On Thursday, November 3rd the House Ways and Means Committee released its long-awaited tax proposal which would make significant changes to the existing tax rules for businesses and individuals.
Presented below is our analysis of some of the more significant tax provisions. It is very important to keep in mind that what was released was a bill drafted by the House Ways and Means Committee, where it will undergo significant debate and changes before it is brought to a vote. Additionally, the Senate will introduce the same bill and have significant debates and make changes, which will then leave it to the Joint Committee on Taxation to reconcile the two bills into a single bill that can be voted on and approved by both Houses of Congress.
If a final version is agreed to, passed and signed into law by the President, many of the provisions discussed below may be modified or eliminated. We will continue to closely monitor the progress of this legislation as it makes its way through Congress. Most of these provisions are effective after 2017.
I. Proposed Changes for Individuals:
Along with repeal of AMT, tax brackets would be reduced though the top bracket rate remains unchanged. A number of itemized deductions have been repealed entirely or in part. Alimony deductions would be repealed and standard deduction increased. A significant business-related proposal involves an eligibility for a reduced rate on passthrough income especially for passive investors discussed in greater detail below.
-Tax Brackets, Rates and Exemptions
Effective for the 2018 tax year, there would be four income tax brackets at 12%, 25%, 35%, and 39.6% but with the highest income tax brackets as follows:
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- Married Filing Joint
- 35% bracket threshold would start at $260,000
- 39.6% bracket threshold would start at $1,000,000
- Single and Married Filing Separately
- 35% bracket threshold would start at $200,000
- 39.6% bracket threshold would start at $500,000
- Head of Household
- 35% bracket threshold would start at $230,000
- 39.6% bracket threshold would start at $500,000
- Married Filing Joint
Enhancement of Standard Deduction
- Increased to $24,000 for joint filers (and surviving spouses) and $12,000 for individual filers. Single filers with at least one qualifying child could claim $18,000.
Repeal of Personal Exemption
- The deduction for personal exemptions, which is phased out at higher income levels currently, would be repealed.
Reduced Rate on Some Passthrough Business Income:
- Passive investors in a passthrough business (S corp, or partnership) eligible for 25% tax rate on taxable income.
- If “active” (materially participate), 30% as eligible for reduced rate of 25%. The 30% can increase with an election based on facts and circumstances. Such election would be binding for a five-year period.
- However, if personal service business such as law firms, accounting firms, consultants, engineers, financial services, and performing arts largely ineligible for reduced 25% rate. Need to use facts and circumstances to justify return or profit as eligible for reduced 25% rate vs. earned ordinary income treatment.
Alternative Minimum Tax Eliminated:
- For taxpayers with AMT credits carried forward would be able to claim a refund of 50% of the remaining credits (the credits must exceed regular tax for the year) in tax years beginning in 2019, 2020, and 2021. A refund of all remaining credits can be claimed in 2022.
-Itemized Deductions
Taxes:
- Deduction for state and local income and sales tax repealed.
- Deduction for personal state and local property taxes limited to $10,000.
Mortgage:
Deductions for mortgage Interest limited for debt incurred after Nov 2, 2017 (unless written binding contract in place before Nov 2, 2017):
- Only interest on debt of principal residence deductible; vacation home ineligible.
- Limitation reduced to $500,000 (from $1.1 million).
- Interest on home equity loans no longer deductible.
- Existing loans grandfathered.
Charitable Contributions:
- The adjusted gross income limitation for cash contributions to public charities and certain private foundations increased to 60%.
Other Itemized Deductions Eliminated:
- personal casualty losses (unless natural disaster)
- income tax preparation expenses
- medical expenses
- unreimbursed employee business expenses
- moving expenses.
-Other Changes for Individuals:
Alimony:
- For agreements after 2017, alimony payment deduction and income would be eliminated.
Contributions to Medical Savings Accounts:
- Taxpayers would no longer be able to deduct contributions to an Archer MSA and the employer contributions to an Archer MSA would no longer be taxable.
Education:
- The American Opportunity Credit (AOTC), Hope Scholarship Credit (HSC), and Lifetime Learning Credit (LLC) would be integrated into one tax credit, AOTC, providing a 100% credit for the first $2,000 of certain higher education expenses (tuition, fees, course materials) and a 25% tax credit for the next $2,000 of expenses. The credit would also be available for a 5th year of post-secondary education at half the rate as the first four years with $500 being refundable.
- Contributions to Coverdell education savings accounts eliminated after 2017; though tax-free rollovers from existing Coverdell accounts to Section 529 plans allowed. Elementary, high school and apprenticeship program expenses of up to $10,000 per year would be qualified expenses for Section 529 plans.
- Income resulting from the discharge of student debt on account of death or disability excluded from income after 2017
Education Incentives Repealed:
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- Deductions for interest on education loans, qualified tuition and related expenses, exclusion for interest on US savings bonds used to pay qualified higher education expenses, and the exclusion for qualified tuition reduction programs.
- The exclusion for employer – provided education assistance programs.
Individual Income Tax Exclusions:
- Gain on Sale of Personal Residence:
- Eligibility for exclusion of gain on sale of a principal residence modified imposing a 5 out of 8 year test for use
- Availability limited to once every five years.
- Exclusion phased out by a dollar for each dollar AGI that exceeds $500,000 ($250,000 for single filers).
Exclusion For Employer Housing:
- Exclusion for housing provided for the convenience of employer limited to $50,000
- Phased out for high income individuals after 2017
Exclusion for Employee Achievement Awards
- The exclusion for employee achievement awards would be repealed after 2017. The exclusions for dependent care assistance programs, qualified moving expenses and adoption assistance programs will also be repealed.
II. Proposed Business and Entity Changes:
In addition to slashing the corporate tax rate, a number of provisions could affect accounting methods allowing for increased deferral under the cash method and even greater expensing of capital assets. On the flip side, capital gains previously allowed inventors and other similar intangibles are now subject to ordinary income treatment and capital contributions to corporations could be taxable. There are also limitations on interest expense.
–Corporate Tax Rate:
- The income tax rate for corporations would be at a single flat rate of 20%.
–Depreciation/Expensing of Property:
Business can expense qualifying property acquired after September 27, 2017 until 2022. In addition, the proposal states that qualified property does NOT include any assets used in the real property trade or business.
-Section 179 Deductions:
Businesses may immediately expense up to $2 million of section 179 property (rather than $500,000) with a phase-out starting with $20 million of addition. These numbers are indexed for inflation thru 2023.
-Cash/Accrual Method of Accounting:
Accrual method of accounting would be required for (1) Businesses with a corporate partner and average gross receipts over $25 million, rather than current $5 million. This amount is indexed for inflation; (2) Certain industries that have inventory and annual gross receipts that exceed $25 million (rather than current $10 million). In effect, greater use of cash method of accounting, which generally defers income recognition would be permitted.
-Capitalization of Inventory Costs (UNICAP):
Would not be required for those businesses with annual gross receipts of $25 million or less (rather than $10 million). Exemption is for real and personal property purchased for resale or items manufactured by the business.
-Accounting for Long Term Contracts:
Percentage of Completion method would be required for long term contracts for business with average annual gross receipts over $25 million rather than current $10 million.
-Interest Expense:
Deduction limited to 30% of adjusted taxable income, net of certain modifications, including depreciation and amortization, interest income, interest expense and NOLs. Unused deduction can be carried forward 5 years. Limitation does not apply to “small businesses.”
-Self-Created Patents, Trade Secrets, Inventions, Models, Designs:
Any gain or loss on above self-created intangible assets, currently taxed at capital gains rates would be treated as ordinary income tax rates.
-Treatment of Contributions to Capital of a Corporation:
Transfers of money or property solely in exchange for stock would not be exempt contribution to capital but considered taxable to the corporation, viewed essentially as a sale of stock.
-Net Operating Loss:
NOL can only offset 90% (rather than 100%) of income and can no longer be carried back to generate a refund.
-Tax Free Like Kind Exchanges (Section 1031):
Like kind exchanges are limited to real estate. Tangible personal property would no longer be eligible for tax-free like kind exchange treatment.
-Domestic Production Activities Deduction:
DPAI, currently at 9%, would be repealed.
-Meals and Entertainment Expenses:
Only meals would be eligible for deduction at 50%. Entertainment, tax-free fringe benefits and reimbursements for foregoing would not be deductible even at 50% level.
III. International Tax Proposed Changes:
The proposals are inbound friendly and would generate tax planning opportunities especially for repatriation of offshore corporate earnings and profits as well as create inbound investment opportunities when combined with general corporate tax rate changes. This would primarily benefit onshore corporate entities that have offshore earnings and profits and have not repatriated them due to the onerous tax liability they would incur as well as offshore investors looking to invest in the U.S.
On the other hand, there are new deductibility limitations relative to payments made to foreign corporate affiliates that were otherwise deductible in computing U.S. taxable income and new prohibitions against treaty shopping. As with all cross border transactions, diligence is key. Here are the more salient provisions (unless otherwise noted, effective 1/1/18):
-Corporate Offshore Earnings and Profits:
- Tax-free repatriation of dividends from foreign corporations paid to 10% or greater U.S. shareholders.
- However, US shareholder generally must include the pro rata share of post-86 earnings and profits (“E&P”) of foreign corporation to extent not previously taxed in income for year prior to 2018. E&P consisting of cash and cash equivalents taxed at 12%; balance is taxed at 5%. The tax could be paid over a period of 8 years.
- As part of foregoing, elimination of current taxable Subpart F income inclusion for investment of foreign subsidiary earnings in U.S. property by U.S. parent.
- Limited basis adjustment on sale of foreign subsidiary where there has been repatriation on a tax-free basis of foreign subsidiary earnings and profits.
- No deemed indirect tax credit for foreign subsidiaries for income on which the above exemption would apply.
–Profit Ceilings
- Mandatory U.S. parent income inclusion of foreign subsidiary “high returns,” defined as excess of foreign subsidiaries’ return (income) over 7% + federal short term rate. The return is measured on aggregate adjusted bases in depreciable tangible property less interest expense not otherwise subject to current taxation under other existing anti-deferral rules.
– Interest Expense
- Limitation on Interest expense of U.S corporations that are members of a specified “international financial reporting groups” with combined annual global gross receipts over $100 million to 110% of global EBIDTA.
- Excise tax of 20% imposed on any other deductible payments made from U.S. member of above group to foreign affiliate unless foreign affiliate includes payment of US taxable income.
-Treaty Benefits:
- Limited elimination of treaty benefits for rents, royalties, interest, annuities and any other U.S. fixed, determinable annual income paid by a U.S. entity to a foreign affiliated entity other than a parent corporation if payment would not be eligible for treaty benefits if made directly to foreign parent.
-Sourcing of Income From Inventory Sales:
- Allocation of income from the sale of inventory produced in part within the U.S. and sold outside the U.S. or outside the U.S. and sold within the U.S. shall be sourced based on the production activities underlying the inventory.
-Exclusion For Oil and Shipping Income
- Repeal of mandatory U.S. parent company inclusion for (1) foreign-based oil related income; and (2) foreign shipping income if there is a net decrease.
–Misc.
- Domestic Production Activities Deduction expanded for activities in Puerto Rico for 2017 (DPAI repealed effective 1/1/18) and, until 1/1/2023, extends to America Samoa the economic development credit.
IV. ESTATE AND GIFT TAX PROPOSALS
As promised, estate tax is scheduled to be repealed – though not right away. In the interim, the estate tax exclusion amount is doubled. Gift tax remains though with some modifications to avoid taxpayer income shifting.
-Estate Tax/GST Exclusion and Repeal:
The current estate tax exclusion, currently set at $5.49 million per person, would be doubled for the next 6 years through 2023. The estate tax would be repealed starting in 2024. The same rules apply for the generation skipping tax (GST). Exclusion amounts would be indexed for inflation as under current law. Hence, if the bill passes as written, a couple could shield roughly $22.4 million in assets starting next year.
-Gift Tax:
The annual exclusion will remain and for 2018 is indexed to $15,000. As under current law, the estate and GST exclusion amounts will apply to gifts – which, as noted, are doubled. In 2024, when the estate tax is slated to be repealed, the gift tax rate would drop from 40% to 35%.
These tax proposals are subject to and likely will change. Contact your Janover Tax Advisor for the latest updates and tax planning strategies.