An Overview of the “Tax Cuts and Jobs Act of 2017”

On November 2, 2017, Kevin Brady (R - TX), the House Ways and Means Committee Chairman, released the “Tax Cuts and Jobs Act of 2017” (HR 1) (the “Bill”).  The Bill proposes a wide range of changes to the current U.S. tax system, many of which are highly significant.  We expect to see substantial revisions as the Bill progresses through Congress, and is reconciled with the pending Senate version. In the meantime, we have provided a summary of the changes proposed in the Bill as of this date.  Unless otherwise mentioned, all changes in the Bill would be effective beginning in 2018.

INDIVIDUAL TAXATION

The Bill seeks to simplify the Internal Revenue Code (the “Code”) for individuals by requiring fewer tax brackets and by consolidating various exemptions and deductions into a larger Standard Deduction. The Bill would not make changes with respect to the maximum rate for capital gains and qualified dividends. The Bill would also not repeal the 3.8% Net Investment Income Tax or the 0.9% additional Medicare tax on higher-income individuals.

Fewer Tax Brackets. The seven current brackets would be reduced to just four: 12%, 25%, 35%, and 39.6%.

  • 12% Tax Phase Out: There would be a phase-out of the 12% tax bracket for taxpayers with adjusted gross income over $1 million ($1.2 million for joint returns).

Increased Standard Deduction.  In conjunction with the simplified tax rates, the Standard Deduction for individuals would be increased as follows:

  • For Single Individuals, to $12,000
  • For a Head of Household or Married Joint return, to $24,000
  • Additionally, a Single Individual with at least one dependent child would qualify for a Standard Deduction of $18,000.

Reduction in Itemized Deductions.  In concert with simplifying the tax brackets and increasing the Standard Deduction, several itemized deductions would be reduced or eliminated:

  • Mortgage Interest Deduction: For mortgages entered into after November 2, 2017, the deduction for home mortgage interest would be limited to mortgages of $500,000 or less.
    • Exception: Mortgages entered into before November 2, 2017, or the refinancing of such mortgages, would not be subject to this limitation.
    • Elimination of Second Home Deductions: The mortgage interest deduction would be limited to the taxpayer’s primary residence only. No interest on mortgages used to purchase vacation or secondary homes would be allowed.
    • Home Equity Loans: The deduction for interest on home equity loans would be eliminated.
  • State and Local Taxes: The deduction for state and local income taxes and sales taxes would be eliminated for individuals, and the deduction for local real property taxes would be capped at $10,000.
    • Exception for Businesses: State and local taxes paid or accrued in the carrying on of a trade or business would still be deductible.
    • Itemized Deduction Limitation: The Bill would eliminate the overall limitation on itemized deductions for high-income taxpayers.
    • Increase in Charitable Giving Deduction Amount: The limitation on the charitable giving deduction would be raised to 60% of the donor’s adjusted gross income.
    • Deductions Eliminated: The following deductions would be eliminated:
      • Personal exemptions and dependents
      • Personal casualty loses (e.g. fire, storm, theft, etc.)
      • Student loan interest payments
      • College Stadium Seating Licenses (i.e. licenses which permit the purchase of season tickets at a college sports stadium)
      • Tax preparation expenses
      • Medical expenses
      • Moving expenses
      • Trade or business expenses related to being an employee (e.g. a teacher buying teaching supplies for their class).

Reductions in Items Excluded from Income.  As with deductions, current rules allowing individual taxpayers to exclude certain income would be eliminated or reduced:

  • Employer Provided Housing: The exclusion of employer-provided housing from income would be limited to $50,000 for an individual and phased out for high-income taxpayers (those making over $120,000 a year, adjusted for inflation).
  • Gain from the Sale of a Primary Residence: The exclusion of gain from the sale of a taxpayer’s primary residence would require that the residence in question have been the taxpayer’s primary residence for five of the preceding eight years - an increase from the current requirement of two of the last five years. In addition, the exclusion would be phased out for taxpayers with $500,000 or more of adjusted gross income.
  • Exclusions Eliminated: The following exclusions from income would be eliminated:
    • Employee Achievement Awards (i.e. retirement gifts)
    • The value of employer-provided child care
    • Employer moving expense reimbursements
    • Employer provided adoption related expenses
    • Income on the interest of a U.S. Savings Bond which is used to pay for education
    • Income related to Qualified Tuition Reductions made to employees of an educational institution and their spouses and dependents
    • Income related to Employer-Provided Education Assistance.

Changes to Tax Credits.  As part of the simplification of the Code, tax credits available to individuals would be modified in the following ways:

  • Child Tax Credit Increased: The Child Tax Credit would be replaced with a new partially refundable $1,600 a year family credit. In addition, each family member would be entitled to a $300 per year nonrefundable credit. Finally, the amount of income at which these credits begin to phase out would be raised to $230,000 a year for joint filers and $115,000 a year for single filers.
  • Credits Eliminated: The following credits currently available to individuals would be eliminated:
    • Credit for Individuals over 65 on Disability.
    • The Adoption Credit.
    • The Mortgage Credit.
    • The Plug-In Electric Car Credit.
    • The Hope Scholarship Credit.
    • The Lifetime Learning Credit.

Changes to Educational Incentives.  In conjunction with the increase in the Standard Deduction and the elimination of most itemized deductions, changes would be made to certain educational incentives, including an expansion of the American Opportunity Tax Credit, and the exclusion of income related to a discharge of student debt resulting from death or disability.

Changes to Deferred Compensation.  If enacted as proposed, the Tax Cuts and Jobs Act would have far-reaching impact on executive compensation. This could possibly eliminate nonqualified deferred compensation arrangements going forward, as well as adversely impact incentive plan design, nonqualified retirement benefits, and severance arrangements.

  • Introduction of New Section 409B: All compensation would become taxable when it is no longer subject to a substantial service obligation, such that taxation would occur at vesting.
    • Stock options and stock appreciation rights would be taxed upon vesting, whether or not exercised. In essence, the executive could be subject to an income tax without the benefit of the stock option proceeds.
    • Similarly, SERPs and other nonqualified retirement plans would be taxed at vesting, even if distributions may not occur until many years in the future.
    • Severance would be taxed at termination of employment, notwithstanding that it is paid over time and/or conditioned on compliance with a noncompetition covenant.
    • Incentive awards would also be taxed upon vesting, even where payment is deferred for corporate governance or other reasons (e.g., a mandatory deferral).
    • Existing arrangements would be grandfathered under current rules through 2025.
  • Elimination of Limit on Contingent Compensation: The $1 million limit on deductions taken by an employer for contingent commissions or bonuses made to a Covered Employee would be eliminated.
    • Covered Employees: The Bill would amend the definition of “Covered Employee” to mean the CEO, CFO, and the three other highest paid employees.
    • The Section 162(m) deduction limitations would now apply to any individual deemed a covered employee for as long as they receive compensation from the company.
      • The Bill would align the definition of “covered employee” with current SEC disclosure rules, thus subjecting the CFO to the limitation.
    • Expansion of Executive Compensation Excise Tax: The Corporate Excise tax on Executive Compensation would be applied to Not-for-Profits as well; the excise tax would be applied to compensation paid in excess of $1M.
    • Qualified Deferred Compensation: Generally speaking, the changes to qualified deferred compensation plans (i.e., plans subject to ERISA) would make it easier for taxpayers to withdraw amounts from their plan at a younger age:
      • Withdrawals While Still Employed: All pensions, and 401k plans provided by a state or local government, would allow the taxpayer to begin taking distributions once they are 59.5 years old, even if the taxpayer is still working.
      • Elimination of Six-Month Waiting Period for Hardship Distributions: Employees taking a hardship distribution from their 401k plan would be permitted to continue making contributions to such plan, rather than being forced to withhold contributions for six months.
      • Inclusion of Employer Contributions in Hardship Distributions: Employees would be able to take hardship distributions from their 401k plan from all the amounts which have been contributed to the plan, not just employee-contributed amounts.
      • Extended Rollover Period for Plan Loan Offsetting: Any employee who takes out a loan from their 401k plan and then ends their employment would have until the due date for next year’s tax filing, up from 60 days, to contribute the loaned amount to an IRA.
      • New Rules for IRAs: Rules allowing re-characterization of IRAs as Roth IRAs (and vice versa) would be eliminated.

Gift and Estate Tax.  The Bill proposes a major overhaul of the Gift and Estate Taxes. Generally, the Estate Tax would be repealed and, though the Gift Tax will remain, the rate will be reduced:

  • Increase in Excluded Amount for Gift and Estate Taxes: The basic exclusion amount for Gift and Estate Taxes for all gifts and bequests made by an individual, whether living or deceased, would increase to $10,000,000, adjusting for inflation beginning in 2018.
  • Decrease in Gift Tax Rate: The Gift Tax rate for property donated by a living donor would be reduced to 35% beginning in 2024.
  • Elimination of Estate and Generation-Skipping Taxes: As of 2024, both the Estate Tax and the Generation-Skipping Tax would be eliminated.

BUSINESS TAXATION

Reduced Rate for Business-Related Income. Business owners of pass-through entities (e.g. sole proprietorships, partnerships, LLCs, and S-Corporations) would have a portion of their Business-Related Income taxed at a 25% rate rather than at their individual rate. Under the provision, most pass through income not benefitting from the 25% rate would be treated as compensation income:

  • Business Related Income: Business Related Income is equal to any active business income treated as a return on capital, as well as 100% of any net business income derived from passive business activities.
  • Passive Investors in Pass-Through Business Entities: Passive Investor partners would be taxed at the maximum rate of 25% and would still be entitled to preferential rates on long term capital gains and qualified dividend income from such business income, but would be taxed at their ordinary rates on short-term capital gains and interest payments not allocable to a trade or business.
  • Amount Taxed at Business Rate: The amount of income subject to this lower rate would be either:
    • 30% of the business’ income (with the remaining 70% taxed at the normal individual rate); or, at the taxpayers election,
    • The business’ Specified Return on Capital related to the business, divided by the owner’s Net Business Income.
      • Specified Return on Capital is defined as the business’s Deemed Rate of Return, multiplied by the Asset Balance related to the business.
        • Deemed rate of Return is short term AFR for the month in which the taxable year ends, plus seven percentage points.
        • Asset Balance is the adjusted basis of all property used in the business as of the end of the taxable year.
      • Anti-Abuse: The Bill states that special rules will be put in place to prevent individuals from treating wages as business income.
      • Limitation on Professional Service Businesses: Professional Service businesses, such as health, accounting, law, engineering, architecture, consulting, financial services, brokerage services, trading, among others, would only be able to use the alternative capital formula.
    • Like-Kind Exchanges Limited: Like-kind exchanges would only be allowed for real property. Like-kind exchanges for personal property would be eliminated.
    • Technical Termination Rules Eliminated: The Technical Termination rules for partnerships (treating a transfer in a year of 50% or more of the total interest in partnership capital and profits as a liquidation of the partnership and formation of a new partnership) would be eliminated.
    • Contributions to a Business in Excess of Value of Shares: Contributions of capital to a business would be taxable as income if the contributions exceed the fair market value of the stock or partnership interest received in exchange.

ALTERNATIVE MINIMUM TAX

Elimination of the AMT.  The Bill would eliminate the Alternative Minimum Tax (“AMT”). 

  • Refunds of Unused AMT Credits: Taxpayers who have AMT credits that they have carried forward would be able to claim a 50% refund for any remaining credits in 2019-2021, and then a full refund for any unused credits in 2022.

CORPORATE TAXATION

The Bill seeks to simplify the Code with respect to corporations by replacing the current tiered corporate tax rate structure with a flat corporate rate, while eliminating certain deductions and credits to balance out the rate reduction.

Flat Corporate Tax Rate.  The current tiered corporate tax rate would be replaced with a flat 20% rate.

  • Exception for Personal Service Corporations: Personal Service Corporations would be subject to a flat 25% rate.

Accelerated Cost Recovery.  Through at least 2023, businesses would be able to significantly accelerate their cost recovery deductions: 

  • Depreciable Property: Depreciable property placed in service between September 27, 2017, and January 1, 2023, could, at the taxpayer’s election, be 100% deducted in the year it is placed in service, rather than depreciated. The property need not be new property but must not be previously used by the taxpayer.
    • Exception: This change excludes property used by a public utility, or in a “real property business.”
  • Section 179 Property: Up to $5 million in Section 179 property could be immediately expensed, with a phase-out beginning when over $20 million of Section 179 property is placed in service in a given year. These limitations would be indexed for inflation beginning for years after 2017.

Reduction in Business Deductions.  In order to balance out the reduction in the corporate tax rate, the following deductions would be reduced or eliminated:

  • Limitation on Deductible Interest: All businesses (other than those with less than $25 million in gross receipts, public utilities, and real estate businesses) would suffer the disallowance of interest deductions in excess of 30% of “adjusted taxable income” (i.e. taxable income before interest expense, interest income, depreciation, and amortization). Pre-existing loans would not be grandfathered and would be subject to the limitation.
  • Limitation on Carryforward of Net Operating Losses (“NOLs”): NOLs which are carried forward would only be allowable up to 90% of a taxpayer’s taxable income. Such NOLs could be carried forward indefinitely.
    • Increase in NOL Carryforward Amount: After 2017, NOLs carried forward will be increased by the short term AFR plus 4 percentage points.
  • Changes to Timing of NOLs: Businesses generally would not be able to carry back NOLs; however, certain qualifying small businesses and farms would be allowed a one-year carryback of their NOLs.
  • Deductions Eliminated: The following business deductions would be eliminated:
    • Local lobbying expenses
    • The Domestic Production Activity Deduction
    • The Entertainment Expense Deduction (other than costs spent on meals or beverages)
    • Certain unused business credits
    • Employer deductions for fringe benefits provided to employees.

Changes to Tax Credits.  Although the Bill explicitly states that it will retain the R&D Tax Credit and the Low Income Housing Tax Credit, the Bill would eliminate or modify several of the credits which are currently available in order to balance the reduced corporate tax rate.

  • Credits Eliminated: The following credits available to businesses would be eliminated:
    • The credit for Testing of Certain Drugs for Rare Disease or Conditions (the “Orphan Drug Credit”)
    • The credit for Employer-Provided Child Care
    • The Historic Rehabilitation Credit, with a 180-day window for certain planned projects
    • The Work Opportunity Credit
    • The New Markets Tax Credit
    • The Credit for Expenditures to Provide Access to Disabled Individuals
    • The Enhanced Oil Recovery Credit
    • The Credit for Producing Oil and Gas from Marginal Wells.
  • Modification to Energy Credits: Various credits related to renewable energy would be modified. The most notable changes are extensions of the Renewable Energy Tax Credit and Residential Energy Efficient Property Credit.

Elimination of Some Tax Exempt Bond Interest.  The Bill would also eliminate the tax free nature of interest for several government issued bonds, specifically:

  • Interest on Private Activity Bonds
  • Interest on Advanced Refunding Bonds
  • Interest on bonds used to finance professional stadiums.
  • Additionally, Tax Credit Bonds would be eliminated entirely.

Change to Accounting Method Rules for Small Corporations.  A corporation with $25 million in gross receipts would be permitted to use the cash method of accounting, even if such business has inventories. In addition, corporations with $25 million or less in gross receipts would be exempt from the UNICAP rules (capitalization of certain costs related to inventory), and would be able to use the completed-contract method for long-term contracts. Finally, businesses with $25 million or less in gross receipts would be exempt from the interest expense limitation rules noted above.

Other Changes.  The Bill also proposes the following miscellaneous changes to the Code, including:

  • The rules allowing a roll-over of gain from the sale of stock if the proceeds are invested in Small Business Investment Corporations will be repealed.
  • The Credit for FICA taxes attributable to tips in restaurants would be updated to reflect the current minimum wage.

Insurance Companies.  In addition to the broad changes to the taxation of businesses described above, the Bill also contains a number of changes specific to insurance companies.  The details of these changes are beyond the scope of this summary. 

INTERNATIONAL TAXATION

One of the most significant changes in the Bill is a fundamental restructuring of the taxation of foreign income earned by U.S. corporations. Generally speaking, U.S. corporations would no longer be taxed on dividends received from 10% or greater owned foreign subsidiaries, which would (in theory) eliminate the inclination to retain offshore earnings outside the U.S. Concurrently, all deferred earnings held in a 10% owned foreign subsidiary would be deemed repatriated and taxed immediately at the rate of 12% for E&P (earnings and profits) held in cash or cash equivalents, and a rate of 5% for all other E&P.

Tax Exemption of Subsidiary Dividends.  All dividends from a 10% or more owned foreign subsidiary owned for at least a six month period would be tax exempt.  To conform to this change, the tax on Controlled Foreign Corporation earnings invested in U.S. property under Section 956 would be eliminated with respect to domestic corporate taxpayers.

  • Reduction in Basis of Subsidiary Stock: The basis of stock in a 10% foreign subsidiary will be reduced by the exempt dividend income received from that subsidiary, but only for the calculation of any loss on disposition.
  • Recognition of Deferred Foreign Income: Any U.S. shareholder owning 10% or more of a foreign subsidiary would include in its last tax year prior to 2018 the E&P of such subsidiary to the extent such profits have not yet been included in U.S. income.
    • S-Corporation and REIT Exception: This provision will not apply if the U.S. Shareholder is an S-Corporation or REIT. In the case of an S-Corporation, tax on repatriation may be deferred until the entity ceases to be an S-Corporation or otherwise liquidates; however, if such tax is deferred, the S-Corporation must be made jointly and severally liable for the tax.
    • Foreign Tax Credit: The Foreign Tax Credit would be partially disallowed for dividends exempt under the Bill to the extent of E&P not subject to the tax. The Foreign Tax Credit would still be available with respect to Subpart F income, but only to the extent such income is included in a U.S. Shareholder’s gross income.
  • Source of Income Based on Production Location of Property: Income from the sale of property produced within the U.S. and sold outside (or vice versa) would be sourced exclusively based on production location.

Subpart F Income.  In addition to the changes discussed with respect to dividend income, changes are also being proposed which would expand Subpart F income: 

  • Deemed Ownership of Foreign Held Stock: S. corporations may be treated as owning stock in a foreign entity which is held by a foreign shareholder of the U.S. corporation.
  • Elimination of Timing Exception for Controlled Foreign Corporations (“CFCs”): A U.S. corporation would be taxed on a CFC’s Subpart F income even if the corporation has not held stock in the CFC for more than 30 days during the year in which the Subpart F income was earned by the CFC.
  • Limitations on Subpart F Income: New rules would help to limit Subpart F income, including eliminating a category of Subpart F income related to foreign oil extraction, and making permanent the “look-through” rule related to exclusion of income on payments made from one Controlled Foreign Corporation to another.

Base Erosion.  The Bill also seeks to reduce base erosion through the use of transfer pricing and tax treaty shopping.

  • Foreign High Returns Tax: The Bill would require a taxpayer to include in income 50% of “foreign high returns” in Controlled Foreign Corporations. The “minimum rate” on such “foreign high returns” would thus be 10%.
    • Foreign High Returns: This begins with the aggregate net income of the shareholder’s CFCs, less ECI, Subpart F income, certain commodities, income excepted from Subpart F under Code Section 954(c)(6), and certain commodities income. This amount would then be reduced by a percentage (seven percent plus the federal short term rate) of the CFCs’ aggregate basis in associated tangible depreciable business property to the extent (if any) that such basis exceeds the CFCs’ aggregate interest expense.
    • Foreign Tax Credits: Foreign Tax Credits would be available for 80% of the income included in “foreign high returns.” However, such “foreign high return” amounts would be treated as a separate basket.
  • Limitation on Interest Deductions: The deductible interest of a U.S. corporation that is a member of an “International Financial Reporting Group” (i.e. groups with consolidated/audited financial statements and average gross receipts greater than $100 million) would be limited to the excess of the corporation’s share of the interest over 110% of the corporation’s share of the group’s global earnings, before taxes, depreciation, etc.
  • Excise Tax on Payments to Foreign Affiliates: Payments by a U.S. corporation to a related foreign corporation that are deductible, includable in the cost of goods sold, or includable in the basis of a depreciable or amortizable asset, would be subject to a 20% excise tax, unless such payments are treated as effectively connected income. Alternatively, the foreign related party may elect to report the income in question as U.S. Effectively Connected Income, and pay tax thereon.  The Chairman’s Mark introduced the possibility that foreign tax credits would be available to offset in part the U.S. tax under that election.

Foreign Investment Income.  The Bill also proposes a few changes to the treatment of foreign investment income.

  • Insurance Company Exception on PFICs: The exception from the Passive Foreign Investment Corporation “(PFIC”) rules excluding income earned in the active sale of insurance are amended so that such income will only be excluded if the PFIC would be treated as an insurance company under U.S. law.
  • FDAP Treaty Rules: The statutory 30% withholding tax on income related to Fixed, Determinable, Annual, or Periodical (“FDAP”) income will not be waived by reason of a tax treaty unless such tax would also be waived if the payment were made to a foreign parent of the foreign subsidiary.

TAX EXEMPT ENTITIES

Finally, the Bill proposes several changes to Not-for-Profit entities (“NFPs”). Generally, the changes increase the instances in which a NFP will incur the Unrelated Business Income Tax (“UBIT”) and investment income. 

  • Expansion of UBIT Income: All tax-exempt entities will be potentially subject to UBIT.
  • Standardizing Investment Income Excise Tax: Private Foundations would be subject to a 1.4% excise tax on investment income, rather than the 2% or 1% variable system currently in place.
  • University Endowment Taxation: Private colleges and universities having at least 500 students and assets worth at least $100,000 per student would be subject to the 1.4% excise tax on investments.
  • Taxation of Fringe Benefits: NFPs would be taxed on fringe benefits provided to employees.
  • Political Speech by Churches: Churches would be allowed to make statements related to political campaigns during church services.

ADDITIONAL UPDATES OF NOTE

The Bill will certainly undergo a number of amendments as it progresses through the legislative process. It will be important to keep abreast of changes to ensure that one’s tax planning remains current. The most salient amendments to date include the following. 

  • Carried Interest Restrictions: There would be a three-year holding period requirement for partnership interests received in connection with performing services to be eligible for long-term capital gain tax rates. Otherwise, it would be subject to tax as short-term capital gain. However, language in the bill suggests that real estate developments, which do not ordinarily generate portfolio income, may receive an exemption to this rule.
  • Non-publicly Traded Stock Options: The harsh proposed treatment of stock options would be mitigated for holders of options in closely-held businesses.  This amendment would allow employees who receive stock options as compensation for the performance of services the possibility to defer recognition of income for up to five years from date of grant.
  • Earned Income Tax Credit Compliance: The amendment includes new rules that require claims to reflect earnings from self-employment, impose additional reporting requirements on employers, and give the Internal Revenue Service additional authority to substantiate claims.
  • Dependent Care Assistance Program Exclusion: The amendment extends the exclusion for up to $5,000 of employer-provided dependent-care assistance through December 31, 2022.

PLANNING CONSIDERATIONS

Generally speaking, it would not be prudent to implement any plans based on these proposals as currently stated. As mentioned above, there are compelling reasons to believe that these proposals are likely to change significantly in the coming weeks and months. The Senate is due to release its bill on November 9, 2017. Both the House and Senate bills will go through changes in their respective chambers and then through a combined “reconciliation” process. FGMK will be providing additional analysis of the process, and suggested planning ideas as appropriate, as the bills progress through Congress to passage and enactment. 

The summary information in this document is based on pending legislative proposals and is being provided for educational purposes only.  These proposals are subject to change, and it is believed likely will change from the contents noted herein.  Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice.  We encourage any recipients to contact the authors for any inquiries regarding the contents.  FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.

 

For any questions regarding this document, please contact:

 Fuad Saba, Partner

(312) 818-4305

fsaba@fgmk.com

  

Randy Markowitz, Partner

(847) 940-3241

rmarkowitz@fgmk.com

 

Perry Weinstein, Partner

(847) 940-3233

pweinstein@fgmk.com

 

Charles F. Schultz, Partner

(312) 818-4303

cschultzIII@fgmk.com

 

About FGMK

FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

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