Authored by Mary Miske
The House of Representatives released the initial draft of its tax reform bill, the Tax Cuts and Jobs Act (TCJA), on Thursday, Nov. 2, 2017. There are various provisions of the TCJA that may be of interest to depository and lending institutions. Unless otherwise noted, these changes are proposed to take effect in 2018. Note that the bill now heads to mark up by the Ways and Means Committee, so changes to the provisions are likely.
Business provisions of interest
The TCJA reduces the current corporate rate to 20 percent from 35 percent.
Pass-through tax rate
A reduced rate of 25 percent will apply to pass-through businesses 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 providers, 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. That ratio would be based on the federal short-term rate plus 7 percent multiplied by the capital investment in the business. The asset balance/capital investment would be the taxpayer’s adjusted basis of property used in the business as of the end of the year. For this purpose, bonus depreciation and section 179 expensing would be disregarded.
Note that the default capital percentage for owners of the above-mentioned professional services firms under the second option above is zero. However, the TCJA would allow these owners to use an alternative capital percentage relative to the business’s capital investments, subject to certain limitations.
Alternative minimum tax (AMT)
The corporate AMT would be repealed as part of the rate reduction package. The AMT credit carryforward from prior years could be claimed as a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2019 through 2021 with the remainder deductible in 2022.
Net operating losses (NOLs)
Taxpayers would only be able to deduct an NOL carryforward or carryback in an amount equal to 90 percent of taxable income, effectively adopting the AMT rule under current law. The carryforward period would also be extended to an indefinite period from twenty years, and the carryback option is eliminated with few exceptions.
The deduction for amounts paid by insured depository institutions pursuant to an assessment by the Federal Deposit Insurance Corporation (FDIC) to support the Deposit Insurance Fund would be limited for institutions with consolidated assets in excess of $10 billion and eliminated for institutions with consolidated assets in excess of $50 billion.
Private activity bond reforms
The proposal would repeal the tax-exempt status for qualified activity bonds and terminate the qualified bond classifications.
Tax credit bonds
The proposal would repeal tax credit bonds.
Business net interest expense
Interest expense deductions 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 (NOLs), 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. Since banks generally have net interest income v. net interest expense, this provision is unlikely to apply to a bank. However, it should be noted that this rule applies on an entity by entity level and could apply to the non-bank members of the consolidated group who have interest expense.
Qualified property and Sec. 179 expensing
Businesses would be able to fully expense qualified property (tangible personal property with a recovery period of 20 years or less) acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023. In addition, the small business expensing provision under IRC 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.
Tax-deferral via like-kind exchanges after 2017 would only be available for exchanges of real property. Transition relief would be available for personal property exchanges in which the taxpayer either disposed of the relinquished property or acquired the replacement property on or before Dec. 31, 2017.
Deduction for excessive employee remuneration
The $1 million yearly limit on the deduction for compensation with respect to a covered employee of a publicly traded corporation would be modified to repeal the exceptions for commissions and performance-based compensation. “Covered employees” would include the CEO, CFO and the three highest paid employees. Once an employee qualifies as a covered employee, the deduction limitation would apply to that person so long as the corporation pays remuneration to that person (or to any beneficiaries).
Low income housing credit
The low income housing credit is preserved under the current proposal.
Tax credits being repealed
Various business tax credits would be repealed, including:
- New market tax credits: No new credits would be allotted after 2017. However, credits that have already been allocated may be used over the course of seven years.
- Employer-provided child care credit
- Rehabilitation credit: Under a transition rule, the credit would continue to apply to expenditures during a 24 month period selected by the taxpayer. That period would have to begin within 180 days after Jan. 1, 2018.
- Work opportunity credit
Expense deduction limitations
Entertainment expenses will no longer be deductible. In addition, no deduction for transportation fringe benefits or other amenities will be allowed. Only food and beverages, as well as qualifying business meals will be deductible, subject to a 50 percent limitation.
Selected non-business provisions of interest
Limitations on nonqualified deferred compensation
Employees would be taxed on compensation as soon as there is no substantial risk of forfeiture, defined to include only future performance of substantial services. Substantial risk of forfeiture would not include non-compete covenants or conditions that do not relate to future performance of services. This provision would generally be effective for amounts attributable to services performed after 2017. However, existing plans based on pre-2018 service would be grandfathered until the last tax year beginning before 2026.
Employee achievement awards
The bill would repeal the exclusion from income for employee achievement awards.
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.
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 if the principal amount of the new debt exceeds the principal amount of the debt that is being refinanced. If a taxpayer has a binding contract in effect before Nov. 2, that debt will be treated as incurred before that date and eligible for the $1 million cap. Interest arising from mortgages on secondary residences and home equity lines of credit would no longer be deductible.
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.
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.
Note that there are likely to be changes to the tax reform provisions in the coming weeks. We recommend speaking with your Baker Tilly tax advisor to understand how the changes may impact your organization. Our team will continue to follow the changes to the tax reform package and keep our clients updated.
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.