avoiding a filibuster in the Senate will likely require careful adherence to the instructions set forth in the budget reconciliation bill Congress passed last month, which relies heavily on an official score for the bill.
Here’s a summary of several significant provisions in the bill prior to any chairman amendments or markup. Unless stated otherwise, these provisions generally would apply to tax years beginning after 2017.
Consolidated Income Tax Rate Brackets – The TCJA would consolidate the seven current tax brackets into four, with corresponding rates of 12, 25, 35 and 39.6 percent, as follows:
The tax brackets are adjusted for inflation using a chained measurement method of the Consumer Price Index. For taxpayers with adjusted gross income (AGI) exceeding $1 million ($1.2 million for married taxpayers filing jointly), the benefit of the 12-percent bracket is phased out. This surcharge could result in $24,840 in additional tax for joint filers with AGI exceeding the $414,000 phase-out range, since this is the additional tax that would’ve been assessed if the income in the 12-percent bracket had been taxed at 39.6 percent instead.
Expanded Standard Deduction – The bill would nearly double the standard deduction under current law for single and married filers to $12,200 and $24,400, respectively. This increase is in line with Congress’ goal of simplifying the tax filing process for middle-income taxpayers by reducing the number of taxpayers who itemize their deductions. An enhanced standard deduction would effectively create an expanded “zero tax bracket” wherein fewer lower-income taxpayers are subject to federal income tax.
Personal Exemptions – The personal exemption is consolidated into the larger standard deduction under the bill and repealed along with the current deduction phaseout.
Child Tax Credit (CTC) – The TCJA would increase the CTC from $1,000 to $1,600 and allow for an additional $300 tax credit per taxpayer, spouse or other nonchild dependent. The additional $300 “family credit” is temporary and set to expire after five years. The TCJA also would increase the credit’s phase-out limit from $75,000 to $115,000 for single filers ($110,000 to $230,000 for married taxpayers filing jointly). Taxpayers will be required to provide Social Security numbers to claim the refundable portion of the tax credit, equal to 15 percent of earned income in excess of $3,000. These changes are intended to expand the range of middle-income taxpayers eligible for the CTC.
Limited Pool of Itemized Deductions – The bill would drastically slash the number of deductions available to taxpayers who elect to itemize rather than take the (expanded) standard deduction. Several deductions will remain intact if this bill becomes law: home mortgage interest, charitable contributions and local real property taxes, state and local income taxes related to a trade or business or income-producing activities, investment interest expense and gambling losses (to the extent of winnings). This means deductions for state and local tax not related to a trade or business or income-producing activities, tax preparation fees, medical expenses and casualty losses would no longer be allowed. Notably, the special above-the-line deduction for personal casualty losses provided for within the Disaster Tax Relief and Airport and Airway Extension Act of 2017 wouldn’t be affected. See BKD’s October alert for the significant tax measures included in that legislation.
While the bill maintains most of the current deductibility rules and limitations for charitable contributions, it would increase the cash contribution limitation from 50 percent of adjusted gross income to 60 percent. In addition, the bill would repeal the special rule that allows an 80 percent deduction of the amount paid to colleges for the right to purchase tickets for athletic events.
For homes purchased after November 2, 2017, the home mortgage interest deduction will be limited to the first $500,000 of indebtedness—a deviation from the current $1 million cap. Furthermore, this deduction only will be eligible for principal residences and wouldn’t extend to home equity loans. Interest deductions for existing mortgages will remain unchanged. Property tax deductions also will see a new restriction with write-offs limited to $10,000.
The Pease limitation, a provision added to the tax code in the early 1990s that reduces the allowable amount of itemized deductions for higher-income taxpayers, would be repealed under the TCJA.
Various Tax Credits Repealed – Nonrefundable credits facing repeal under the TCJA include:
- The credit for the elderly or the disabled
- The credit for qualified adoption expenses
- The mortgage credit certificates
- The qualified plug-in electric drive motor vehicle credit
Education Incentives – Under current law, taxpayers have three education credit incentives to choose from: the American Opportunity Tax Credit (AOTC), Hope Scholarship Credit and Lifetime Learning Credit. The qualifications for these credits currently vary based on phase-out levels and overall tax benefit provided. The TCJA would essentially consolidate the three credits into a single “enhanced” version of the AOTC. The new credit would provide a 100 percent tax credit for the first $2,000 of qualified education expenses and a 25 percent credit for the next $2,000 of qualified expenses. These limitations mimic current law; however, the new credit would decrease the maximum refundable amount from $1,000 to $500. The bill also would avail taxpayers to an additional fifth year of credit eligibility, with the overall benefit for that year reduced by half.
Other major education-related changes the TCJA would make to current tax law include the repeal of the above-the-line deductions for qualified student loan interest payments and qualified tuition and related expenses. In addition, Section 529 plan distributions up to $10,000 per year would be allowed for elementary and high school expenses.
Additional education incentives slated for repeal with the new bill include exclusions for:
- U.S. savings bond interest when used to pay qualified education expenses
- Qualified tuition reduction programs
- Employer-provided education assistance programs
Transfer Taxes – The TCJA would double the 2011 basic exclusion amount for estate, gift and generation-skipping taxes from $5 million to $10 million, adjusted for inflation. This would result in an $11.2 million exemption per person for 2018. In addition, if enacted, the bill would create a full repeal of the estate and generation-skipping taxes after 2023. Transfers occurring at death would still benefit from a step-up in basis in the beneficiary’s hands.
Under the bill, the maximum rate for gift taxes is lowered to 35 percent for gifts made after December 31, 2023.
Individual Alternative Minimum Tax (AMT) Repeal – An area of common ground among House Republican tax reform proposals, President Donald Trump and the Big Six is the elimination of the AMT. The intent of the AMT has eroded over the years, with the additional tax falling on taxpayers who weren’t necessarily the intended target. Originally intended to ensure high-income taxpayers are subject to some level of tax liability, a taxpayer’s AMT is determined based on a separate calculation of taxable income and is only paid if this “alternative” calculation results in a higher amount of tax than would be paid if only the regular tax applied.
Taxpayers with AMT credits going into 2018 would be able to claim 50 percent of those credits per year from 2019 to 2021, with the balance in 2022.
Other Notable Provisions
The following current-law provisions would be repealed under the TCJA:
- Above-the-line deduction for alimony payments (payor) along with the corresponding income inclusion (payee) for divorce decrees executed after 2017
- Above-the-line deduction for qualified moving expenses
- Above-the-line deduction for contributions to an Archer medical savings account
- Above-the-line deduction for all unreimbursed employee expenses except certain expenses of members of reserve components of the U.S. military
- Exclusion for dependent care assistance programs
The following current-law provisions would be modified under the TCJA:
- Exclusion for employer-provided housing limited to $50,000, subject to phaseout
- Exclusion of gain from the sale of a principal residence will be phased out for higher-income taxpayers and require the home to be the taxpayer’s principal residence for at least five of the previous eight years, as opposed to two of the previous five as under current law
- Reduces minimum age for allowable in-service distributions from 62 to 59½
Corporate Tax Rate – Under current law, corporate income is subject to a graduated rate scale ranging from 15 percent to 35 percent. The TCJA would immediately and permanently do away with the graduated rate system and set a flat rate of 20 percent. Personal service corporations also would see a rate reduction from the current 35 percent flat rate to 25 percent.
Pass-Through Tax Rate – Currently, the business profits of sole proprietorships, partnerships and S corporations are taxed according to the entities’ owners’ marginal tax rates, which equates to a maximum rate of 39.6 percent under the current and proposed law. The TCJA would shift the rate structure for these businesses by creating a 25 percent rate cap on flowthrough income. With this shift comes the possibility for the mischaracterization of individual wage income into pass-through income. The bill plans to thwart such efforts by establishing safeguards to explicitly distinguish between these two types of income: passive owners would receive the full benefit of the lower 25 percent rate, while owners who actively participate in a business would be required to calculate the portion of income that represents “wages.” A 70 percent wage “safe harbor” is included in the bill.
Full & Immediate Capital Asset Expensing – Another key change the TCJA would make to current law is the expansion of cost recovery mechanisms. The Protecting Americans from Tax Hikes Act of 2015 made permanent the ability to immediately expense certain assets, up to a $500,000 inflation-adjusted limit, subject to an overall phaseout. Bonus depreciation of 50 percent also is available for qualified property but is currently subject to a phasedown effective in 2018 and 2019 and only is allowed for “new” assets. The new bill would expand both the bonus depreciation and Section 179 expensing limitations by increasing the eligible bonus percentage to 100 percent for qualified property acquired after September 27, 2017, and allowing $5 million of assets to be expensed under Section 179 (beginning in 2018), with a phase-out amount of $20 million. For bonus depreciation purposes, the new bill also would expand the definition of “qualified property” by removing the requirement that original use must begin with the taxpayer. However, qualified property wouldn’t include any property used by a regulated public utility company or in a real property trade or business. These provisions are temporary and would expire December 31, 2022.
Limitation on Net Interest Expense – Only businesses with average gross receipts of $25 million or less would be allowed to take a net interest expense deduction under the new law. For all other businesses, interest expense deductions would be limited to 30 percent of the entity’s adjusted taxable income, i.e., taxable income without regard to business interest expense, business interest income, net operating loss (NOL), amortization, depreciation and depletion. Any excess is eligible for carryover to the succeeding five tax years. Congress’ motivation behind this provision was to inhibit the incentive companies may have to fund operations through debt versus equity financing.
Repeal of Corporate AMT – Similar to individuals, corporations also would see an AMT repeal with the ability to recognize remaining credit carryforwards over a four-year period.
Other Notable Provisions
The following current-law provisions would be repealed under the TCJA:
- Nine percent deduction for domestic production activities
- Technical termination of a partnership upon the sale or exchange of 50 percent or more of the total interests in partnership capital and profits within a 12-month period
- Work opportunity credit
- Exclusion of private activity bonds from gross income
The following current-law provisions would be modified under the TCJA:
- Nonqualified deferred compensation – Recipient taxed on compensation as soon as there is no substantial risk of forfeiture, i.e.,taxed at the time the compensation vests. The provision would be effective for services performed after 2017. Current rules would apply to existing deferred compensation plans through 2025.
- Method of accounting – $5 million average gross receipts test threshold for corporations and partnerships with a corporate partner would be increased to $25 million, without considering prior-year eligibility. Businesses with inventories would be allowed to use the cash method if they fall under the $25 million threshold and treat inventories as nonincidental materials and supplies, i.e., expense when used or consumed.
- Accounting for inventories – Currently, taxpayers with gross receipts of $10 million or less are exempt from the uniform capitalization rules of IRC Section 263A for property acquired for resale. The TCJA increases this exemption threshold to $25 million and expands it to include manufactured property.
- Accounting for long-term contracts – The $10 million gross receipts exception to the percentage-of-completion method would increase to $25 million. This increase also would apply to the completed-contract method.
- NOL carryovers would be limited to 90 percent of the taxpayer’s taxable income for the year. This change aligns with the current NOL rule for calculating AMT but also eliminates the possibility for carrybacks under most situations. However, NOLs arising after the 2017 tax year may be indefinitely carried forward and increased by an interest factor to preserve their values.
- Like-kind exchanges under IRC Section 1031 only would be allowed for real property transactions.
- The deduction for entertainment, amusement or recreation activities is repealed; however, the deduction for qualified meal expenses will remain, subject to the same 50 percent limitation.
- Several provisions affecting insurance companies, including NOLs, computation of reserves, modification of proration and discounting rules and capitalization of certain policy acquisition expenses.
- Limited or no deduction for Federal Deposit Insurance Corporation premiums paid by financial institutions with more than $10 billion in consolidated assets.
Taxation of Foreign Income
One of the major international provisions of TCJA is a shift from taxing companies on a worldwide income basis to a territorial tax system. The idea is that this will encourage U.S. companies to bring their foreign earnings back to the United States. Components of the new system include:
Dividend Exemption System – Enactment of the new bill would cause a dramatic change in the way foreign income is reported under the U.S. tax system. Under the TCJA, 100 percent of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder owning 10 percent or more of the foreign corporation’s stock would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes paid or accrued with respect to any exempt dividend.
Repatriation of Foreign Earnings – The TCJA would enact deemed repatriation of deferred foreign profits at 12 percent for cash or cash equivalents with the remainder taxed at a reduced rate of 5 percent. The taxpayer can elect to pay the tax over a period of up to eight years.
Other international components of the bill include provisions aimed at anti-base erosion and modifications to the subpart F rules.
Executive Compensation – The TCJA would create a 20 percent excise tax on compensation in excess of $1 million paid to any of an exempt organization’s five highest-paid employees.
Net Investment Income – Private colleges and universities would be subject to a 1.4 percent excise tax on net investment income under the TCJA. This provision only would apply to institutions with 500 or more students and assets with a value of at least $100,000 per full-time student, not including those used directly in carrying out the institution’s educational purpose.
Donor-Advised Funds – The TCJA would require donor-advised funds to annually disclose their policies on inactive funds as well as the average amount of grants made from those funds.
Excise Tax on Private Foundations – The TCJA would eliminate the two-tier excise tax rate system and create a single rate of 1.4 percent on the foundation’s net investment income.
Given the limited number of working days left in the year and abundance of nontax-related items still to be addressed, Congress’ goal of passing legislation through the House by Thanksgiving and hitting the president’s desk by Christmas may be ambitious. Mixed levels of support from the president and rest of the congressional base create further uncertainty in the tax environment. Nevertheless, the next stop for tax reform is with the House Ways and Means Committee. Their markup of the bill is set to begin Monday, November 6. The Senate Finance Committee also has announced plans to release its version of a tax bill.
Stay tuned for BKD’s 2017 Year-End Tax Advisor, where we’ll detail the tax planning strategies you should consider as a result of potential tax reform. In the meantime, those strategies should align with the recommendations provided in our previous BKD Thoughtware® article, and be sure to keep an eye on BKD’s Tax Reform Resource Center for the latest updates.