The House of Representatives released the initial draft of its tax reform bill, the Tax Cuts and Jobs Act (TCJA), on Thursday. The bill now heads to markup by the Ways and Means Committee next week. Speaker Paul Ryan indicated he expects the full House to hold a vote on the bill the week of Nov. 13. If it passes, it would then head to the Senate where the Senate Finance Committee is already drafting its own tax reform bill. Despite the optimistic timeline, expect this to be a contentious process as many provisions and revenue raisers will be fiercely debated.
The budget reconciliation recently passed by both houses of Congress allows for $1.5 trillion in tax revenue losses over the next 10 years. However, under budget rules, all cuts that increase the deficit must sunset after 10 years. This is similar to the Bush tax cuts that previously expired in 2012. However, while the deficit can increase by $1.5 trillion under the budget resolution, revenue losses under the framework have been projected to be at least $4 trillion. Therefore, tax writers continue to debate how to bridge the revenue loss. Potential “pay-fors” include:
- eliminating deductions for state and local (income) taxes and many other itemized deductions
- repealing personal exemptions
- using repatriation taxes to fund tax cuts rather than infrastructure improvements
- phasing out the estate tax by 2023
In this alert, we compare certain provisions in the TCJA and the tax reform framework announced a few weeks ago. An extensive analysis is included in our annual year-end tax letter which will be issued in the coming days. Unless otherwise noted, these changes are proposed to take effect in 2018.
Rates. The framework provided for a 20 percent corporate tax rate. The TCJA reduces the current corporate rate to 20 percent from 35 percent. The corporate alternative minimum tax (AMT) would be repealed as part of the rate reduction package.
A reduced rate of 25 percent will apply to pass-through business entities, which include partnerships, S corporations and sole proprietorships, albeit with restrictions. The limitations are aimed at preventing abuse of the 25 percent rate -- such as high-earning individuals forming themselves into corporations to get a tax cut.
Professional services, including doctors, lawyers, accountants and others, generally will not qualify for the reduced rate.
Other business owners could choose one of two options:
- Classify 70 percent of their income as wages (taxed at their individual tax rate) -- with 30 percent as business income, taxable at the 25 percent rate.
- Set the ratio of their wage income to business income based on the level of their capital investment.
Repatriation of foreign earnings. An estimated $2.6 trillion in corporate profits is currently parked abroad to avoid the U.S. corporate income tax. The TCJA imposes a one-time tax of 12 percent on U.S. companies’ accumulated offshore earnings that are held as cash — and 5 percent for noncash holdings. The tax can be remitted over eight years and will be recognized on a corporation’s first tax return for tax years beginning before 2018.
Business expensing. Businesses would be able to fully expense qualified property (tangible personal property with a recovery period of 20 years or less) acquired after Sept. 27, 2017, and before Jan. 1, 2023. In addition, the small business expensing provision under section 179 would be increased to $5 million and the phase-out amount would be increased to $20 million. The increased section 179 provision would be applicable to tax years beginning after 2017 and before 2023.
Business interest. Interest deductions for every business, regardless of entity form, would be subject to disallowance for net interest expense in excess of 30 percent of the business’s adjusted taxable income. Adjusted taxable income is a business’s taxable income computed without regard to business interest expense, business interest income, net operating losses, and depreciation, amortization, and depletion. For pass-through entities, the disallowance would be determined at the entity level rather than the partner or shareholder level. This rule will not apply to small businesses with average gross receipts of less than $25 million.
Like-kind exchanges. Like-kind exchanges would generally be repealed after 2017. However, exchanges of real property could still qualify.
Rates. The framework would replace the current seven-bracket system with three rates of 12, 25 and 35 percent. The TCJA includes four individual income tax brackets, with the top bracket remaining at 39.6 percent but increasing the applicable income level to $1 million, up from $418,400 for single filers and $470,700 for joint filers. The individual AMT would be repealed.
Home mortgage interest. The bill maintains the mortgage interest deduction in its current form, but only for existing mortgages. It reduces the deduction for new mortgages to $500,000 from the current $1 million principal cap. For this purpose, a new mortgage is one entered into or refinanced after Nov. 2, 2017.
Deductions for state and local taxes. Deductions for most state and local taxes are generally eliminated. However, the TCJA allows a deduction of up to $10,000 for property taxes.
Other individual itemized deductions. With the exception of charitable donations, all other itemized deductions, including deductions for medical care, would be repealed.
Alimony. Alimony payments would no longer be deductible by the payor or included in the income of the recipient. This repeal would apply to any divorce or separation decree executed after 2017 as well as any modification to an existing agreement made after 2017.
Retirement accounts. Changes to the deductibility of contributions to retirement plans, such as 401(k)s, were widely expected. The bill makes no changes to the current deductibility rules. However, changes could be made during markup or in the Senate version of the bill.
Exclusion for gain on sale of a principal residence. The $500,000 exclusion would be retained but modified. The exclusions would be phased out by one dollar for every dollar that a taxpayer’s average modified AGI for a three-year period (including the year of the sale) exceeds $500,000 ($250,000 for single filers). Further, to qualify for the gain exclusion, the residence has to be the taxpayer’s principal residence for five out of eight years, compared to two out of five under current law.
Estate taxes. The basic $5 million exemption amount is doubled, effective in 2018. Further, the estate tax will be eliminated beginning after 2023 while the beneficiaries’ step-up in basis would be maintained.
In summary, this bill should be viewed as a starting point for negotiations, not a final product. Significant differences exist between the Senate and House on the shape of reform as well as the methods to raise revenue to fund the rate reductions. In addition, numerous members of Congress remain resistant to allowing the deficit to increase by any amount.
For related insights and in-depth analysis, see our Tax Reform Resource Center.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.