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House Republicans released their long-awaited tax reform bill which will affect individual income tax rates, as well as business income tax rates.

House Republicans Release Tax Reform Bill

On Thursday, November 2, the House Republicans released their long-awaited tax reform bill, entitled the “Tax Cuts and Jobs Act.”  429 pages in length, the bill’s release is the first step in a multi-step process. Between now and the enactment of any final tax reform bill into law, many changes, some no doubt quite significant, will be made to this legislation. 

Following are brief highlights of this bill.  EisnerAmper will shortly issue a more comprehensive summary.  And, we will continue to keep you informed of future developments with respect to the current tax reform initiative.

Individual Provisions

  •  The current seven tax brackets would be consolidated into four brackets of 12%, 25%, 35% and 39.6%.  For married taxpayers filing jointly, the 39.6% bracket threshold would be $1,000,000; in the case of unmarried individuals, it would be $500,000.
  • Personal exemptions would be eliminated and consolidated into a larger standard deduction --$24,000 for married taxpayers filing jointly and $12,000 for single filers. 
  • Most itemized deductions would be repealed, except for charitable contributions, up to $10,000 of state and local real property taxes and certain mortgage interest.  The deduction for interest on existing mortgages would continue, but for debt incurred after November 2, 2017, interest paid on only $500,000 of principal residence mortgage debt would be deductible.  Amongst the deductions repealed would be: state and local income or sales taxes, personal casualty losses, wagering losses, tax preparation expenses, medical expenses, alimony payments, moving expenses, contributions to medical savings accounts and expenses attributable to the trade or business of being an employee.
  • The bill would not change the current treatment of “carried interests.”
  • Pre-tax contribution levels for retirement accounts, such as a tax-deferred 401(k) account, would be retained.  
  • The individual alternative minimum tax would be repealed. 
  • The child care credit would be increased to $1,600 per child under 17; alternatively, a credit of $300 would be allowed for non-child dependents.  A family flexibility credit of $300 would be allowed with respect to a taxpayer (each spouse in the case of a joint return) who is neither a child nor a non-child dependent.  The refundable portion of the child credit would be limited to $1,000.  The family flexibility credit and the non-child dependent credit would be effective for taxable years ending before January 1, 2023.
  • The many existing provisions on education incentives would be consolidated and simplified.  Certain deductions and exclusions would be repealed.
  • The estate tax would be phased out over six years.  The “basic exclusion amount” would be doubled from $5 million (as of 2011) to $10 million, which is indexed for inflation ($10.98 million for 2017).  Beginning after 2023, the estate and generation-skipping tax would be repealed while maintaining a beneficiary’s step-up basis in estate property. 
  • Beginning in 2024, the gift tax is lowered to a top rate of 35% and retains a basic exclusion amount of $10 million and an annual exclusion of $14,000 (as of 2017), indexed for inflation.

Business Provisions

  • The corporate tax rate would be a flat 20%.  Personal service corporations would be subject to a flat 25% rate. 
  • The corporate alternative minimum tax would be repealed.
  • A portion of net income distributed by a pass-through entity (i.e., sole proprietorship, partnership, limited liability company (LLC) taxed as a partnership or S corporation) to an owner or shareholder may be treated as “business income” subject to a maximum rate of 25%, instead of ordinary individual income tax rates.  The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary individual income tax rates.  Rules are provided to determine the proportion of business income and to prevent the recharacterization of actual wages paid as business income.  Net income derived from a passive business activity would be treated as business income and fully eligible for the 25% maximum rate.  Under certain default rules, owners or shareholders receiving net income derived from an active business activity (including wages received) would treat 70% of business income as ordinary income and 30% as business income eligible for the 25% rate; alternatively, such owners or shareholders may elect to apply a specified formula based on the business’s capital investments to determine an allocation greater than 30%.  Certain personal services businesses, such as law firms and accounting firms, would generally not be eligible for the reduced 25% rate on business income with respect to such personal services business, though they would be allowed to use the alternative formula based on the business’s capital investments, subject to certain limitations.
  • Businesses would be allowed to fully and immediately expense the cost of qualified property (not including structures) acquired and placed in service after September 27, 2017 and before January 1, 2023. 
  • “Section 179” small business expensing limitations would be increased to $5 million and the phase-out amount would be increased to $20 million, effective for tax years beginning after 2017 and before 2023.  These amounts would be indexed for inflation.  The definition of qualifying property would be expanded, effective for certain property acquired and placed in service after November 2, 2017. 
  • Businesses would have greater access to the cash method of accounting, including certain circumstances where a business has inventories. 
  • Every business, regardless of form, would be subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income.  The net interest expense disallowance would be determined at the tax filer level, e.g., at the partnership level rather than the partner level.  An exemption from this rule would be provided for small business with average gross receipts of $25 million or less.  Also, this provision would not apply to a real property trade or business.
  • The special rule under existing law allowing deferral of gain on like-kind exchanges would be modified to allow for like-kind exchanges only with respect to real property.
  • Numerous corporate deductions and credits would be repealed.  For example, the deduction for income attributable to domestic production activities would be repealed.  However, the research and development tax credit and the low-income housing credit would be retained.

International Provisions

  • The bill proposes significant changes to the taxation of business income earned outside the U.S. – including moving away from a deferral system to a “territorial” system.
  • It introduces a “participation exemption” system to the U.S. for the taxation of foreign income (similar to many European countries) whereby 100% of the foreign-sourced portion of dividends received from 10% or more owned foreign corporations would be exempt from U.S. tax.  No foreign tax credit would be allowed on any dividend qualifying for the participation exemption.
  • As a transition to this new system, the bill would deem a repatriation of previously deferred foreign earnings.
  • A current U.S. tax would be imposed on deferred earnings and profits of foreign corporations owned by 10% or greater U.S. shareholders. The rate would be 12% on earnings and profits (E&P) comprising cash or cash equivalents and 5% on the remaining E&P that has been reinvested in a foreign corporation’s business (e.g., property, plant and equipment).  An election is available to pay the tax in equal installments over a period of up to eight years.  Foreign tax credits would be partially available to offset the tax. 
  • If foreign E&P is taxed on transition to the participation exemption, the E&P can then be repatriated tax-free to the U.S. – subject to possible foreign withholding tax.
  • To address “base erosion,” a U.S. parent of one or more foreign subsidiaries would be subject to the 20% U.S. corporate tax rate on 50% of the U.S. parent’s “foreign high returns” (i.e., a 10% tax).  High returns would be measured as the excess of the subsidiaries’ income over a routine return (7% plus the federal short-term rate) on the subsidiaries’ bases in tangible property, adjusted downward for interest expense.
  • The deductible net interest expense of a U.S. corporation that is a member of an international financial reporting group would be limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s global earnings before interest, taxes, depreciation and amortization (EBIDTA).
  • Payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible in the basis of a depreciable or amortizable asset would be subject to a 20% excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a U.S. trade or business.
  • There are also a number of other potentially impactful international tax provisions included in the bill that we will discuss in more detail in future commentary. 

Please note:  As this alert was going to press, Chairman Brady of the House Ways and Means Committee released an “Amendment in the Nature of a Substitute” of his comprehensive tax reform legislation.  This alert reflects the bill as originally drafted.  Mark-up of the bill will begin on Monday, November 6, with the Chairman’s hope that a bill will be approved by the full House prior to the Thanksgiving recess.

 

Richard Shapiro, Tax Director and member of EisnerAmper’s Financial Services and Corporate Tax Groups, has more than 40 years’ experience in federal income taxation, including the taxation of financial instruments and transactions, both domestic and international, corporate taxation and mergers and acquisitions.

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