November has been a busy month for tax reform efforts:
- November 2
- The Tax Cuts and Jobs Act of 2017 (TCJA) was released, offering the first real glimpse into the details of various tax reform proposals that have been heavily debated following last year’s presidential election
- November 9
- The House Ways and Means Committee passed the TCJA with a 24 to 16 vote along party lines, including several amendments offered by Chairman Kevin Brady
- The Senate Finance Committee released details on its version of the TCJA
- November 16
- The entire House passed the amended version of the TCJA that passed the Ways and Means Committee by a 227 to 205 vote
- The Senate Finance Committee passed its modified version of the TCJA with a 14 to 12 vote
With Congress on recess for the Thanksgiving holiday, the next steps following the Senate’s November 27 return include a stop with the Senate Budget Committee before heading for a full Senate vote, all with an eye toward having a bill on President Donald Trump’s desk by Christmas.
As the various tax reform proposals developed, there were numerous differences in the reform packages’ provisions. Significant provisions in the House reform packages were omitted from the reform packages under consideration by the Senate, and vice versa. While some differences have already been eliminated as tax reform discussion continued in Washington, several differences remain.
The proposed tax reform packages include far-reaching provisions that, if enacted, would likely affect many taxpayers. With the wide range of tax reform proposals, and the varied stages of discussion and debate on the congressional reform packages, it’s been difficult to follow all the moving pieces in the tax reform puzzle. To help you keep the pieces straight, a comparison of highlights from the current House and Senate tax reform plans can be found in BKD’s Tax Reform Resource Center. The following is our top-10 list of tax reform proposals that, in our opinion, would have the most significant effect on private equity investors and their portfolio companies. Unless stated otherwise, these provisions generally would apply to tax years beginning after 2017:
- Corporate tax rate – A reduction of the corporate rate has been discussed extensively in recent years. Both the House and Senate propose a reduction of the corporate tax to a flat 20 percent rate, but with differing effective dates. While this rate reduction may improve the overall worldwide ranking of our corporate rate, the true effect of the reduced rate isn’t straightforward, given numerous other reform proposals would eliminate or defer certain deductions and broaden the tax base subject to taxation.
- Pass-through tax rate – Pass-through entities, i.e., S corporations, partnerships and limited liability companies taxed as partnerships, generally avoid the double taxation inherent with C corps and, as a result, have often become the entity type of choice in recent years. Instead, a pass-through entity’s income passes through to and is reported on the tax returns of its equity owners. The character of the passed-through income is retained and is taxed at ordinary or capital gains rates as applicable. Certain limitations restrict the availability of S corps in some instances, and tax law changes in recent years, e.g., higher individual tax rates compared to corporate tax rates, the permanence of the Section 1202 gain exclusion, etc., have made C corps preferable in some instances. The House and Senate bills both provide a benefit for pass-through income—the House provides a reduced tax rate of 25 percent applied to 30 percent of the net active business income under a default provision1, while the Senate bill would allow a 17.4 percent deduction of domestic qualified business income limited to 50 percent of W-2 wages2.
- Individual tax rates – In many cases, much of the taxable income of private equity funds or their portfolio companies is reported on the tax returns of individual taxpayers, making the tax rate applicable to that income important. The House and Senate are both proposing revisions to the individual income tax brackets. Whether these revisions affect individual private equity investors depends on their respective circumstances. In general, tax rates would be reduced under both the House and Senate versions of the TCJA and the 3.8 percent net investment income tax on unearned income would be retained. The House bill would consolidate the seven current tax brackets into four, with corresponding rates of 12, 25, 35 and 39.6 percent, while the Senate bill retains the current seven-bracket rate structure with the new rates of 10, 12, 22, 24, 32, 35 and 38.5 percent. In addition to differences in the rates and number of brackets, another key difference is that the reduced rates expire after December 31, 2025, under the Senate version of the bill. It’s important to note that while the bills feature reductions in the ordinary tax rates for many, some taxpayers may actually face a higher rate on this income if the proposals are adopted due to the condensing of the tax brackets. Consult your tax advisor to learn more about how these changes may affect your situation.
- Bonus depreciation – Current law allows for a declining percentage of bonus depreciation deductions for 2018 to 2020 (40 percent, 30 percent and 20 percent, respectively). The House and Senate versions both generally enhance bonus depreciation for property placed in service through 2022, allowing a 100 percent deduction for qualified property placed in service after September 27, 2017. The definition of qualified property under the House bill would be expanded by removing the requirement that original use begin with the taxpayer.
- Section 179 expensing – Bonus depreciation and Section 179 expensing are similar in that both allow for immediate deduction of the cost of qualified assets, but the rules of each provision differ in that some taxpayers use bonus depreciation while others take advantage of the Section 179 expensing provisions. Under current law, the annual Section 179 deduction is capped at $520,000 for 2018, with a deduction phaseout if assets placed in service during the tax year exceed $2,070,000 for 2018. The House version would enhance the annual deduction to $5 million through December 31, 2022, with a deduction phaseout beginning at $20 million of assets placed in service. The Senate version only provides for a $1 million deduction, with a deduction phaseout beginning at a much lower threshold of $2.5 million of assets placed in service; however, it expands the definition of qualified property to include certain improvements to nonresidential real property, including roofs, HVAC systems, fire protection and alarm systems and security systems.
- Interest expense – In one of the more significant proposed changes for private equity investors, both the House and Senate propose limitations that would be imposed on the amount of allowable annual interest expense deductions. In general terms, there are no limits on the amount of interest expense that can be deducted annually under current law. Much would change under the House and Senate proposals. In the House, the tax reform proposal would limit annual interest expense deductions to 30 percent of the entity’s “adjusted taxable income,” defined as taxable income without regard to business interest expense, business interest income, net operating loss (NOL), amortization, depreciation and depletion3. The disallowed excess would be carried over, similar to net operating loss deductions, for potential deduction in the next five years but subject to the same 30 percent annual limitation. The Senate version of the bill proposes the same 30 percent limitation; however, the disallowed excess could be carried forward indefinitely and “adjusted taxable income” is defined as taxable income without regard to items not properly allocable to a trade or business, any business interest expense or business interest income, the 17.4 percent pass-through income deduction and any NOL deduction4.
- NOL – Current law provides a buffer to the ups and downs of business cycles and the challenges of profitability for many startup businesses, by allowing the carryback and carryforward of unused NOLs. These losses can be carried back to the two prior tax years to claim tax refunds, if available. If the NOL isn’t fully used by carryback, the remainder is carried forward for deduction in future years, with a current carryforward period of 20 years. There is generally no limitation on the amount of the NOL deduction for regular tax purposes, so available losses can offset 100 percent of income in the carryback or carryforward tax years. The House proposal would eliminate the NOL carryback period but limit the deduction to 90 percent of taxable income and allow for an unlimited carryforward period with the carryforward amount adjusted by an interest factor to preserve its value. The Senate version similarly allows for an unlimited carryforward period; however, the amount wouldn’t be adjusted for inflation and the limitation on the deduction would increase to 80 percent of taxable income for periods after 2025.
- Research and development (R&D) tax credit – Many technology-based businesses, as well as certain manufacturers, take advantage of the federal income tax credit and immediate expensing of costs incurred for investment in qualified R&D activities. The House and Senate proposals retain the current law provisions of the R&D credit.6
- Taxation of foreign earnings – It’s not unusual for U.S. business entities to own and operate foreign subsidiaries. It’s also not unusual for U.S. businesses to employ various measures to accumulate earnings in foreign jurisdictions and avoid current income taxation of those earnings by the United States. The House and Senate tax versions of the bill include provisions to incentivize the repatriation of accumulated foreign earnings by applying a favorable reduced tax rate—14 percent or less in the House version, 10 percent or less in the Senate proposal—to the repatriated earnings7. In both versions, the applicable tax would be payable over an eight-year period. Also significant in both the House and Senate proposals are provisions to move the U.S. from its current worldwide system of taxation to a territorial system of taxation, a system typical of the taxing regimes in most other countries.
- Carried interest – Carried interest taxation has been discussed often in recent years and has frequently been targeted as an area for tax reform in the budget proposals of several past U.S. presidents and in previous tax reform proposals. Currently, a carried interest received in exchange for the performance of services is subject to favorable capital gains rates if held longer than one year, rather than the higher ordinary income tax rates typically applicable to compensation received for the performance of services. Perhaps somewhat surprisingly, carried interests in the House and Senate proposals would continue to be subject to favorable capital gains tax rates if the carried interest is held for a period of three years or more. Capital gains tax rates would remain at the current rates of 20 percent or less under the House and Senate proposals, plus the 3.8 percent net investment income tax on unearned income when modified adjusted gross income exceeds $200,000 where applicable.
Although recent momentum and progress of the reform packages in the House and Senate gives us a clearer picture of where tax reform might be headed, the final provisions remain unknown, and even passage of tax reform is still tentative at this point.
The tax reforms proposed by the House and Senate are varied, and the effects would be widespread. That said, many of the reforms as currently proposed will have to change—under a reconciled congressional tax reform package—given the many differences that exist between the two current proposals. In addition, as Congress considers the cost of tax reform and potentially looks to offset some of the cost of the current reform proposals, almost any provision is subject to change, other new provisions could be proposed or inserted and some of the current proposals could be eliminated. Only time will tell if agreement can be reached and if the first substantive tax reform in more than 30 years will become a reality.
For a closer look at tax reform’s effects on private equity, register for the November 29 webinar, “Tax Reform & PE Funds: What You Need to Know.” In addition, check in with BKD’s Tax Reform Resource Center often to stay informed on the most recent developments.
1 Default provision treats the remaining 70 percent as wage income subject to ordinary individual rates. This default categorization isn’t available to professional service firms. An alternative calculation based on actual level of capital investment also is available. A reduced rate is provided for small businesses.
2 Deduction doesn’t apply to specified service businesses, except in the case of a taxpayer whose taxable income doesn’t exceed $250,000 for single filers ($500,000 married filing jointly (MFJ)) with a phaseout beginning at the same levels over the next $50,000 ($100,000) of taxable income. Deduction expires after December 31, 2025.
3 This deduction isn’t limited for any taxpayer that meets the $25 million gross receipts test, is a regulated public utility business or a real property business.
4 Interest deduction isn’t limited for any taxpayer that meets a $15 million gross receipts test, is a regulated public utility business (including electric cooperatives) or a real property business. Farming businesses may elect not to be subject to limitation provided they use the Alternative Depreciation System (ADS) method to depreciate farming property with a recovery period of 10 years or more.
5 Repealed after 2025 if on-budget federal revenue exceeds $27.487 trillion by an amount greater than or equal to $900 trillion for the period October 1, 2017, through September 30, 2026.
6 Under the House bill, for tax periods beginning after December 31, 2022, certain research & experimentation expenses, including software development costs, would be required to be capitalized & amortized over a five-year period. For foreign research projects, this amortization period increases to 15 years.
Under the Senate bill, for tax periods beginning after December 31, 2025, certain research and experimentation expenditures, including software development costs but excluding land acquisition and improvement costs and mine exploration costs (including oil and gas), would be required to be capitalized and amortized over a five-year period. For foreign research projects, this amortization period increases to 15 years. Upon retirement, abandonment or disposition of property, any remaining basis would continue to be amortized over the remaining amortization period. In addition, an additional reporting requirement and penalty for failure to file is added for tax periods beginning after December 31, 2024.
7 The House bill provides a 14 percent rate for cash and cash equivalents, 7 percent otherwise. The Senate bill provides a 10 percent rate for cash and cash equivalents, 5 percent otherwise.