On Friday, December 15, the U.S. House of Representative and Senate conferees reached agreement on the Tax Cuts and Jobs Act (H.R. 1) (the “Final Bill”), and released legislative text, an explanation, and the Joint Committee on Taxation estimated budget effects (commonly referred to as the “score”). Next week the House and Senate are each expected to pass the bill, and it is expected to be sent to the President for signature the following week. As the conferees actually signed the conference text, changes (even of a limited and/or technical nature) are extremely unlikely at this point.
The Final Bill largely follows the Senate bill, but with certain important differences. We outline some of the most significant differences between the Final Bill, the earlier House bill, and the Senate bill. We then discuss in detail some of the most significant provisions of the Final Bill. The provisions discussed are generally proposed to apply to tax years beginning after December 31, 2017, subject to certain exceptions (only some of which are noted below). While we discuss some of these provisions in detail, we do not address all restrictions, exclusions, and various other nuances applicable to any given provision.
Summary of significant changes in the Final Bill
- Under the Final Bill, the corporate tax rate is 21%, which is higher than the 20% rate in both bills. The rate will take effect as of January 1, 2018. (The Senate bill would have reduced the rate as of January 1, 2019.)
- Initially, interest deductions will generally be limited to 30% of earnings before interest, taxes, depreciation, and amortization (“EBITDA”); beginning January 1, 2022, the deduction will be limited to 30% of earnings before interest and taxes (“EBIT”). The EBITDA formula is more generous to taxpayers.
- The deduction for qualified pass-through business income generally follows the Senate bill except that the deduction is set at 20% for a maximum effective rate of 29.6% ([100% – 20%] * 37% = 29.6%). The Senate bill proposed a 23% deduction.
- The threshold to avoid the W-2 wage limitation and the “specified trade or business” exclusion is reduced to $315,000 (joint return) or $157,500 (single taxpayer). The W-2 wage limitation is modified to be the greater of the individual’s share of (a) 50% of the W-2 wages of the pass-through business or (b) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable tangible property used in the production of qualified business income.
- The definition of specified service trade or business is modified to exclude engineering and architecture services (so that engineers and architects benefit from the pass-through deduction) and takes into account the reputation or skill of owners (and not only employees, as under the Senate bill). As a result, the owners of a pass-through business with taxable income in excess of $315,000 (for joint filers) that depends on the reputation or skill of its employees generally will not qualify for the pass-through deduction.
- The deduction sunsets for tax years beginning after December 31, 2025.
- The Final Bill repeals the corporate alternative minimum tax (“AMT”). The Senate bill would have preserved the AMT.
- The tax rates for the one-time deemed repatriation of foreign earnings are increased to 8% on non-cash assets (up from 7.5% in the Senate bill) and 15.5% on cash assets (up from 14.5% in the Senate bill).
- The Final Bill does not include the proposal to limit disproportionate net interest expense deductions for U.S. members of worldwide affiliated groups that had been contained in the Senate and House bills.
- The Final Bill retains section 956. Both the Senate bill and the House bill would have repealed section 956 as to U.S. corporate shareholders.
- Under the Final Bill, the “active trade or business” exception to gain recognition under section 367 will be repealed. Accordingly, gain (but not loss) will be required to be recognized when a U.S. taxpayer transfers appreciated property to a foreign corporation in a transaction that would otherwise qualify as tax-free, even if used in an active trade or business, unless another exception applies.
- The Final Bill does not include the provision in the Senate bill that would have permitted a CFC to distribute intangible property to a corporate shareholder without recognizing gain (and therefore without causing its United States shareholders to recognize gain).
- The Final Bill does not accelerate the worldwide interest allocation rules (and they will continue to go in effect after December 21, 2020).
- The Final Bill does not include a provision in the House and Senate bills that would have made permanent the look-through rule for payments of dividends, interest and equivalents, rents, and royalties from one CFC to another CFC.
- The top rate has been reduced to 37% from 39.6% under current law. The Senate bill proposed a top rate of 38.5%.
- The Final Bill follows the Senate bill and repeals the Affordable Care Act’s “individual mandate.”
- The Final Bill follows the Senate bill with respect to the child tax credit ($2,000 per eligible dependent), except that it increases the refundable portion of the child tax credit to $1,400 (from $1,100 under the Senate bill), and reduces the phase out to $400,000 for married taxpayers and $200,000 for single individuals (from $500,000 for all taxpayers under the Senate bill).
- The Final Bill increases the individual AMT exemption amount to $109,400 for married taxpayers ($70,300 for single taxpayers) from $84,500/$54,300 under current law, and increases the AMT exemption phase-out to $1,000,000 (joint filers) and $500,000 (all other taxpayers) from $160,900 and $120,700, respectively.
- The Final Bill limits the deduction for state and local taxes paid to an aggregate cap of $10,000 for property taxes and either income or sales taxes. The House and Senate bills capped the deduction at $10,000, but would have limited it to property taxes only.
- The Final Bill reduces to $750,000 the amount of acquisition indebtedness on which taxpayers may deduct home mortgage interest (from $1 million under current law).
- The current law 10% adjusted gross income (“AGI”) floor for medical expense deductions will be lowered temporarily from 10% to 7.5% for tax years beginning after December 31, 2016, and ending before January 1, 2019, after which the medical expense deduction will be retained as under current law.
- Most changes to taxation of individuals (excluding ACA individual mandate repeal) sunset for tax years beginning after December 31, 2025.
Detailed discussion of the Final Bill
I. Business Provisions.
21% tax rate on corporate income beginning in 2018; corporate AMT repealed.
The Final Bill permanently reduces the corporate tax rate from 35% to 21% effective for tax years beginning after December 31, 2017. (The House and Senate bills had proposed a reduction to 20%, although the Senate bill would have delayed introduction of the new rate until 2019.) The Final Bill also eliminates the special fixed rate of 35% for personal service corporations.
The Final Bill follows the House bill and repeals the corporate alternative minimum tax (“AMT”) entirely.
Correlative reduction of corporate dividends received deduction (“DRD”).
Under the Final Bill, the amount of dividends received that a corporation could deduct from its taxable income will be reduced to 50%, in the case of 70% deductible dividends under current law, or 65%, in the case of 80% deductible dividends. Combined with the corporate rate reduction to 21%, the effect is to preserve the rate of tax for a corporate shareholder entitled to a 70% deduction under current law at 10.5% and increase the rate slightly for a corporate shareholder entitled to the 80% DRD under current law from 7% to 7.35%. A corporation will continue to deduct 100% of the dividends received from another corporation within the same affiliated group.
Net business interest deductions limited to 30% of earnings before interest and taxes.
Under the Final Bill net business interest deductions will generally be limited to 30% of a taxpayer’s adjusted taxable income, which before January 1, 2022 is calculated under a formula similar to earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and on after January 1, 2022 under a formula similar to earnings before interest and taxes (“EBIT”). The House bill had used the EBITDA formula permanently and the Senate bill had used the EBIT formula permanently. Excluded interest deductions could be carried forward indefinitely. “Business interest” will include any interest paid or accrued on indebtedness “properly allocable to a trade or business” but will not include “investment interest” (as described in section 163(d)). However, floor plan financing interest, i.e., interest paid or accrued on indebtedness used to finance the purchase of motor vehicle inventories, will not be subject to the limitation.
The limitation will not apply to taxpayers with gross receipts of $25 million or less, or to certain regulated public utilities. Additionally, real property development, construction, rental property management, or similar companies may elect out of this limitation.
For a partnership, the limitation will be applied at the partnership level, applying additional rules to prevent any double counting of the deduction and to allow for an increased deduction limit for excess taxable income applying rules similar to those in current section 163(j). For a group of affiliate corporations filing a consolidated return, the limitation similarly applies at the consolidated return level.
NOL deductions limited to 80% of taxable income beginning in 2018.
The Final Bill limits deductions for net operating losses (“NOLs”) to 80% of taxable income for any tax year. (Both the House and Senate bills had proposed a 90% limitation, although the Senate bill would have further reduced the limitation to 80% for tax years beginning after December 31, 2022.) NOLs will no longer expire after 20 years but will be carried forward indefinitely to future tax years; however, the current two-year carryback of NOLs will no longer be available to most taxpayers. The current rules for NOLs (i.e., ability to carry back 2 years, carry forward 20 years, and offset 100% of taxable income) will continue to apply to property and casualty insurance companies.
The Final Bill does not include an inflation adjustment for amounts carried forward (proposed in the House bill).
Denial of nonrecognition for like-kind exchanges of personal property.
The Final Bill, like both the House and Senate bills, limits nonrecognition treatment under section 1031 to like-kind exchanges of real property. Non-simultaneous transfers not completed by December 31, 2017 will be grandfathered, so long as the taxpayer has either received or disposed of the property to be exchanged on or before December 31, 2017.
Temporary full expensing of business assets; other cost recovery changes.
Temporary 100% expensing for certain business assets.
The Final Bill allows 100% expensing of the cost of certain business property placed into service after September 27, 2017 and before January 1, 2023. The Final Bill follows the House bill in allowing immediate expensing for used as well as new eligible property; the analogous Senate bill provision applied only to new property. Beginning in 2023, the immediate first-year expensing will be reduced to 80%, followed by 60% in 2024, 40% in 2025, 20% in 2026, and reduced to 0% thereafter. A transition rule in the Final Bill allows taxpayers to elect to expense 50% of the cost of eligible business property rather than the full 100% for their first tax year beginning after September 27, 2017.
Under the Final Bill, immediate expensing will be available only to taxpayers subject to the net interest deduction limitation in new section 163(j). Therefore, real estate-related trades and businesses electing out of section 163(j) will not be entitled to immediate expensing under this provision.
Reduced cost recovery periods for qualified improvement property; current recovery periods for residential rental and nonresidential real property retained.
Under the Final Bill, the recovery period for all “qualified improvement property” (including qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) will be standardized at 15 years. The Final Bill preserves cost recovery periods for residential rental and nonresidential real property at, respectively, 27.5 years and 39 years. (The Senate bill would have reduced the recovery period to 25 years in both cases.)
Expansion of section 179 expensing.
The Final Bill follows the Senate bill in permitting immediate expensing for up to $1,000,000 of the cost of qualifying tangible personal property placed into service after December 31, 2017, an increase from the $500,000 cap under current law, but less than the House bill’s proposal to allow expensing of up to $5 million. The Final Bill, like the Senate bill, expands the definition of qualified real property eligible for section 179 expensing to include certain improvements (e.g., roofs, heating, and alarms systems) made to nonresidential real property after the property is first placed in service.
The benefit under the Final Bill will be reduced (but not below zero) to the extent the value of qualifying property placed into service exceeds $2,500,000 for the tax year (compared to $2 million under current law). Under the Final Bill, the expansion takes effect for tax years beginning after December 31, 2017 and will be permanent.
Required amortization for specified research and experimental expenditures.
Effective for amounts paid or incurred in tax years beginning after December 31, 2021, the Final Bill will require taxpayers to capital and amortize certain research and experimental expenditures (including software development costs) which, under current law, are immediately deductible. The cost recovery period for these expenditures will be 5 years if related to research conducted within the United States, and 15 years if conducted outside of the United States. Like the House and Senate bills, the Final Bill specifically applies to software development expenditures.
Certain contributions to capital included in gross income.
The Final Bill adopts a proposal from the House bill to treat certain contributions to the capital of a corporation—other than money or stock contributed in exchange for stock or equity—as gross income to the corporation. Generally, the contributions giving rise to gross income will include contributions (i) in aid of construction or otherwise by a customer or potential customer, or (ii) by government entities or civic groups (other than a shareholder). The Final Bill corrects the overbreadth of the House bill, which would have applied in unintended circumstances.
Modification of accounting methods for taxpayers with gross receipts of $25 million or less.
The Final Bill, like the House bill, generally permits taxpayers with gross receipts not exceeding $25 million for the three prior tax years (the “25 million gross receipts test”) to elect to use the cash method of accounting. (The Senate bill would have set this cap to $15 million; the maximum under current law is $5 million.) The current exceptions from the required use of accrual accounting for certain categories of taxpayers—including taxpayers that do not satisfy the $25 million gross receipts test—will remain.
Taxpayers satisfying the $25 million gross receipts test will not be required to comply with the specific inventory accounting rules imposed under current section 471 but could instead determine cost of goods sold applying their financial accounting method. Additionally, taxpayers meeting this test will be exempt from the 30% limitation on net interest expense deductions, the uniform capitalization rules under section 263A and, if additional requirements are satisfied, from required use of the percentage-of-completion method of calculating taxable income from certain small construction contracts. The $25 million cap will be adjusted for inflation starting in tax years beginning after December 31, 2018.
Repeal of deduction for domestic production activities.
The Final Bill repeals the deduction for domestic production activities under section 199, effective for taxpayers that are C corporations in tax years beginning after December 31, 2018, and for all other taxpayers in tax years beginning after December 31, 2017.
20% deduction (equivalent to a 29.6% maximum effective rate) for qualified business income of certain pass-through business owners.
The Final Bill largely follows the Senate bill and provides for a maximum effective rate of 29.6% on an individual’s domestic “qualified business income” from a partnership, S corporation, or sole proprietorship. Amounts received as dividends from real estate investment trusts (“REITs”) and the qualified trade or business income from a “qualified publicly traded partnership” will also be eligible for this deduction. The reduced maximum rate arises from a 20% deduction ([100% – 20%] * 37% proposed top marginal rate = 29.6%) and is slightly lower than the 29.645% maximum rate proposed in the Senate bill, which provided for a 23% deduction ([100% – 23%] * 38.5% proposed top marginal rate = 29.645%). Qualified business losses carry forward to the next tax year and reduce the amount of qualified business income included in determining the amount of the deduction for that year.
Qualified business income is net income and gain arising from a qualified trade or business. Qualified trade or business excludes “specified service trades or businesses” except for taxpayers with taxable income below a given threshold ($315,000 for married individuals filing jointly and $157,500 for single taxpayers). The thresholds in the Final Bill are significantly less than the $500,000 and $250,000 thresholds under the Senate bill.
Specified service businesses include any trade or business activity involving the performance of services in the areas of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business the principal asset of which is the reputation or skill of its employees or owners, or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. The Final Bill omits engineering and architecture from the Senate bill’s list of specified service businesses, but expands the list to include businesses whose principal asset is the reputation or skill of its employees or owners (instead of merely employees, as proposed in the Senate bill). “Qualified business income” must be income that would be treated as effectively connected with a U.S. trade or business if earned by a non-U.S. person, and does not include certain forms of “investment” income (e.g., capital gain, most dividends, and interest that is not allocable to a qualified trade or business). However, rental income and royalties are not excluded and may qualify for the pass-through deduction.
The deduction for qualified business income sunsets after December 31, 2025.
Deduction capped at (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of qualified property investment.
The amount of the deduction available to a taxpayer from a partnership or S corporation cannot exceed the greater of (a) 50% of the taxpayer’s share of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” “Qualified property” is defined as depreciable tangible property that is held by and available for use in a qualified trade or business at the close of the taxable year, is used in the production of qualified business income, and for which the “depreciable period” has not ended before the close of the tax year. The depreciable period with respect to qualified property is the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date or (b) the last day of the last full year of the applicable recovery period that will apply to the property under section 168 (without regard to section 168(g)).
As a result of the new test, the owners of a pass-through entity with no employees that is engaged in a qualified trade or business can benefit from the deduction (and the 29.6% effective rate) with respect to a return of up to 12.5% per year on its investment in depreciable tangible property. To illustrate, a taxpayer with a $100 qualified property investment will be eligible for a deduction of up to $2.50 (2.5% of $100). If the taxpayer earned a 12.5% return on its capital investment, resulting in qualified business income of $12.50 (12.5% * $100), the taxpayer could deduct 20% of the entire return (20% * $12.50 = $2.50) without exceeding the cap.
The W-2 wage/qualified property limitation will not apply to individuals with taxable incomes at or below $315,000 for married individuals filing jointly or $157,000 for single individuals, and will phase-in completely over the next $100,000 or $50,000, as applicable, of taxable income. Qualified business income earned through a publicly traded partnership and otherwise eligible for the deduction will also not be subject to the limitation.
Other changes to pass-through taxation.
Limitation on active pass-through losses.
The Final Bill follows the Senate bill and provides that deductions for “excess business losses” of flow-through taxpayers (i.e., taxpayers other than C corporations) will not be permitted to offset non-business income of the taxpayer. These losses will be treated as NOLs and carried forward into subsequent tax years. An “excess business loss” is defined as the excess of a taxpayer’s aggregate deductions attributable to trades or business of the taxpayer over the sum of the taxpayer’s aggregate gross income plus a threshold amount ($500,000 for married individuals filing jointly and $250,000 for single individuals, indexed for inflation). The determination whether a net business loss exceeds the threshold amount is made at the individual partner or S corporation shareholder level.
Changes to substantial built-in loss rules; new limits on allocations of partnership losses.
The Final Bill adopts the proposal in the Senate bill to modify the definition of substantial built-in loss for purposes of section 743(d), which under current law requires a partnership to adjust the basis of partnership assets with substantial built-in losses upon transfer of an interest in the partnership. Under the Final Bill, a substantial built-in loss will exist if a fully taxable disposition of all of the partnership’s assets at fair market value will result in an allocation of loss to the transferee in excess of $250,000.
The Final Bill also adopts a proposal in the Senate bill to take into account a partner’s distributive share of partnership charitable contributions and foreign taxes paid in determining the basis limitation for an allocation of partnership losses.
Extended 3-year holding period required for carried interests.
Under the Final Bill, individual holders of carried interests will be required to satisfy a 3-year holding period (rather than the one-year period under current law) to qualify for long-term capital gains rates on income in respect of profits interests received in exchange for services. The rule will apply to a partnership interest that is held by or transferred to a taxpayer in connection with the performance by that taxpayer (or a related party) of substantial services for an “applicable trade or business.” An “applicable trade or business” is one that is conducted on a regular, continuous, and substantial basis (and may include activity by multiple entities) and consists of the development of certain specified assets or the investment in and/or disposition of specified assets (including identification of specified assets for investment and/or disposition). “Specified assets” include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts, and an interest in a partnership to the extent attributable to specified assets.
The 3-year holding period will apply to allocations of distributive share as well as transfers of partnership interests to related parties (to the extent allocable to capital asset held for 3 years or less).
The provision does not apply to carried interests held directly or indirectly through a corporation, apparently including S corporations
II. Foreign income provisions.
One-time tax of 8%/15.5% on deferred foreign income.
The Final Bill largely follows the Senate bill and imposes a one-time tax on a United States shareholder’s pro rata share of the accumulated, undistributed earnings of a foreign corporation of which it owns 10% or more of the vote or value (a “specified foreign corporation”). The amount of accumulated foreign earnings subject to tax under this provision is determined as the greater of post-1986 accumulated foreign earnings and profits as of November 2, 2017 or December 31, 2017 (without reduction for distributions during the taxable year, other than to another specified foreign corporation). Under the Final Bill, a specified foreign corporation includes all CFCs and all foreign corporations (other than passive foreign investment companies, or “PFICs”) of which a U.S. person owns a 10% voting interest. However, in the case of a foreign corporation that is not a CFC, there must be at least one 10% U.S. shareholder that is a domestic C corporation. Earnings of a specified foreign corporation attributable either to U.S. effectively connected income (“ECI”) or to dividends received directly or indirectly from 80%-owned domestic C corporations will be excluded.
The Final Bill provides for partial deductibility of the foreign earnings deemed repatriated in whatever amount is necessary to achieve a 15.5% rate of tax on earnings held in the form of cash or cash equivalents and 8% on all other earnings, a slight increase over the 14.5%/7.5% and 14%/7% rates proposed under the Senate and House bills. The deemed repatriations giving rise to this tax will occur during the specified foreign corporation’s last tax year beginning before January 1, 2018.
Under the Final Bill, the tax on repatriation will be payable over an 8-year period at the taxpayer’s election. REITs will be permitted to elect to meet their distribution requirements with respect to accumulated foreign earnings over this same 8-year period using the same annual installment percentages. Income recognized on the deemed repatriation is excluded for purposes of the REIT gross income tests.
Additionally, under the Final Bill, U.S. shareholders will be able to net foreign E&P deficits and qualified deficits against untaxed earnings to determine the amount of inclusion. U.S. shareholders will also be able to choose whether to offset their foreign NOLs against the amount deemed included in the repatriation, or whether to preserve these NOLs to offset future tax liability.
The Final Bill specifically authorizes regulations to increase the amount of post-1986 earnings and profits in respect of tax strategies designed to reduce those earnings and profits.
Recapture tax on expatriated entities.
Under the Senate bill (but not the House bill), if a U.S. corporate shareholder becomes an “expatriated entity” within the 10-year period following enactment of the proposed legislation, the reduced tax rate applicable to its share of any foreign earnings deemed repatriated by virtue of this provision will be retroactively increased to 35%. The amount of additional tax due will be computed by reference to the year of the deemed inclusion (which for calendar year taxpayers will be 2017), but will be assessed in the year of the U.S. shareholder’s expatriation.
Shift to territorial system of international taxation through foreign-source dividends received deduction (DRD).
The Final Bill, like the House and Senate bills, will shift the current U.S. “worldwide” international tax system, under which U.S. companies are taxable on worldwide income, to a “territorial” system under which foreign active profits are generally exempt from tax. Foreign-source income is excluded by way of a 100% deduction of the foreign-source portion of dividends paid by a specified foreign corporation to a United States shareholder that is a C corporation (referred to here as a “U.S. corporate shareholder”), provided (i) the recipient holds the underlying stock for 365 days or more during the 731-day period beginning on the date that is 365 days before the date on which the stock becomes ex-dividend with respect to the dividend and (ii) the recipient meets the definition of “United States shareholder” with respect to the specified foreign corporation making the distribution at all times during this holding period. Under the Final Bill, controlled foreign corporations (CFCs) that are treated as domestic corporations for purposes of computing taxable income are treated as domestic corporations for purposes of this provision and are therefore eligible for the deduction. Additionally, U.S. corporate shareholders that hold interests in specified foreign corporations indirectly (e.g., through an interest in a partnership) are eligible for the deduction on a pass-through basis.
No foreign tax credit or deduction will be permitted for any exempt foreign-source dividend, and neither the exempt dividend nor deductions allocable to the foreign-source portion of the underlying stock will be considered in calculating the foreign tax credit limitation of the U.S. corporate shareholder. A U.S. corporate shareholder’s basis in the foreign corporation stock will be reduced, solely for purposes of determining a loss on later disposition of the stock, by an amount equal to the portion of any dividend received with respect to the stock from the foreign corporation that was not taxed by reason of the dividends received deduction.
Gain from the sale of stock of a foreign corporation by a U.S. corporate shareholder that has been held for at least one year will be treated as a dividend for purposes of calculating any foreign-source DRD. Similar rules will apply to treat gain from the sale by a CFC of stock in a lower-tier CFC as a dividend to the U.S. shareholder of the selling CFC. However, (i) the foreign-source portion of the dividend will be treated as subpart F income of the selling CFC, (ii) the United States shareholders with respect to the selling CFC will be required to include in income their pro rata share of that subpart F income, and (iii) the dividends received deduction will be allowable to the United States shareholder in the same manner as if the subpart F income were a dividend received by the shareholder from the selling CFC.
Foreign-source DRD disallowed for hybrid dividends and dividends from PFICs and inverted corporations.
The Final bill follows the Senate bill and provides that the deduction for foreign-source dividends will not be available for “hybrid dividends” received by a U.S. corporate shareholder from a CFC. Accordingly, repatriated hybrid dividends will be taxable. A hybrid dividend is any payment received from a CFC for which the CFC received a deduction or other tax benefit with respect to foreign income, war profits, and excess profits taxes.
Hybrid dividends between CFCs sharing a common 10% U.S. corporate shareholder will be treated as subpart F income of the recipient CFC and therefore includible in the income of the 10% U.S. corporate shareholder during the same tax year.
In addition, the Final Bill specifically disallows any foreign-source DRD with respect to dividends received from PFICs (that are not also CFCs), and from “inverted” entities (i.e., entities meeting the definition of “surrogate foreign corporation” in section 7874 that are not treated as domestic corporations).
Transferred loss recapture rules.
Under the Final Bill, transferred loss recapture rules will apply to transfers of substantially all of the assets of a domestic corporation’s foreign branch to a foreign corporation in which the domestic transferor is a U.S. corporate shareholder.
Repeal of the active trade or business exception.
Under current law, if a U.S. taxpayer transfers property used in the active conduct of a trade or business to a foreign corporation under a transaction that would otherwise qualify for tax-free treatment, the transaction is treated as tax-free. Under the Final Bill, this “active trade or business exception” to section 367 is repealed and any gain (but not loss) on the transfer would be recognized.
10.5% tax on “global intangible low-taxed income” (“GILTI”).
Notwithstanding the general territoriality rule, the Final Bill follows the Senate bill and will tax a U.S. shareholder’s share of a CFC’s “global intangible low-taxed income,” or “GILTI,” at a special 10.5% effective rate (which will increase to 13.125% for tax years beginning after December 31, 2025.). As a result of the GILTI rate, the minimum foreign tax rate at which no residual GILTI tax will be owed is 13.125%. Very generally, GILTI is active (non-Subpart F) income in excess of an implied return of 10% of the CFC’s adjusted bases in tangible depreciable property used to generate the active income. (The House bill contained a similar concept.)
More specifically, a U.S shareholder’s GILTI is measured as the excess (if any) of its aggregate pro rata share of “net CFC tested income” over a deemed tangible income return of 10% on its aggregate pro rata share of the CFCs’ “qualified business asset investment,” or “QBAI” (generally, depreciable tangible property used in the production of tested income), less the interest expense taken into account in determining its net CFC tested income for the taxable year to the extent that the interest expense exceeds the interest income properly allocable to the interest income that is taken into account in determining its net CFC tested income. “Net CFC tested income” generally means the aggregate of a U.S. shareholder’s pro rata share of “active” net income (or loss) from each CFC of which it is a U.S. shareholder (i.e., Subpart F income, effectively-connected income, foreign oil and gas income, and certain other categories of income are excluded).
The mechanism for arriving at the special 10.5% rate is a 50% deduction: (100% GILTI inclusion – 50% deduction) * 21% corporate tax rate = 10.5%. This deduction will be decreased to 37.5% in tax years beginning after December 31, 2025.
GILTI will be treated similarly to subpart F income (and so will be includible currently to any United States shareholder). U.S. corporate shareholder with GILTI inclusions will be permitted a foreign tax credit equal to 80% of its ratable share of foreign taxes deemed paid attributable to net CFC tested income. Non-passive GILTI will be in a separate foreign tax credit basket, with no carryforward or carryback available for excess credits.
Reduced 13.125% “patent box” rate for “foreign-derived intangible income.”
The Final Bill adopts the Senate bill’s proposal to tax the deemed intangible income of a U.S. C corporation (other than a REIT or a RIC) derived in connection with foreign sales or foreign use (the corporation’s “foreign derived intangible income,” or “FDII”) at a special 13.125% rate (increasing to 16.406% in tax years beginning after December 31, 2025). The House bill does not have an analogous concept.
Mechanically, the proposal permits a 37.5% deduction for “foreign-derived intangible income” (“FDII”). A 37.5% deduction results in a net tax of 13.125% ([100% – 37.5%] * 21% = 13.25%). FDII is the amount that bears the same ratio to the corporation’s “deemed intangible income” (“DII”) as its “foreign-derived deduction eligible income” (“FDDEI”) bears to its “deduction eligible income” (“DEI”).
DEI is the gross income of a U.S. corporation (less applicable deductions), excluding any subpart F income of the corporation includible under section 951, any amount of GILTI included in the gross income of the corporation, financial services income, dividends received from CFCs with respect to which the corporation is a United States shareholder, domestic oil and gas income, and the corporation’s foreign branch income.
DII is equal to the excess of the corporation’s DEI over its “deemed tangible income return,” which is 10% of the corporation’s qualified business asset investment (defined the same for FDII purposes as for GILTI purposes, discussed above). Finally, FDDEI is DEI that is derived in connection with (1) property that is sold by the taxpayer to any person that is not a United States person and is for foreign use or (2) services provided by the taxpayer to any person, or with respect to property, that is not located in the United States.
The provision is generally designed to provide an incentive for U.S. corporations to retain their intellectual property in the United States rather than to transfer it to a foreign affiliate, which will develop the intellectual property and license it to third parties. However, because the reduced 13.125% tax rate applicable to FDII is still not as low as the 10.5% rate applicable to GILTI, an incentive may still exist to develop intellectual property abroad rather than in the United States.
The deduction for FDII will decrease to 21.875% (and the effective tax rate on FDII will increase to 16.406%) for tax years beginning after December 31, 2025.
No tax-free distributions of intangibles by CFCs.
The Final Bill does not include the provision in the Senate bill that would have permitted a CFC to distribute intangible property to a corporate shareholder without recognizing gain (and therefore without causing its other United States shareholders to recognize gain). Accordingly, the distribution of appreciated intangible property by a CFC to a corporate shareholder will generally result in recognition of income by the United States shareholders of the CFC, as under current law.
“United States shareholder” to include any United States person that owns 10% or more of the value of a foreign corporation; downward attribution from a foreign person to a related U.S. person.
Under current law, a United States shareholder is defined as a United States person that owns more than 10% of the voting power of a foreign corporation. The Final Bill follows the Senate bill and will change the definition so that any U.S. person that owns shares worth 10% or more of the total value of all classes of stock of a foreign corporation will be a “United States shareholder” of that corporation required to include in income its share of the corporation’s subpart F income if that corporation were a CFC. This change represents a fundamental expansion of the CFC rules that have been in place since 1962. The provision is effective for tax years of foreign corporations beginning after December 31, 2017, and for tax years of U.S. shareholders with or within which the tax years of foreign corporation end.
The Final Bill provides for expanded downward attribution from a foreign person of its stock in a foreign corporation to a related U.S. person for purposes of determining whether the U.S. person is a United States shareholder and whether the foreign corporation is a CFC. A United States shareholder’s ratable share of a CFC’s subpart F inclusion will be determined without regard to this attribution.
The Final Bill also provides that certain transactions used to “de-control” a CFC are ineffective. This change is effective for the last tax year of foreign corporations beginning before January 1, 2018 and each subsequent year of the foreign corporation, and for the tax years of United States shareholders with or within which the tax years of foreign corporations end.
Retention of section 956 for all United States shareholders; look-through rule for related CFCs not made permanent.
The Final Senate bill retains section 956. Both the Senate bill and the House bill would have repealed section 956 with respect to United States shareholders that are C corporations.
Foreign base company oil-related income will be removed from the subpart F regime, withdrawals of excluded subpart F income from qualified shipping operations will no longer give rise to subpart F inclusions, and the amount of foreign base company income considered de minimis ($1 million in 2017) will be indexed for inflation.
The Final Bill does not make look-through rule for payments of dividends, interest and equivalents, rents, and royalties from one CFC to another CFC permanent. Both the House and Senate bills would have made the look-through rule permanent for tax years of foreign corporations beginning after December 31, 2019.
Proposals to prevent base erosion.
Base erosion minimum tax imposed on large C corporations.
The Final Bill follows the Senate bill and imposes a “base erosion anti-abuse tax” (or “BEAT”) equal to roughly the excess of 10% over the difference between a taxpayer’s actual tax liability over the tax liability it would have had if payments to foreign affiliates were not deductible, property purchased from foreign affiliates was not depreciable, and payments to foreign parents of inverted companies were not deductible. The Final Bill contains a transition rule (that was not in the Senate bill) that reduces the minimum tax to 5% for tax years beginning after December 31, 2017 and before January 1, 2019. The minimum tax increases from 10% to 12.5% in tax years beginning after December 31, 2025. The Final Bill increases the rates applicable to banks and securities dealers to 11% for tax years beginning after December 31, 2017 and 13.5% for tax years beginning after December 31, 2025.
Specifically, the Final Bill will require a corporate taxpayer to pay an amount equal to the excess of 10% of the taxpayer’s “modified taxable income” for the tax year over an amount of “regular tax liability,” subject to certain adjustments. “Modified taxable income” is defined as the taxpayer’s taxable income under chapter 1, determined without regard to any “base erosion tax benefit” or “payment” or the “base erosion percentage” of any allowable NOL deduction. “Base erosion payments” generally include amounts paid or accrued by a taxpayer to a related foreign party if the payment is either deductible or subject to the allowance for depreciation, any reduction in gross receipts due to a payment or accrual to a related surrogate foreign corporation or a member of its expanded affiliated group, and premium or other payments or accruals to a foreign related party with respect to reinsurance contracts. Related parties include a 25% owner of the taxpayer, any person related to the taxpayer or the 25% owner under the attribution rules of sections 267(b) and 707(b)(1), and any person related to the taxpayer for purposes of section 482. Additional reporting requirements will also be imposed.
Payments to related parties for services that satisfy the services cost method under the section 482 transfer-pricing rules and do not contain a markup component (whether or not contributing significantly to the fundamental risks of the business’s success or failure) as well as “qualified derivative payments” for mark-to-market taxpayers (subject to certain anti-abuse rules), are not considered base erosion payments.
The BEAT applies only to taxpayers that are corporations (other than a RIC, a REIT, or an S corporation) with average annual gross receipts equal to or exceeding $500 million, and only if at least 4% of the taxpayer’s deductions are related to payments to related foreign persons. The provision applies to U.S. corporations and also to foreign corporations engaged in a U.S. trade or business for purposes of determining the tax due on their effectively connected income (ECI).
Final Bill does not include the proposal to limit disproportionate net interest expense deductions for U.S. members of worldwide affiliated groups.
The Final Bill does not contain a provision in the Senate bill that would have limited net interest expense deductions with respect to indebtedness of a U.S. corporate member of a worldwide affiliated group based on the amount by which total U.S. group indebtedness exceeds 110% of the debt allocable to the U.S. group assuming all members had proportionate debt-to-equity ratios. The House bill contained a similar provision.
Changes to section 482 transfer-pricing rules with respect to intangibles.
The Final Bill follows the Senate bill and modifies the definition of intangible property for purposes of sections 367 (relevant to outbound restructurings) and 482 (intercompany transfer pricing) to explicitly include workforce in place, goodwill, and going concern value. The Final Bill will codify the “realistic alternative” principle adopted by the IRS in regulations for determining the arm’s length price for intangibles in an intercompany transaction and will authorize the IRS to require an aggregate method of valuing intangibles and appears to reverse the Tax Court’s recent decision in Amazon.com v. Commissioner, currently on appeal to the Ninth Circuit.
Denial of deductions for amounts paid or accrued to related parties that are hybrid entities.
The Final Bill adopts a provision in the Senate bill to disallow deductions for amounts of interest or royalties paid or accrued to a related party if the payment or accrual is either (1) not included in income under the tax law of the recipient’s country of residence, or (2) deductible by the recipient under the tax law of the recipient’s country of residence. (The House bill instead would have imposed a general 20% tax on deductible payments to related foreign entities, regardless of whether deductible in the recipient country). The Final Bill further instructs the Secretary to issue regulations or other guidance to apply the deduction limitation to domestic entities and foreign and domestic branches even if not meeting the statutory definition of a hybrid entity.
Dividends from surrogate foreign corporations not eligible for QDI treatment.
Under the Final Bill, dividends received by individual shareholders with respect to stock owned in “surrogate foreign corporations” will not be eligible for reduced tax rates applicable to “qualified dividend income” (generally, long-term capital gains rates if holding periods are satisfied). The restriction will only apply to corporations that first become surrogate foreign corporations after the date of enactment.
Changes to foreign tax credit system.
The Final Bill follows the Senate and House bills and repeals the deemed-paid credit on dividends received by a 10% U.S. corporate shareholder of a foreign corporation. Instead, a deemed-paid credit will be provided for any income inclusion under subpart F (but only to the extent properly attributable to the subpart F inclusion). Foreign branch income, which generally includes business profits allocable to a qualified business unit but excludes passive category income, will be allocated to its own foreign tax credit basket. The Final Bill provides that taxpayers may accelerate the recapture of unused overall domestic losses (incurred in any tax year beginning before January 1, 2018), which could then be offset with any unused foreign tax credits of the taxpayer.
Sources of income and expenses.
Source of inventory sales determined solely based on the location of production activities.
Under the Final Bill (as under the House and Senate bills), the determination of the source of income from inventory sales will be based solely on the location of production activities (and allocated among two or more jurisdictions, where appropriate).
No acceleration of effective date of worldwide interest allocation rules.
The Final Bill does not accelerate the worldwide interest allocation rules (and they will continue to go in effect after December 21, 2020). The Senate bill would have accelerated the rules to apply to tax years beginning after December 31, 2017.
Treatment of foreign insurance companies as PFICs unless loss, loss adjustment expenses, and reserves constitute 25% of total assets.
Under the Final Bill (which follows the House and Senate bills), the determination whether a foreign insurance company is a passive foreign investment company (PFIC) will be based on the company’s insurance liabilities. More specifically, a foreign insurance company will generally be treated as a PFIC unless (1) the foreign company would be taxed as an insurance company were it a U.S. corporation and (2) the company’s loss and loss adjustment expenses and certain reserves constitute more than 25% of the foreign corporation’s total assets as represented on the company’s GAAP (or equivalent) financial statements. The 25% threshold could be reduced to 10% in certain situations if a U.S. owner of the company so elects and the failure to reach the 25% threshold is due to circumstances specific to the insurance business.
Codification of Revenue Ruling 91-32; treatment of gain on the sale of an interest in a partnership that is engaged in a trade or business in the United States as income that is effectively connected with a U.S. trade or business.
The Final Bill generally follows the Senate bill and reverses the recent Tax Court decision in Grecian Magnesite Mining v. Commissioner, and effectively codifies Revenue Ruling 91-32, by treating gain or loss from the sale of an interest in a partnership is treated as income “effectively connected” with a U.S. trade or business to the extent attributable to a trade or business of the partnership in the United States. Specifically, the Final Bill will treat the sale of a partnership interest as a sale of all of the partnership’s assets for their fair market value as of that date, and determines the amount of effectively connected gain or loss allocable to the selling partner based on the amount that would be allocated to that partner in a hypothetical liquidation. The House bill did not contain a similar provision.
The Final Bill, like the Senate bill, requires the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that it is neither a nonresident alien nor a foreign corporation. The Final Bill additionally grants additional regulatory authority to the IRS (not contained in the Senate bill) to permit brokers to withhold the requisite tax as agent of the transferee. The provision generally applies for sales, exchanges, and dispositions on or after November 27, 2017, except for the withholding tax provisions, which are effective for sales, exchanges, and dispositions after December 31, 2017.
Nearly all individual changes to expire after December 31, 2025; ACA individual mandate repealed.
The Final Bill follows the Senate bill and provides that individuals lacking minimum health coverage mandated by the Affordable Care Act (ACA) will no longer be required to make shared responsibility contributions (commonly known as the “individual mandate”). This will effectively repeal the individual mandate, a central pillar of the ACA.
In addition, the Final Bill follows the Senate bill and generally provides that all proposed changes to individual taxation will sunset in tax years beginning after December 31, 2025. (This includes generally all provisions discussed in this section, Part III—Individuals, as well as the 20% qualified business income deduction discussed in Part I.) The exceptions to this general expiration are repeal of the ACA individual mandate, the denial of alimony deduction, and the transition to “chained CPI-U” for indexing inflation. The Final Bill adjusts the capital gain and ordinary income brackets for inflation based on chained CPI-U, a method generally thought to increase the brackets at a slower rate than currently and may shift taxpayers into higher brackets over time.
Seven-bracket structure retained with adjustments (10%; 12%; 22%; 24%; 32%; 35%; 37%)
The Final Bill largely follows the Senate bill and will retain a seven-bracket structure, as currently, adjusting the brackets and rates and reducing the top rate from 39.6% to 37%. Taxpayers currently in the 10% bracket will remain in the 10% bracket. The Final Bill also retains a separate rate structure for heads of household. A comparison of the proposed rate structures in the Final and Senate bills to current law is illustrated in the chart below.
The current maximum rates for net long-term capital gains (including qualified dividend income) will be retained, as will be the 25% rate applicable to unrecaptured section 1250 gain and the 28% rate on 28%-rate gain. The 3.8% surtax on net investment income (also known as the “Medicare tax”) is retained.
Increased standard deduction; repeal of personal exemptions.
The Final bill will increase the 2018 standard deduction from $6,500 to $12,000 for individuals, from $9,350 to $18,000 for heads of household, and from $13,000 to $24,000 for married couples, to be adjusted for inflation based on chained CPI-U starting in tax years after December 31, 2018. Like the House and Senate bills, the Final Bill repeals personal exemptions ($4,150 for each exemption in 2018 under current law). Taxpayers with gross income below the applicable standard deduction are not required to file U.S. federal income tax returns.
This increase in the standard deduction is expected to simplify tax filings for millions of low-and middle-income families. However, because the charitable deduction is available only for taxpayers who itemize, the increased standard deduction may tend to reduce charitable contributions.
Expanded child tax credit; new non-child dependent credit.
The Final Bill generally follows the Senate bill with respect to the child tax credit, which is increased to $2,000 per qualifying child from $1,000 under current law (subject to the sunset applicable to all individual provisions after 2025). The $2,000 amount is not indexed for inflation.
Under the Final Bill, the phase-out for the credit will begin at incomes equal to or exceeding $400,000 for married individuals filing jointly and $200,000 for single individuals, not quite as generous as the $500,000 threshold that would have applied to all taxpayers in the Senate bill, but considerably more generous than the thresholds under both current law ($115,000 for joint filers) and the House bill ($230,000, for joint filers). The Final Bill increases the refundable portion of the child tax credit to $1,400 (compared with $1,000 under current law and $1,100 under the Senate bill after inflation adjustment). The Final Bill also follows the Senate bill and provides a $500 nonrefundable credit for all non-child dependents.
Individual Alternative Minimum Tax (AMT) retained with increased exemption thresholds.
The Final Bill retains the individual AMT but increases the AMT exemption amounts to $109,400 from $78,750 for joint filers and to $70,300 from $50,600 for all other filers. The phase-out threshold is increased to $1,000,000 from $150,000 for joint filers and to $500,000 from $112,500 for all other filers.
Limitations, repeals, and other changes to individual itemized deductions.
Repeal of the “Pease” limitations on deductions.
The Final Bill (following the House and Senate bills) will repeal the Pease limitation on deductions, which under current law effectively amount to a 1.18% marginal tax (3% x 39.6%) for certain high-income taxpayers.
Increased charitable deduction.
Under current law, cash contributions to a public charity are deductible only to the extent of 50% of the taxpayer’s adjusted gross income (AGI). The Final Bill (as was the case for the Senate bill and House bill) will increase this limit to 60% of AGI.
Deduction for state and local income taxes repealed; deduction preserved for up to $10,000 of state and local income, property, and sales taxes paid.
The Final Bill generally follows the House and Senate bills in capping the deduction for state and local taxes paid at $10,000. However, while the House and Senate bills would have limited the deduction to state and local property taxes, the Final Bill will allow taxpayers to include state and local income and sales taxes, which, together with property taxes, will be subject to an aggregate $10,000 cap. Under the Final Bill, prepayments of 2018 state and local income taxes are not deductible. The Final Bill is silent on the effect of prepayment of property taxes. The loss of deduction for state and local income taxes will have the greatest impact on individuals living in high-tax states and municipalities, such as New York City and New York State, California, Massachusetts, and New Jersey. The same $10,000 cap applies to all individual filing statuses (including joint filers) and will not be indexed for inflation.
Taxes paid or accrued in carrying on a trade or business or section 212 activity (relating to the production of income) that are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F will continue to be deductible. (These taxes include real estate and personal property taxes on business assets, highway use taxes, licenses, regulatory fees, and similar items.) While state and local income taxes imposed on individual owners of a partnership or other pass-through business will not be deductible, it appears that, under the Final bill, entity-level taxes that are taken into account in determining a pass-through owner’s distributive share of pass-through income will continue to be deductible.
Temporary increase to medical expense deduction.
The Final Bill follows the Senate bill and will allow a deduction for unreimbursed medical expenses in excess of 7.5% of AGI for tax years beginning after December 31, 2016 and ending before January 1, 2019. For tax years beginning January 1, 2019 or later, the medical expense deduction is allowed to the extent such expenses exceed 10% of AGI, as under current law.
Home mortgage interest deduction limited to acquisition indebtedness of $750,000.
The Final Bill allows taxpayers to deduct home mortgage interest accrued on acquisition indebtedness of up to $750,000 (reduced from $1 million under current law). In the case of acquisition indebtedness incurred before December 15, 2017, and for taxable years beginning after December 31, 2025 (regardless of when the indebtedness was incurred), a taxpayer may treat up to $1 million as acquisition indebtedness. Refinancing indebtedness is generally treated as incurred on the date of the original indebtedness, except to the extent exceeding the amount of the original indebtedness.
The Final Bill repeals the deduction for interest on home equity indebtedness but preserves the deduction for interest on indebtedness used to acquire a second home (together with acquisition indebtedness on a principal residence, subject to an aggregate cap of $750,000). The House bill would have limited the deduction to interest on indebtedness used to purchase a principal residence.
Repeal of casualty and theft loss deduction except for presidential declared major disasters.
The Final Bill follows the Senate bill and generally repeals individual deductions for personal casualty and theft losses, with limited exceptions for certain officially recognized disasters.
Wagering loss limitation.
Under the Final Bill (as was the case under the Senate and House bills), deductions for wagering losses will only be allowed to the extent of wagering gains from the same tax year.
Repeal of miscellaneous itemized and other deductions.
The Final Bill follows the Senate bill and repeals miscellaneous itemized deductions subject to the 2% AGI floor under current law (e.g., deductions for the production or collection of income, unreimbursed expenses attributable to the trade or business of being an employee, repayments of income received under a claim of right, repayments of Social Security benefits, etc.). The deductions for tax preparation expenses and moving expenses are also repealed. However, the Final Bill does not change the current law deductions for interest on qualifying student loans and for certain eligible educator expenses.
No deduction for alimony payments; payments excluded from income of recipient.
The Final Bill generally follows the House bill and denies a deduction for alimony and maintenance payments, and excludes alimony payments from the recipient’s income. However, the Final Bill delays the effective date of the provision by one year to apply to any divorce or separation instrument executed after December 31, 2019, or any divorce or separation agreement executed on or before December 31, 2018 and modified after that date, if the modification expressly provides that the Final Bill applies to the modification. Unlike the other changes to individual tax provisions, the loss of alimony deduction does not sunset after 2025.
Self-created property not treated as a capital asset.
The Final Bill adopts the House bill’s provision and denies capital gain treatment to a patent, invention, copyright, model, or design that is held by the taxpayer who credited the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property.
No change to income exclusion for sale of a personal residence, discounted tuition benefits; moving expense deduction repealed.
The Final Bill does not include a provision in the House and Senate bills that would have limited the exclusion of gain on sale of a personal residence to individuals who have owned and used the residence as a principal residence for at least 5 of the 8 years preceding the sale (compared with a 2-year use and ownership requirement under current law)).
The Final Bill repeals the exclusions from income under current law for qualified moving expense reimbursements other than for members of the U.S. Armed Forces. However, the Final Bill does not contain a provision in the House bill that would have required university employees and their families receiving free or discounted tuition to include the amount of this discount in gross income.
Estate and generation-skipping transfer taxes retained with increased exemption amount.
The Final Bill follows the Senate bill and retains the estate tax but doubles the estate and gift tax exemption amounts from $5 million per person under current law to $10 million (approximately $11.2 million in 2018 when indexed for inflation). The income tax basis of inherited property will continue to be stepped up to fair market value at death, as under current law. The increased exemption amount applies to estates of individuals whose deaths occur after December 31, 2017 and to generation-skipping transfers and gifts made after this same date.
Roth re-characterizations disallowed.
The Final Bill follows the House bill and the Senate bill by eliminating the ability of an individual to recharacterize a traditional IRA contribution as a Roth IRA contribution (which, under current law, is permitted for a limited period of time after the contribution is made). However, the Final Bill differs from the House bill and the Senate bill by continuing to allow an individual’s contribution for a year that was initially characterized as a Roth IRA to be recharacterized prior to the due date for the individual’s tax return for that year as a traditional IRA contribution.
IV. Employee benefits and executive compensation.
Loss of deduction for performance pay over $1 million.
The Final Bill, like the House bill and the Senate bill, amends section 162(m), which under current law imposes a $1 million limit on the annual compensation deduction for any “covered employee,” in several significant ways. First, the Final bill will eliminate the exemption for “performance-based” compensation currently relied upon by a majority of publicly held corporations paying executive officers annual compensation exceeding $1 million.
Second, the Final bill modifies the definition of “covered employee” to include a company’s principal executive officer and principal financial officers at any time during the tax year, as well as the company’s three highest-paid employees (excluding the principal executive officer and principal financial officer). An individual who becomes a covered employee for any taxable year beginning after December 31, 2016 would continue to be a covered employee in subsequent years, even if the individual is no longer an employee of the company or is deceased.
Third, the Final bill will expand the number of corporations subject to the limitation to include all domestic publicly traded corporations and all foreign companies publicly traded as American depository receipts (ADRs).
The Final Bill, like the Senate bill, will provide transition relief by grandfathering remuneration paid under a written, binding contract in effect on November 2, 2017, provided that the contract has not been materially modified since that time.
21% excise tax on excessive compensation paid by tax-exempt organizations.
The Final Bill imposes a 21% excise tax on any compensation paid by most exempt organizations to their five highest paid employees in any given year (“covered employees”) to the extent exceeding $1 million for the year, which is similar to the House bill and Senate bill. (The House Senate bills proposed a 20% excise tax rate; the Final Bill adjusts the rate to 21%, presumably to align with the 21% corporate tax rate in the Final Bill.) An individual who becomes a covered employee for any taxable year beginning after December 31, 2016 will continue to be a covered employee in subsequent years. Compensation for this purpose includes all cash and non-cash remuneration (including most benefits other than designated Roth contributions) as well as payments from persons or organizations related to the employer. The Final Bill provides that for this purpose, compensation is treated as paid when it is no longer subject to a substantial risk of forfeiture (within the meaning of section 457(f)). Unlike the House bill and Senate bill, the Final Bill provides that amounts that are paid to a licensed medical professional (including a veterinarian) for the performance of medical or veterinary services is not treated as compensation for purposes of determining the excise tax.
Certain severance “excess parachute payments” to covered employees will also be subject to the 21% excise tax. This applies to compensation payments that are contingent on a covered employee’s separation from employment. If the parachute payments equal or exceed three times the employee’s “base amount,” then the 21% excise tax will apply to the portion of the parachute payments that are in excess of the employee’s base amount. For this purpose, the “base amount” is determined by applying the current rules of section 280G, which generally provide that a covered employee’s base amount is the individual’s average annual taxable income from the organization over the five-year period immediately preceding the year in which the separation from service occurs (or any shorter period of service with the organization if less than five years). Notably, the Final Bill differs from both the House bill and the Senate bill by providing that a parachute payment does include any payment to either (1) a licensed medical professional (including a veterinarian) to the extent that such payment is for the performance of medical or veterinary services or (ii) an individual who is not a highly compensated employee as defined in section 414(q) (generally, an employee who receives annual compensation over $120,000 (as of 2018, subject to annual adjustment)).
New 5-year deferral election for certain forms of equity compensation.
The Final Bill contains a provision, similar to that in the House bill, allowing “qualified employees” to make an elective 5-year deferral on income inclusion for equity compensation in the form of restricted stock units and stock options issued by private companies whose stock is not readily tradable and which have a written plan under which, in an applicable calendar year, at least 80% of U.S. employees are granted equity compensation with the same rights and privileges. Generally, an individual will not be a “qualified employee,” and will instead be an “excluded employee,” if the individual is a 1% owner of the corporation at any time during the calendar year or at any time during the last 10 calendar years, is or was the CEO or CFO (or certain family members), or is one of the four highest paid officers of the corporation at any time during the tax year or for any of the last 10 tax years. The election to defer would have to be made within 30 days of the employee’s right to stock becoming substantially vested or transferable, whichever is earlier, and would be made in a manner similar to an 83(b) election. Under the Senate bill, if a qualified employee makes an election to defer income inclusion on a restricted stock unit or stock option, earlier income inclusion would still be required if certain events occur (e.g., the stock becomes transferable, the individual becomes an “excluded employee,” or the company has an IPO).
Limitation on deductions associated with fringe benefits and entertainment expenses.
The Final Bill, like the House and Senate bills, generally disallows deductions with respect to entertainment and recreation activities, membership dues, and facilities used in connection with recreation or membership activities even if directly related to the active conduct of the taxpayer’s trade or business. Deductions for expenses associated with providing any qualified transportation fringe or commuter transportation would generally be disallowed.
The Final Bill follows the Senate bill and limits the deduction for certain meals provided to employees for the convenience of the employer to 50% of the expenses incurred. The Final Bill, like the Senate bill, will disallow the deduction entirely in tax years beginning after December 31, 2025.
V. Miscellaneous provisions.
Acceleration of accruals to conform with financial accounting.
The Final Bill follows the Senate bill and deems the “all events test” to be satisfied with respect to an item when it is taken into account for financial accounting purposes on an audited financial statement (or similar statement as provided in regulations). Certain long-term contract income will not be subject to this rule. Taxpayers may continue to defer recognition of income associated with certain advance payment contracts as currently provided in Revenue Procedure 2004-34.
It appears that this provision as drafted requires a mark-to-market taxpayer to include in income marked gains, but not marked losses, no later than the period in which they are taken into account for financial accounting purposes, although there is no evidence of whether Conference Committee intends this result or not.
Proposal to require FIFO method for determining basis in securities sold or exchanged removed from Final Bill; investors may continue to identify specific shares to sell or give.
The Final Bill preserves current law for determining a taxpayer’s cost basis in securities and does not adopt the Senate bill’s proposal to mandate “first in, first out” (FIFO) for sales and gifts of securities.
Limitation on deduction for FDIC premiums.
Under the Final Bill, deductions for FDIC premiums paid by financial institutions with total consolidated assets worth $10 billion or more will be reduced by an increasing percentage based on the amount of total consolidated assets, with 100% of the deduction being disallowed for financial institutions with assets worth $50 billion or more. (Under current law, FDIC premiums are generally fully deductible as ordinary and necessary business expenses.) The provision was in both the House and Senate bills.
Eligible beneficiaries of electing small business trusts to include nonresident aliens.
Under the Final Bill, like the Senate bill (but not the House bill), a nonresident alien will be eligible to be a potential current beneficiary of an electing small business trust (“ESBT”). While a nonresident alien is not permitted to hold an interest in an S corporation directly under current law, an ESBT can be a shareholder of an S corporation. Thus this change may allow nonresident aliens to hold indirect interests in S corporations.
The Final Bill also follows the Senate Bill and clarifies that the limits for charitable contributions applicable to individuals (including, for example, limits on percentage of income and carry forwards of deductions) apply to ESBTs.
VI. Tax-exempt organizations.
Excise tax on large private colleges and universities.
The Final Bill generally follows the Senate bill and imposes a 1.4% excise tax on the net investment income of private tax-exempt colleges and universities with at least 500 full-time, tuition-paying students and assets with an aggregate fair market value of at least $500,000 per student (excluding those assets used directly for purposes of educating students). The Final Bill limits the excise tax to include only institutions more than 50% of the tuition-paying students of which are located in the United States. The House bill would have set the per-student value threshold at $250,000 rather than $500,000.
No imposition of UBTI on “super tax exempts.”
The Final Bill does not contain the provision in the House bill that would have imposed the tax on “unrelated business taxable income” (“UBTI”) on state organizations that earn income described in section 115 (describing exclusion from tax for income derived from the exercise of an essential government function).
Separate netting required for unrelated trade or business activities.
The Final Bill follows the Senate bill and also will require the computation of UBTI separately for each unrelated trade or business of the organization. (Under current law, income from all of an exempt organization’s unrelated trade or business activities is calculated on an aggregate basis.) This change will prevent a tax-exempt organization from using expenses related to one trade or business to offset UBTI generated from another trade or business. Net operating losses will be able to be deducted only against income from the specific trade or business from which the losses arose.
Repeal of exemption for advanced refunding bonds; exemption for private activity bonds retained.
The Final Bill follows both bills and ends the tax exemption for interest earned on “advanced refunding bonds,” which under current law are used to refinance tax-exempt bonds issued by state and local governments and certain charitable activities of section 501(c)(3) organizations. The repeal will apply to advanced refunding bonds issued after December 31, 2017.
The Final Bill does not, however, repeal the exemption for interest earned on private activity bonds, as had been proposed in the House bill.
The Final Bill also continues to permit exemption for interest earned on bonds the proceeds of which are used to finance or refinance professional sports stadiums. The House bill had proposed to repeal the exemption for these bonds.
No change to the excise tax on private foundations.
The Final Bill does not change the 1% or 2% excise tax on private foundations. The House Bill would have replaced the two rates with a single rate of 1.4%.
Johnson Amendment retained.
The Final Bill does not alter the “Johnson Amendment” that prohibits section 501(c)(3) charities from engaging in certain political or campaign activities.
Exception to private foundation excess business holdings rules for philanthropic businesses removed in the Final Bill.
Under current law, a 5% excise tax is imposed on the value of certain “excess business holdings” held by a private foundation if not disposed of within a set period. This tax may increase to 200% if the 5% tax is imposed on a private foundation and the foundation does not dispose of the excess business holdings within the applicable tax year. The House bill would have exempted certain philanthropic business holdings from this tax if the following requirements are satisfied: (1) the private foundation acquires the business under a will or testamentary trust and owns 100% of the interests in the business at all times in the relevant tax year; (2) the business distributes an amount equal to its net operating income to the private foundation within 120 days of the close of the tax year; and (3) the business and private foundation are independently operated. The Final Bill does not include this provision.