The Situation: On November 2, 2017, the House Ways and Means Committee released its first draft of much-anticipated comprehensive U.S. tax reform legislation as the "Tax Cuts and Jobs Act." Chairman Brady’s markup of the bill was released today.
The Result: Far-reaching changes are proposed to individual, business, and international taxation.
Looking Ahead: The House Ways and Means Committee plans to begin marking up the bill on November 6. The Senate is expected to release its own tax bill shortly. After reconciliation between the House and Senate bills, President Trump hopes to sign the legislation before Christmas.
On November 2, 2017, the House Ways and Means Committee released its draft of the "Tax Cuts and Jobs Act." This Commentary summarizes certain key provisions of the bill, most of which would be effective for taxable years beginning after December 31, 2017.
Individual Tax Reform
The number of individual tax rate brackets would be reduced from seven to four: 12 percent, 25 percent, 35 percent, and 39.6 percent, and the income threshold subject to the 39.6 percent bracket would be increased to $1 million for taxpayers filing jointly and $500,000 for other individuals. Taxpayers filing a joint return with income in excess of $1.2 million, or other taxpayers with income in excess of $1 million, would pay a 6 percent surtax in an amount that would negate the benefit of the 12 percent bracket.
The state and local income tax deduction would be eliminated, the property tax deduction would be limited to $10,000 for joint filers and unmarried individuals, and the deductibility of interest on principal residence mortgage indebtedness would be limited to new mortgages of no more than $500,000, down from $1 million, and mortgage interest deductions would be eliminated on second residences.
- Increases the unified credit against estate, gift, and generation-skipping transfer taxes to $10 million.
- Repeals the estate and generation-skipping transfer taxes for taxable years after December 31, 2023, and preserves basis step-up upon death.
- Caps the amount of imputed rent income taxpayers may exclude for employer-provided housing at $50,000.
- Eliminates a number of itemized deductions, including for personal casualty losses, tax preparation expenses, alimony payments, medical expenses, and charitable contributions tied to athletic event seating rights, but increases the charitable contribution ceiling for cash contributions to 60 percent of adjusted gross income.
Curtailment of Nonqualified Deferred Compensation
Section 409A would be eliminated and replaced with Section 409B for services performed after December 31, 2017. Under Section 409B, an employee would be taxed on nonqualified deferred compensation as soon as there is no substantial risk of forfeiture. Nonqualified deferred compensation is broadly defined and would include stock options and SERPs, and substantial risk of forfeiture is narrowly defined and would be limited to the performance of substantial future services. With respect to services performed before January 1, 2018, nonqualified deferred compensation would be required to be included in income by the later of 2026 or the year in which there is no substantial risk of forfeiture.
$1 Million Limitation on Executive Officer Compensation
The $1 million deduction limit for compensation paid to named executive officers of publicly traded companies would be expanded, including elimination of the performance-based compensation exception and the application of the limit to principal financial officers and former named executive officers.
Business Tax Reform
Corporate Tax Rate
The corporate tax rate would be changed from a graduated rate structure with a maximum rate of 35 percent to a flat 20 percent rate. Personal services corporations (for instance, some accounting, law, and medical firms) would be subject to a flat 25 percent corporate rate.
Pass-Though Business Income
Individual owners of a trade or business, including through pass-through entities (e.g., partnerships, limited liability companies, and S corporations), would be subject to a maximum tax rate of 25 percent on the income of the business derived from passive business activities ("business income"). Income derived from active business activities (including wages) would continue to be subject to ordinary tax rates. The amount of income treated as business income (and eligible for the 25 percent rate) would be based on each individual owner or shareholder's "capital percentage." Generally, the owner or shareholder could elect either a capital percentage of 30 percent, or to apply a formula based on a rate of return (the applicable federal short-term rate plus 7 percent) multiplied by the capital investments of the business. The default capital percentage would be 0 percent for certain personal services businesses (e.g., service businesses in the fields of law, accounting, consulting, engineering, financial services, or the performing arts). However, an owner of a personal services business would be able to elect to use an alternative capital percentage based on the business's capital investments. The 25 percent rate would also apply to certain dividends from a real estate investment trust (REIT).
Temporarily, taxpayers would be permitted to fully "expense" (i.e., take a 100 percent deduction for) acquisition costs of certain business property (but excluding most intangible property) by increasing the property's bonus depreciation deduction from 50 percent to 100 percent. However, property qualifying for immediate expensing will generally be property that has a 20-year or lower recovery period and that is subject to the MACRS depreciation regime, which excludes, for instance, many types of real property. These expensing changes are temporary only; immediate expensing would only be allowed (subject to some exceptions) for property acquired after September 27, 2017, and placed in service before January 1, 2023.
Elimination of Business Tax Credits
A number of business tax credits would be repealed under the bill, including the orphan drug credit, the employer-provided child care credit, the rehabilitation credit, the work opportunity credit, and the credit for expenditures to provide access to disabled individuals. The deduction for certain unused business credits would also be repealed. No additional new markets tax credits would be allocated after 2017.
Limitations on Interest Deductions
Businesses would be subject to a limitation on net interest expense deductions (i.e., deductions of interest expense in excess of interest income). A deduction for net interest expense in excess of 30 percent of the business's adjusted taxable income would be disallowed, with an exception for debt incurred in a real estate business. Any disallowed amounts would be carried forward to the succeeding five taxable years, but such carryforwards may be limited in use following an ownership change. For partnerships, the net interest expense disallowance would be determined at the partnership level. Certain small businesses would be exempt from these rules. Domestic corporations that are members of "international financial reporting groups" would also be limited in their ability to deduct net interest expense based on EBITDA.
- The rule treating a partnership as terminating as the result of a sale of 50 percent or more of its interests during a 12-month period (a technical termination) would be repealed.
- The deduction for domestic production activities would be repealed.
- Net operating loss ("NOL") deductions would generally be limited to 90 percent of the taxpayer's taxable income. NOL carrybacks would generally be repealed. NOLs arising in taxable years beginning after 2017 that are carried forward would be increased by an interest factor to reflect inflation.
- An entity would include in taxable income the amount of any contribution to its capital, to the extent such amount exceeds the fair market value of any equity issued in exchange for the contribution.
- Repeals the rule treating gain from an individual's sale of a patent as long-term capital gain.
U.S. International Tax Reform
Territorial System of Taxation
Dividends received by a U.S. corporate shareholder from a 10 percent-owned foreign corporation out of the foreign corporation's foreign source earnings would be 100 percent deductible by the recipient, provided that the stock upon which such distribution was made had been held by the U.S. shareholder for at least 180 days.
Mandatory Taxation of Foreign Earnings
Accumulated foreign earnings determined as of either (i) November 2, 2017, or (ii) December 31, 2017, (whichever is greater) would be subject to a one-time tax at a rate of 12 percent (to the extent of foreign held cash) or 5 percent otherwise. For this purpose, foreign held cash (including cash equivalents such as net accounts receivable and commercial paper) counted in determining the rate would equal the average amount of such foreign held cash on (i) November 2, 2017; (ii) the close of the last taxable year ending prior to November 2, 2017; and (iii) the close of the second-last taxable year ending prior to November 2, 2017. The tax could be paid over eight years at the taxpayer's election.
Current Taxation of New Category of Foreign Income
Fifty percent of a controlled foreign corporation's ("CFC's") "foreign high return amount" would be subject to current U.S. tax imposed on the CFC's U.S. shareholders. The foreign high return amount is equal to the CFC's net income, minus the amount by which approximately 8.5 percent (7 percent plus the short-term applicable federal rate) of the CFC's tax basis in depreciable tangible property exceeds the CFC's interest expense.
Excise Tax on Outbound Payments
Domestic corporations would be subject to an excise tax (at the highest corporate tax rate) on deductible payments (including payments for cost of goods sold, inventory, and depreciable or amortizable assets) made to related foreign members (i.e., members of the same international financial reporting group that file consolidated financial statements and that in the aggregate would report an average over the immediately preceding three years of $100 million or more in payments subject to this excise tax). Payments received by these foreign members from related domestic corporations that represent interest, U.S. source passive earnings, income effectively connected with a U.S. trade or business, or certain actively traded commodity payments would be exempt from this excise tax. In lieu of paying the excise tax, an election could be made to treat the foreign member's income as effectively connected with a U.S. trade or business; although expenses would be limited to the group’s net income ratio, resulting in a higher tax base.
- Investments by CFCs in U.S. property would no longer be subject to subpart F income to the extent that the CFCs' U.S. shareholders are corporations.
- The source of income for sales of inventory would be determined solely by reference to the location(s) where production activities occurred, rather than the location of title passage.
- Indirect foreign tax credits would be eliminated, but subpart F income would be reduced by foreign taxes paid on such income.
- The subpart F "look-through" rule for payments between CFCs would be made permanent.
The House Ways and Means Committee plans to begin marking up the bill next week. The Senate is also expected to release its own tax reform bill next week, which may differ significantly from the House bill. The House hopes to pass its bill before the holiday recess that begins on November 20, and the Senate hopes to follow soon thereafter. President Trump has announced his desire to have tax legislation signed into law "before Christmas."
Four Key Takeaways
1. The "Tax Cuts and Jobs Act" potentially brings sweeping reforms to the U.S. tax code.
2. The number of individual tax rate brackets would be reduced from seven to four, and substantial new limits are proposed for itemized deductions.
3. Corporate tax rates would be set at a flat 20 percent rate. Alterations to expensing and depreciation allowances are also in the bill.
4. Reforms to the U.S. international tax system include a transition to a territorial system, provisions for the taxation of accumulated foreign earnings, and other changes.