Authored by Patrick Balthazor, Paul Dillon, Michelle Hobbs and Mike Schiavo
Last week, the Senate passed its own version of the Tax Cuts and Jobs Act (TCJA), its tax reform bill with the same name as the House’s version. The Senate significantly modified the bill approved by the Senate Finance Committee prior to Thanksgiving. This alert will focus on the key changes.
In part, these changes were the result of the need to raise revenue in order to meet Senate budget rules as well as responding to pushback by several “deficit hawks,” who are concerned with the bill adding $1.5 trillion to the deficit over the next 10 years. Even with amendments, the Joint Committee on Taxation estimates the TCJA will cost $1.45 trillion over a decade based on “static scoring,” which does not account for the bill’s estimated economic impact. Taking that into consideration, the “dynamic scoring” estimates the bill will cost $1 trillion over the next 10 years.
Tax rate for pass-through business entities. The original Senate bill included a 17.4 percent deduction for pass-through businesses. Amendments on the Senate floor increased that deduction to 23 percent. The House version does not contain a similar deduction; instead, it applies a complex formula to determine the percentage of pass-through business income subject to lower rates. While the Senate version may be easier to administer, there is no indication the House will agree to this approach.
Be aware the Senate version is not an outright 23 percent deduction. Rather, the deduction is the lesser of 23 percent of 1) qualified income of the pass-through business, or 2) 50 percent of the W-2 wages with respect to the qualified trade or business. This is similar to the wage limitation used in the Internal Revenue Code section 199 domestic production activities deduction (which would be repealed in both versions of the TCJA).
Retention of the alternative minimum tax (AMT). Among the most significant changes is the retention of both the individual and corporate AMT — each of which would have been repealed under the original bill.
- The individual AMT exemption amounts would be increased to $109,400 from the 2017 amount of $84,500 for joint filers and surviving spouses, and to $70,300 from the 2017 amount of $54,300 for unmarried individuals.
- The alternative minimum taxable income amounts at which the aforementioned exemptions phaseout for individuals would be increased to $208,400 from the 2017 amount of $160,900 for joint filers and surviving spouses, and to $156,300 from the 2017 amount of $120,700 for all other taxpayers. These thresholds would be indexed for inflation.
- Corporate AMT would remain. The Senate tax bill would preserve the existing 20 percent corporate AMT rate. Retaining the AMT could prevent companies from making use of planned tax breaks related to intellectual property, spending on new equipment and research and development. The AMT may fall hardest on technology and utilities companies.
Repatriation of foreign earnings. Last-minute changes were made to the repatriation rates to help pay for the rate reduction for pass-through businesses. The Senate bill’s rates on the deemed repatriation of offshore accumulated earnings is now closely in line with the House bill’s: 14.5 percent for earnings held as cash and 7.5 percent for other earnings. The House bill calls for rates of 14 and 7 percent, respectively.
Business interest. Both the House and Senate generally restrict the ability to deduct business interest to 30 percent of income. The Senate added a provision that mirrors the House to provide an exception to the limitation for “floor plan” interest, generally paid by automobile dealers and similar businesses. Under the Senate amendment, these businesses would be allowed a full deduction of interest expense related to “floor plan financing indebtedness.” However, the 100 percent expensing of assets would not be allowed to any business with floor plan financing debt that takes the full interest expense deduction.
State and local tax (SALT) deduction. The Senate added an amendment to allow individuals an itemized deduction of up to $10,000 for state and local property taxes, mirroring the provision included in the House bill. The retention of the property tax deduction is doubtful to benefit a substantial portion of homeowners since the loss of the state income tax deduction will make it unlikely they will be able to itemize deductions.
Medical expense deductions. Another amendment would allow individuals to deduct medical expenses in 2017 and 2018 if the expenses exceed 7.5 percent of adjusted gross income (AGI). Under current law, those expenses are deductible once they exceed 10 percent of AGI.
Private activity bonds. The Senate proposes retaining the private activity bond tax exemption, used by universities, hospitals and lower-income housing, as well as advanced refunds, which comprises about 20 percent of issuance. However, the House version would eliminate this tax exemption. If enacted, this could lead to higher borrowing costs for municipal issuers and increase the strain on local budgets. While no changes were made to this provision during Senate debate, expect intense lobbying on this issue from both local governments and tax-exempt organizations during the reconciliation process.
- Pass-through entity form changes. Numerous questions have arisen on whether pass-through businesses should convert to C corporations to take advantage of the lower corporate rate as well as the ability to retain the deduction for state and local income taxes. Analysis of this question greatly depends on a business’s facts and circumstances, including how the tax structure is expected to evolve over time. While final enactment of tax reform is still far from certain, the tax rate for pass-through businesses is even more uncertain. The approaches for pass-through entities are considerably different between the Senate and House versions, so any analysis should be continually revised as negotiations proceed. In addition, keep in mind that this tax reform creates an estimated $1.5 trillion deficit over 10 years. While the corporate rate reduction is described as “permanent,” should control of Congress and/or the White House change in the short term, it is possible the corporate rate and other rules may also change. Evaluation of entity form changes should include these factors.
- Tax rates for pass-through businesses. Both the House and Senate versions have relatively complex proposals to attempt to equalize the effective tax rate for business income between corporations and pass-through entities. Service businesses, such as law and accounting firms and medical practices, generally are not eligible for more preferential treatment. However, there are exceptions based on a taxpayer’s AGI. Once the House and Senate agree on an approach, tax planning should focus on the ability to take advantage of these provisions while understanding the restrictions.
- Business interest expense deduction limitation. Both versions of the TCJA limit the amount of business interest deduction to 30 percent of entity-level adjusted taxable income. Entities with less than $25 million (House) or $15 million (Senate) in average gross receipts would be exempt from this limit. Under the Senate bill, disallowed amounts could be carried forward indefinitely, while the House bill has a five-year carryforward period. In addition, excess partnership business interest expense would be treated as excess business interest allocated to each partner in the same manner as the non-separately stated taxable income/loss of the partnership. Each partner would then carry forward unused business interest that would be available against future business income or would be added back to basis upon disposition of the partnership interest.
- Planning for the balance of 2017, defer income and accelerate deductions. If tax rates substantially decrease (for instance to 20 percent from 35 percent), the acceleration of deductions into the higher tax rate period or the deferral of income into the lower tax rate period (even if due to temporary difference changes) may result in a permanent benefit of the tax rates differential. Potential opportunities may include the following:
- Fixed asset reviews. Consider cost segregation studies, repairs and maintenance expense reviews, bonus depreciation and section 179 expensing.
- Incentive compensation/bonuses. Consider paying bonuses prior to year-end, modifying bonus plan documents or making a board resolution to fix the amount of bonuses that will be paid by 2 and a half months after year-end (even if the fixed amount is less than the potential bonus amount).
- Prepaid expenses. Review accounting methods for prepaid expenses and consider changing accounting methods to accelerate expenses.
- Qualified plan contributions. Consider contributing the maximum allowable contribution to a defined contribution pension plan by the earlier of the extended due date for the 2017 return or the filing of the 2017 return.
- Undo a Roth conversion? A proposal in the House bill would eliminate the ability to undo or “re-characterize” individual retirement account conversions. If you decided to move pre-tax IRA money to a post-tax Roth IRA account, you normally would have until Oct. 15 of the year following the conversion to undo the transaction. But that rule could be altered, meaning you should decide by the end of December if you want to change your mind. It may make sense to wait until next year if you’ll be in a lower tax bracket.
The bill now heads to conference committee between the House and the Senate to work out the differences. Anticipated to be a contentious process, critical disagreements are expected over the phaseout of individual rate reductions, the taxation of pass-through businesses and the ultimate corporate rate. Other stumbling blocks may include the repeal of the individual mandate, attempted fixes for the healthcare marketplace included in the Senate version, along with retention of AMT and the estate tax.
Some observers have speculated that most provisions from the Senate version are likely to prevail due to the closer voting margin in the Senate. However, House Ways and Means Committee Chairman Kevin Brady recently insisted that the Senate version will not receive deference just to comply with Senate budget rules.
For a more complete comparison of the House and Senate versions, see our previous alert.
We continue to monitor the legislative process and will publish insights and analysis as negotiations move through Congress.
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.