House GOP Bill, H.R. 1 and Chairman’s Mark Amendments of November 9, 2017
On November 2, 2017, the Republican GOP released a comprehensive tax reform plan which introduced a set of individual and corporate tax reforms that have received much attention and criticism from both sides of the aisle. Summaries of the proposed legislation were described in this forum in “House Republicans Release Tax Reform Plan: Ways And Means Committee Chair Brady Suggests Flex Rate Package” posted on November 2, 2017, and “Republican GOP Tax Bill Introduces Major Reforms To The Taxation Of U.S. Corporations Engaged In Business Operations Overseas: Introduction Of The Participation Exemption” posted on November 3, 2017.
In his second amendment to the Tax Cuts and Jobs Act, H.R. 1, Chairman Kevin Brady (R-TX), summarized several amendments to the House GOP Bill designed to help American families, provide tax relief to “Main Street startups” and increase American competitiveness.
These changes are summarized as follows.
The original version of H.R. 1 repealed the tax credit for adoption. Chairman Brady, in his Chairman’s Mark, has reinstated the adoption tax credit. Section 23 allows a credit for expenses of adopting a child in an amount equal to the taxpayer’s “qualified adoption expenses”. The credit may not exceed $13,570 (2017) as adjusted for inflation and is subject to the tax liability limitations of section 26.
The House GOP Bill will allow a taxpayer to rollover excess assets from a tax-advantaged 529 savings account into an ABLE account to help Americans with disabilities.
The House GOP Bill which disallowed the deduction for moving expenses will not apply to military families.
The House GOP Bill would have eliminated section 409A by requiring service providers to be subject to immediate income taxation on deferred compensation arrangements once the legally enforceable contract rights are not subject to a substantial risk of forfeiture. This provision was to be contained in new section 409B. This is a very good thing. Thank you, Mr. Brady.
A key provision in the House GOP Bill a portion of the net income distributed by a pass-through entity to an owner or shareholder may be treated as “business income” and subject to a 25% maximum rate of income tax instead of being taxed at the ordinary individual income tax rates. The remaining portion of net business income would be taxed at the ordinary rate. This provision would only benefit taxpayers with income exceeding $260,000 per year when the effective rate increases to 35% for taxpayers filing joint returns. Net income derived from a passive business activity would, somewhat ironically, be treated entirely as business income and fully eligible for the 25% maximum rate. Owners or shareholders receiving net income from an active business activity (including wages received) would determine their business income based on a “capital percentage” of the net income from such activities. Under the “capital percentage” test, 30% percent to the net business income derived from active business activities will be eligible for the 25% rate. The balance, or 70%, would be subject to ordinary income tax rates. Alternatively, owners or shareholders may elect to apply a formula based on facts-and-circumstances of their business, to determine a capital percentage of greater than 30%. That formula would measure the capital percentage based on a rate of return (the Federal short-term rate plus 7%) multiplied by the capital investments of the business. Once made, the alternative election is binding for 5 years. Other special rules apply. One special rule is that the determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules under section 469 and regulations. Another special rule would apply to prevent the recharacterization of actual wages paid as business income. An owner’s capital percentage would be limited if actual wages or payments for services exceeds the taxpayer’s otherwise applicable capital percentage. The capital percentage for personal service partnerships and S corporation is 0%. It is noteworthy that no change was made to this provision but there is a “Main Street” softener introduced in the form of a new, low tax rate for startup businesses earning less than $75,000 in income at 9% instead of 15% under current law. (see next paragraph).
New 9% Business Rate for Owners of Pass-Throughs. H.R. 1, as recently modified by the Chairman’s Mark, introduces a new 9% rate in lieu of the 12% rate and would apply to the first $75,000 in net business taxable income of an active owner or shareholder earning less than $150,000 in taxable income through a pass-through business. This 9% rate would phase out for income over $150,000 and would be effectively eliminated at $225,000. The 9% rate itself would be phased in over 5 years so it would not be fully effective under 2022. This change was heavily endorsed by the National Federation of Independent Business.
Amendment Just Released on Research and Development Costs. An amendment designed to generate revenue requires that some research and experimentation expenses be capitalized and amortized over a 5 year period or 15 years for expenditures attributable to research conduct outside of the U.S.
Amendment to Excise on Some Payments to Related Foreign Corporations. This amendment to H.R. 1, as just announced by the Chairman’s Mark, changes the proposed excise tax on some payments from domestic to foreign corporations. It first eliminates the markup on deemed expenses. Second, it expands the foreign tax credit to 80% of foreign taxes paid and refines the definition of foreign taxes paid for this purpose based on section 906.
Manager's Mark Amendment to Dividends Received Deduction (DRD). The amendment reduces the 80% DRD to 50% and maintains current law effective tax rates on income from such dividends.
As revised by the Chairman’s Mark, the House Ways and Means Committee passed the Tax Cut and Jobs Act late last week.
Senate GOP Tax Plan Released: Differences with House GOP Bill
On November 10, 2017, the Senate Finance Committee Chairman, Orrin Hatch (R-Utah) released the Senate GOP’s version of the Tax Cuts and Jobs Act which in many instances is the same as the House GOP version contained in H.R.1. There are some differences, however, that will have to be worked out in markup and in the Conference Committee assuming the Senate GOP Bill is passed by the Senate, before sending back bills to both the House and the Senate for passage.
Change Individual Income Tax Brackets. Unlike the four tax brackets in H.R. 1 12%, 25%, 35% and 39.6%, the Senate Bill would have seven brackets as contained in the current tax law: 10% (income up to $9,525 for individuals, $19,050 for married couples filing jointly); 12% (over $9,515 to $38,750, over $19,050 to $77,400 for couples); 22.5% (over $38,700 to $60,000; over $77,400 to $120,000 for couples); 25% (over $60,000 to $170,000, over $120,000 to $290,000 for couples); 32.5% (over $170,000 to $200,000; over $290,000 to $390,000 for couples); 35% (over $200,000 to $500,000; over $390,000 to $1,000,000 for couples) and 38.5% (over $500,000; over $1,000,000 for couples).
Maximum Individual Tax Rate Reduced to 38.5%. This is in contrast to the 39.6% maximum tax rate in the House Bill.
State and Local Tax Deductions Eliminated. As with the House GOP Bill, taxpayers would not be able to deduct state and local property and other taxes in computing taxable income. This presumably would include the $10,000 of ad valorem taxes on real property that the House GOP Bill permitted. This change in the law, which has been part of the Internal Revenue Code since 1913, would have an adverse impact on moderate to high-income individuals in high-tax states such as New York, California, New Jersey, Connecticut, and Massachusetts.
This dramatic and drastic change in the tax law interjects desired political outcomes to the House Republicans, particularly from the “red” states, in thwarting what was hoped to have been a bona fide, a bipartisan effort to provide needed tax reform, including rate reductions, not only U.S. corporations but also to moderate to high income wage-earners, including professionals. Obviously, Mr. Brady and his colleagues expect high-income professionals such as doctors, dentists, lawyers, engineers, architects, accountants, to stay calm as their aggregate tax rate climbs to 50% and perhaps significantly above 50%. This is tax reform? This is a tax cut? Of course not. But see “Small Business Tax Relief” discussed below. Remember investors will be taxed at a 25% maximum rate on passive income so such individuals not being permitted to deduct state and local taxes and ad valorem taxes may push up their effective tax rate to 40%.
One of the stated rationales for many of the individual income tax changes, particularly the elimination of the SALT deduction is that the standard deduction is nearly double, from $6,350 to $12,000 for individuals, and from $12,700 to $24,000 for married couples filing jointly. Another rationale is that low-tax state residents are viewed by some as having long subsidized high-tax state residents and public spending by permitting high-tax state residents to deduct SALT.
It is ironic that taxpayers engaged in business, as defined, including partners in partnerships engaged in business, who pay tax on their company’s profits through individual returns, may still be permitted to deduct their state and local taxes as ordinary and necessary business expenses. Some commentators have speculated that may ultimately be what the law allows. At present, however, individuals, whether or not service providers, would not be allowed to deduct state or local taxes, including ad valorem taxes.
The Mortgage Interest Deduction Remains Unchanged. The Senate Plan keeps in place the current law on individuals being able to deduct interest on the first $1M of mortgage debt. The House plan scaled it back to allowing the deductibility of interest on $500,000.
Real Estate Depreciation or Cost Recovery Period. Under the Senate GOP Bill, the depreciation period for real property improvements would be reduced from 39 years to 25 years.
Estate and Generating Skipping Transfer Taxes Retained. The House GOP Bill repealed these taxes in 2024 and increased the exemption amount from $5.4M per married couple to $11M per married couple. The Senate GOP Plan retains the estate and presumably generation-skipping transfer tax.
Corporate 20% Tax Rate Reduction Does Not Begin Until 2019. This is unlike the H.R. 1 which would apply the stimulus tax rate cut for corporations in 2018.
Medical Expense Deduction Retained. This is of course disallowed in the House GOP Bill.
Small Business Tax Relief. Unlike the House GOP Bill rules on owners of pass-throughs and S corporations to partially qualify under the 25% rate rule on active business income, the Senate House Plan allows all businesses organized as pass-through entities to reduce their income by 17.4% and that would apply to any business, including law firms or physician’s practices. While this reform does not suffer from the lack of horizontal equity (fairness) like that symptomatic of the House GOP Bill under its 25% rate provision, the elimination of the state and local tax deduction for high-tax states imposes a greater cost than the 17.4% deduction. At the current maximum federal rate of 39.6% (which the Senate would reduce to 38.5%), a 17.4% deduction reduces the maximum federal tax rate under the Senate GOP Bill to 32%. So with a (hypothetical) high state tax rate of say 12%, the non-deductibility of the state and local taxes seems more palatable. But, will this deduction phase-out in recapturing the lower tax brackets? Presumably, the answer would be “yes”. On the other hand, highly compensated service providers to C or regular corporations don’t seem to qualify for the 17.4% deduction at all and would still be subject to a phase-out rate of up to 45%. This is fair? Corporations pay tax at 20%, passive income pass-throughs at 25%, and high wager earnings at 38 or 39.6% without SALT deductions and with phase-outs of lower brackets. Sounds like the adoption of a higher tax model and not a tax cut at least as to high-income, blue state professionals such as doctors, lawyers, accountants, etc.
Some Additional Thoughts on the International Tax Reforms In H.R. 1: Participation-Exemption
As previously posted last week on highlighting the international tax provisions of H.R. 1, under Section 4001 of H.R. 1, the taxation of U.S. corporations on the foreign earnings of their foreign subsidiaries when these earnings are distributed would be replaced with a dividend-exemption system. Under the exemption system, 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes (including withholding taxes) paid or accrued with respect to any exempt dividend, and no deductions for expenses properly allocable to an exempt dividend (or stock that gives rise to exempt dividends) would be taken into account for purposes of determining the U.S. corporate shareholder's foreign-source income. The provision would be effective for distributions made after 2017. The provision is designed to make U.S. companies more competitive globally, along with the reduction in the corporate tax rate to 20% and the introduction of the participation-exemption. Under Section 4002, of H.R. 1, present section 956 would be eliminated as to 10% U.S. shareholders of foreign corporations with respect to a foreign subsidiary’s undistributed earnings that are reinvested in United States property. The provision would be effective for tax years of foreign corporations beginning after 2017. Under Section 4003 of H.R. 1, a U.S. parent would reduce the basis of its stock in a foreign subsidiary by the amount of any exempt dividends received by the U.S. parent from its foreign subsidiary, but only for purposes of determining the amount of a loss (but not the amount of any gain) on the sale or exchange of the foreign subsidiary stock by its U.S. parent. This provision would be effective for distributions made after 2017. Then under section 4004, U.S. shareholders owning at least 10% of a foreign subsidiary, generally would include in income for the subsidiary’s last tax year beginning before 2018, the shareholder’s pro rata share of the net post-1986 historical earnings and profits of the foreign subsidiary to the extent such E&P has not been previously subject to U.S. tax determined as of November 2, 2017, or December 31, 2017, whichever is higher. Under House GOP Bill, section 4301, provides that a U.S. parent of one or more foreign subsidiaries would be subject to current U.S. income taxation on 50% of the U.S. parent’s foreign high returns. Foreign high returns would be measured as the excess of the U.S. parent’s foreign subsidiaries’ aggregate net income over a routine return (7% plus the Federal short-term rate) on the foreign subsidiaries’ aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. This is an important anti-base erosion measure expected to raise $77.1 billion over the 10 year scoring period. But still, foreign tax credits presumably would be available to offset this income inclusion.
The portion of E&P consisting of cash or cash equivalents would be taxed at a reduced rate of 12% while any remaining E&P would be taxed at a reduced rate of 5%. It is interesting why there should be a much lower rate for non-cash or non-cash equivalent deemed distributions. Foreign tax credit carryforwards would be available in full and foreign tax credits resulting by the deemed repatriation would be partially available in reducing U.S. tax. Recall that the Obama Administration’s purging of E&P proposal had suggested a 14% rate on repatriation of post-1986 E&P.
A U.S. shareholder could elect to pay the repatriation tax liability over a period of up to 8 years in equal annual installments of 12.5% of the total tax liability due. If the U.S. shareholder is an S corporation, the provision would not apply until the corporation ceases to be an S corporation, substantially all of the assets of the S corporation are sold or liquidated, the S corporation ceases to exist or conduct business or stock in the S corporation is transferred.
The reforms only apply to 10% owned foreign corporations by U.S. corporations. Otherwise, non-U.S. corporations or U.S. corporations owning less than 10% of the voting stock of a foreign corporation are subject to the current set of rules. Section 956, for example, will remain in effect for noncorporate taxpayers that are U.S. shareholders of a controlled foreign corporation. Despite the fact that individuals and non-corporate shareholders are not eligible for the participation-exemption, the deemed repatriation rule, i.e., the purging of earnings and profits provision, also applies to non-corporate U.S. shareholders as well as the high-income inclusion rule for foreign high returns.
The Joint Committee on Taxation (JCX-46-17) estimates that these and related reforms that convert our international corporate tax rules to more of a territoriality based framework would only reduce revenue by $205.1 billion over 10 years.
While it is likely that various provisions will face further revision and changes and perhaps the harshness of the non-deductibility of SALT will be mitigated or, if not, perhaps jeopardize passage of the legislation, it is certain that the international tax changes will have a profound impact on patterns of international investment and conducting business operations overseas for U.S. corporations and will also have a big impact on foreign corporations and treaty partners.
Assuming H.R. 1 passes the set of international provisions in their present form, there will be a tremendous amount of immediate guidance required to be issued by the Treasury and the Service in providing additional technical rules and reporting requirements. Given the present effective date for taxable years beginning in 2018, it is unlikely that the Treasury and the Service have the resources to issue such guidance in a timely and comprehensive manner.
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