U.S. House and Senate Republicans have reached a deal that reconciles the differences between the House and Senate tax reform plans, paving the way for a final vote next week and final passage of tax reform by Christmas. The deal will reduce the top individual income tax rate to 37 percent (from 39.6 percent) and reduce the corporate income tax rate to 21 percent (from 35 percent). Full details of the agreement were not immediately available; however, the tax reform plan is certain to make profound changes to the tax code that will affect all U.S. taxpayers. This article describes some of the key provisions of the House and Senate bills that are likely to be included in some form in the final legislation, and how they will affect individuals and businesses in 2017 and beyond.
2017 Planning Opportunities. The House and Senate bills increase the standard deduction to as much as $24,400 for a joint return but eliminate or curtail many popular itemized deductions. Both the House and Senate bills eliminate the deduction for state-and-local taxes, for example, and would cap the deduction for property tax at $10,000. The agreement between House and Senate Republicans was said to allow individuals to deduct a combined $10,000 of state-and-local taxes and property taxes. These changes present a number of year-end tax planning opportunities.
- Individuals who currently deduct property taxes in excess of $10,000 should consider prepaying taxes that aren’t due until 2018 by December 31, 2017 in order to benefit from the deduction one final time before it is scaled back. Before prepaying, however, taxpayers should confirm they will not be subject to the Alternative Minimum Tax (AMT) for 2017, because property taxes are not deductible for AMT purposes.
December 18, 2017 UPDATE: The conference agreement between the House and Senate prevents individuals from claiming an itemized deduction in 2017 for a prepayment of income tax for a future taxable year. Under the text of the legislation, which appears headed for passage this week: “an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, shall be treated as paid on the last day of the taxable year for which such tax is so imposed.” As the conference report explains: “an individual may not claim an itemized deduction in 2017 on a prepayment of income tax for a future taxable year in order to avoid the dollar limitation applicable for taxable years beginning after 2017.” This provision was not in either the House or Senate tax reform bills and eliminates a significant tax planning opportunity for 2017.
Individuals may still claim a valid deduction in 2017 for a payment of their remaining 2017 state income tax liability before December 31, 2017, assuming they are not subject to the Alternative Minimum Tax (AMT). In addition, individuals may still claim a valid deduction in 2017 for a prepayment of their 2018 property tax liability - assuming again that they are not subject to the AMT.
- Taxpayers who currently itemize deductions but expect to claim the standard deduction beginning in 2018 (because their itemized deductions do not exceed $24,000) should consider prepaying their anticipated 2018 charitable contributions by December 31, 2017, since they will be unable to deduct charitable contributions if they claim the standard deduction.
- The Senate bill would require individuals to use the first-in first-out method for computing gain on securities sold after December 31, 2017. If this change is included in the final bill, it would restrict individuals’ ability to identify specific lots of stock for sale, donation, or gifting. In particular, the change could have a substantial impact on individuals holding large concentrations of stock by forcing them to sell their oldest (and possibly lowest basis) stock first. Thus, investors may want to consider selling some high-basis stock in 2017 because, beginning in 2018, they may lose the ability to identify particular lots of stock to sell.
December 18, 2017 UPDATE: The conference agreement scrapped the provision in the Senate bill that would have required individuals to use the first-in first-out method.
Income from Pass-Through Entities. The House and Senate bills would dramatically change the way in which individuals are taxed on income from partnerships, S corporations, and other pass-through entities.
- Under the House plan, income from a pass-through entity would be taxed at a maximum rate of 25 percent if the recipient does not materially participate in the business.
- The House bill provides that, if the recipient does materially participate in the business, 70 percent of the income generally would be treated as compensation income (taxable at ordinary income rates of as much as 39.6 percent) and 30 percent would be treated as income eligible for the maximum 25 percent rate, unless an owner could demonstrate that more than 30 percent of his or her income from the business was attributable to capital.
- Under the Senate bill, individuals (but not estates or trusts) could deduct 23 percent of their qualified business income passed through from a partnership, S corporation, or other pass-through entity.
- The House-Senate agreement was reported to largely adopt the Senate bill’s approach, but with a lower deduction amount.
- Both the House and Senate bills include special rules intended to prevent individuals who earn income from providing services (such as lawyers, accountants, financial advisors, consultants, and others) from benefitting from the lower rate. A provision in the Senate bill would allow professional service providers to benefit from the 23 percent deduction, however, to the extent their taxable income does not exceed $500,000 (in the case of a joint return), with the deduction phasing out completely once income exceeds $600,000.
December 18, 2017 UPDATE: The conference agreement largely adopts the Senate’s approach, but with some modifications. Among other things, the deduction amount was reduced to 20 percent, and the deduction for professional service providers begins to phase out once taxable income reaches $315,000 and phases out completely once income exceeds $415,000 for a joint return (or half those amounts for a single return), instead of $500,000 and $600,000, respectively, under the Senate bill.
Corporate Income Tax Rate Reduction. Both the House and Senate bills would reduce the corporate income tax rate from 35 percent to 20 percent. That rate was said to have increased to 21 percent in the agreement between the House and Senate.
- The House bill would reduce the rate beginning in 2018, while the Senate bill would delay the lower rate until 2019.
- To encourage businesses to make capital investments, both bills would allow 100 percent expensing for business property placed in service after September 27, 2017.
- The House bill would expand the definition of property eligible for 100 percent expensing to include used property (so long as it was not previously used by the taxpayer). The House bill’s 100 percent expensing provision would expire in 2023 (or 2024 for certain property). The Senate’s 100 percent expensing provision would phase out 100 percent expensing between 2023 and 2028.
- In a last-minute change, the Senate bill would retain the corporate AMT, which could effectively eliminate many corporate deductions. The House-Senate agreement is expected to eliminate the corporate AMT.
December 18, 2017 UPDATE: The conference agreement sets a 21 percent corporate income tax rate and eliminates the corporate AMT.
International Tax Reform. Both the House and Senate bills would make dramatic changes to the U.S. international tax regime, including:
- Both the House and Senate bills would replace the current system, in which U.S. corporations are taxed on foreign subsidiaries’ income when the income is distributed as a dividend, with a dividend exemption system, in which foreign-source dividends from certain foreign subsidiaries would be exempt from U.S. income tax.
- The House and Senate bills would require foreign subsidiaries to pay a deemed repatriation tax on their foreign subsidiaries’ post-1986 earnings and profits. Under the House bill, the tax would be 14 percent on foreign earnings held in cash and cash equivalents and 7 percent on foreign earnings held in illiquid assets; under the Senate bill, the rates would be 14.5 percent and 7.5 percent, respectively.
- To prevent multinational companies from shifting profits to low-tax jurisdictions, both the House and Senate bills would impose current U.S. income tax on 50 percent of the “foreign high return amounts” (under the House bill) or 50 percent of the “global intangible low-taxed income” (under the Senate bill) of a controlled foreign corporation.
- The changes to the U.S. international tax regime may be effective as early as January 1, 2018; however, given the breadth of the changes, it is still possible the effective date will be delayed.
Carried Interest. Both the House and Senate bills would address the tax treatment of so-called “carried interest,” which under current law allows private equity fund managers, hedge fund managers, and some other investment professionals to pay long-term capital gains rates on their share of the profits from an investment partnership. Under the House and Senate bills, beginning after 2018 long-term capital gains attributable to an “applicable partnership interest” would be characterized as short-term capital gain (taxable at ordinary income rates) to the extent applicable to an investment held less than three years. An applicable partnership interest generally means a partnership interest transferred in connection with the performance of substantial services. In effect, the provision would not allow fund managers to benefit from the lower tax rate applicable to long-term capital gains unless the investment that generated the gain was held for at least three years.
Estate, Gift, and GST Tax. Both the House and Senate bills increase the federal estate and gift tax exclusion from its current $5 million (indexed for inflation) per individual to $10 million per individual. If this increase is enacted, the 2018 inflation-adjusted exclusion would increase from $5.6 million to an expected $11.2 million. The notable difference in the two bills is with respect to the future of the estate tax regime.
- The increased exclusion in the House bill would be effective after 2017, and the bill would repeal the estate tax in 2024.
- The increased exclusion in the Senate bill would also be effective after 2017, but the increased exclusion would be effective only for years after 2017 through 2026. The Senate bill does not provide for future repeal of the estate tax.
- Starting in 2024, the House bill would also reduce the gift tax rate from 40% to 35%; the Senate bill makes no change to the gift tax rate.
- The Generation-Skipping Transfer (GST) tax is retained in both bills and the exemption increase would be the same as the estate and gift tax exclusion increase. Like the estate tax, the House bill would repeal the GST tax effective in 2024; the Senate bill does not provide for any future repeal of the GST tax.
- Both the House and Senate bills would preserve the current basis step-up at death. (In the case of the House bill, the basis step-up would be retained even after repeal of the estate tax.) This would be a significant benefit coupled with an increased estate tax exclusion. Based on the proposed exclusion increase, most individuals will not be subject to estate tax, but all individuals would be able to eliminate unrealized gain on appreciated assets at death. Retention of the basis step-up is in contrast with the temporary repeal of the estate tax in 2010; Congress eliminated the automatic basis step-up for 2010 estates.
Provisions Not Likely to Change. Surprisingly, the House and Senate plans would retain some unpopular features of the current tax code that seemed likely to be repealed as recently as a few weeks ago.
- Both plans would retain the 3.8 percent net investment income tax that is imposed on certain net investment income of taxpayers in the higher tax brackets. The net investment income tax, which was enacted to help pay for the Affordable Care Act, is retained despite the fact the Senate bill would repeal the requirement for individuals to have health insurance.
- In addition, the Senate bill would retain the individual AMT but would increase the exemption and phase-out amounts.
We will continue to monitor the tax reform legislation as the final text is released and as the bill is voted on by the House and Senate, if approved, sent to the President for passage.