United States: Overview Of The Proposed 'Tax Cuts And Jobs Act' And How It Differs From Current Law

Overview

On November 2, 2017 the House Republicans finally unveiled their proposed comprehensive tax reform plan (the "GOP Plan" or the "Plan").1 The scope of the GOP Plan is very extensive, and, if enacted, this bill would significantly transform the current tax system affecting all U.S taxpayers, including individuals, businesses, and tax-exempt organizations. This proposed tax reform is likely to be modified in the course of the legislative process, but it is helpful to review the current GOP Plan because it is likely to be used as a starting point and as the framework for future proposals.

This Stroock Special Bulletin provides a general overview of some of the more significant parts of the GOP Plan, and highlights the main differences from current law.

Changes for Individuals

The GOP Plan attempts to simplify the individual tax system by reducing the number of brackets from seven to four (but maintaining the maximum 39.6% rate for income over $500,000 for single taxpayers and $1,000,000 for married taxpayers filings jointly) and by completely eliminating or limiting many of the itemized deductions. On the other hand, the GOP Plan increases the standard deduction and otherwise eliminates the overall limitation on the few remaining itemized deductions.

Among the most significant personal income tax changes is the repeal of the deduction for state and local income and sales taxes (unless incurred in a trade or business).2 Deductibility of state property taxes is limited to $10,000.

The GOP Plan also repeals many other deductions, including, among others, the deduction for tax preparation services, for medical expenses, for alimony payments, for moving expenses, and for casualty losses. The Plan also limits the mortgage interest deduction to the interest paid on $500,000 of acquisition indebtedness, and the deduction is limited to the indebtedness on the principal residence. The good news for existing mortgages is that indebtedness incurred on or before November 2, 2017 is grandfathered up to $1,000,000. The deduction for interest on home equity indebtedness is eliminated without a grandfathering provision for existing home equity indebtedness.

Another very significant change is the repeal of alternative minimum tax ("AMT"), both for individuals and corporations.

The GOP Plan does not affect the capital gains tax rates, nor does it affect the characterization of income as capital gains. The Plan does not repeal the additional 3.8% Net Investment Income Tax (also known as the Obamacare or Medicare tax), although the repeal of this tax has been the target of many other proposed bills.

Business Tax Reform

Corporations

Perhaps the most widely discussed feature of the Plan is the reduction of corporate income tax rates from 35% to 20%. Additionally, the Plan significantly expands opportunities for immediately expensing certain capital expenditures, which has the effect of further lowering the effective corporate income tax rate. Personal services corporations would be subject to a flat 25% corporate tax rate.

The GOP Plan significantly changes the deductibility of Net Operating Losses ("NOL"). Under the Plan, NOL carryover or carryback deductions are limited to 90% of the taxpayer's taxable income and will not expire. Carryback NOL deductions are generally eliminated, except for certain limited carryback NOL deductions for small farms and businesses affected by casualty or natural losses. The Plan also provides that NOLs carried forward will be increased by an interest factor to preserve their value.

Pass-throughs/Partnerships/S Corporations

Net income derived from a "pass through entity" (sole proprietorship, partnership, limited liability company and S corporations) that is engaged in business activity will be subject to a maximum tax rate of 25% for individuals who do not "materially participate" in the business within the meaning of the passive activity loss rules. For individuals who "materially participate" in the business of the pass-through entity, income would be treated as 70% active business income subject to tax at ordinary income rates and 30% as passive income subject to the 25% rate. Alternatively, individuals can apply a facts-and-circumstances test based on the specific business of the pass-through entity in order to establish a percentage that is eligible for the 25% rate in excess of 30%.

There are a few interesting aspects of this proposal to note. For taxpayers who participate in personal services businesses such as law, accounting, consulting, engineering, and financial services, the default percentage of income eligible for the 25% rate would be zero. Qualified dividend income and capital gains would continue to be eligible for the maximum rate of 20%. The proposal does not address the tax treatment of "carried interests" of fund managers, which have been the subject of a number of previous legislative proposals for reform.3

REITs

REIT dividends would also be eligible for the 25% rate unless eligible for more favorable rates as capital gain distributions or qualified dividend income.

Tax Exempt Organizations and Educational Institutions

The GOP Plan reduces the current 2% excise tax on private foundations to 1.4%, but it also eliminates the option to reduce this excise tax to 1% by making certain distributions. More importantly, under the current law, private colleges and universities are not subject to this excise tax, but the GOP Plan would apply the 1.4% excise tax on net investment income to private colleges and universities that have at least 500 students and assets valued at $100,000 per student or more.

The GOP Plans expands the Unrelated Business Income Tax ("UBIT") to all organizations exempt under 501(a), including state and local entities and pension plans. This provision may subject to UBIT state pension funds.

Real Estate Industry

The Plan repeals "like-kind exchange" deferral of taxation for personal property sales, but preserves this favorable treatment for real estate property. The Plan, despite repealing many other deductions, preserved deductibility of property taxes and mortgage interest (although with limitations).

International Taxation

Participation Exemption

The GOP Plan shifts the U.S. corporate tax system closer to a territorial system that exists in most other developed countries. The Plan provides a participation exemption for foreign-sourced dividends paid by a foreign shareholder to a 10% U.S. shareholder. Any dividends exempt from taxation would reduce the basis of the parent's stock in a foreign subsidiary, buy only for purposes of determining the amount of a loss. The GOP Plan also provides that untaxed foreign subsidiary earnings reinvested in United States property would not be taxed. Thus, under the GOP Plan, income earned abroad by corporate subsidiaries, and not taxed in the U.S., can be repatriated or reinvested in the U.S. without incurring any U.S. federal income taxes.

In order to transition to the "participation exemption" system of taxation, the GOP Plan provides for a one-time tax on all unrepatriated and previously untaxed earnings and profits of foreign subsidiary corporations. Unrepatriated earnings and profits are subject to tax at the rate of 12% for cash and 5% for reinvested earnings. The tax on unrepatriated income may be payable over 8 years in equal installments.

The Plan also changes sourcing of income from sale of inventory. Income from the sale of inventory property produced within and sold outside the United States (or vice versa) would be allocated and apportioned between sources within and outside the United States solely on the basis of the production activities with respect to the inventory (as opposed to the current arbitrary 50/50 allocation).

Modifications of CFC and Subpart F Provisions

The GOP Plan repeals the imposition of current U.S. tax on previously excluded foreign shipping income of a foreign subsidiary and on foreign base company oil related income.

Under the current law, if the gross amount of the Subpart F income is less than the lesser of 5% of the foreign subsidiary's gross income or $1 million, then the U.S. parent is not subject to current U.S. tax on that subsidiary's Subpart F income. Under the GOP Plan, the $1 million threshold will be adjusted for inflation starting in 2018.

The GOP Plan also eliminates the provision under current law that a U.S. parent of a CFC is subject to current U.S. tax on its pro rata share of the CFC's subpart F income only if the U.S. parent owns stock in the foreign subsidiary for an uninterrupted period of 30 days or more during the year.

Section 954(c)(6) of the Code provides for the "look-through" of dividends, interest, rents, and royalties that one CFC receives or accrues from a related CFC. This provision is set to expire in 2020. The GOP Plan makes this provision permanent.

The Plan expands constructive ownership rules under Section 958(b) of the Code to include attribution of ownership from a foreign person to a U.S. person. Under the provision, a U.S. corporation would be treated as constructively owning stock held by its foreign shareholder.

Base Erosion

The GOP Plan attempts to tackle the difficult problem of base erosion by taxing foreign subsidiaries that earn "abnormally" high returns. The Plan introduces a new category of foreign subsidiary's income that is included in the income of its U.S. shareholder. Under the provision, a U.S. parent of one or more foreign subsidiaries would pay tax on 50% of the foreign subsidiary's return that exceeds the federal short-term rate plus 7%.

Energy and Renewable Energy Credits

Relatively few changes were proposed to the tax treatment of oil and gas. However, the inflation indexing of the production tax credit for wind would be removed, reducing the credit from what is now 2.3 cents per kilowatt hour of energy produced to 1.5 cents per kilowatt hour. In addition, the GOP Plan clarifies that construction cannot be treated as beginning before a specific date unless there has been continuous construction since that date; this provision applies to all projects, including projects that begin before the effective date of the provision. For solar energy, the 10% investment tax credit for solar and geothermal energy, which is currently permanent, would be scheduled to expire for property the construction of which begins after 2027.

Insurance Company Tax Changes

There are a number of proposed changes that affect insurance companies. NOLs of life insurance companies generated after 2017 will be subject to the same rules as for other corporations. The life insurance company share of the dividends received deduction will be at a flat rate of 40% of the total. Changes in reserve methods for life insurance companies will be subject to the usual rules for accounting method changes, rather than amortized over 10 years. A deduction for increases in reserves (or income from decreases in reserves) would take into account only 76.5% of the increase or decrease in statutory reserves (with some modifications) in computing taxable income. For reserves relating to current contracts there is an 8-year transition rule. The deferred acquisition cost tax add back for premiums will be 11% rather than the current lower rates for annuities and life insurance (except for group policies).

Conclusion

Stroock tax attorneys have been closely monitoring the developments of the various tax reform plans. This plan advanced by the House Republican majority is one of the most comprehensive tax reform plans, and it provides valuable insights into the legislative intentions and priorities. Many details of this bill may change in the course of the legislative process. However, based on the scope of the proposals, it is clear that individual and business tax planning will be significantly affected. We are available to discuss any questions you may have regarding this proposed tax reform and its effect on your tax planning.

Footnotes

1. The Tax Cuts and Jobs Act, H.R. 1, as amended on November 3, 2017 by substituted H.R. 1.

2. If enacted, this provision can have a significant impact on tax distribution provisions of existing partnership agreements.

3. The concept of applying different tax rates to passive and active interest in the partnership can be a precursor to other future changes, such as taxation of "carried interests" at ordinary income rates.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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