By now, you’ve seen media headlines covering the House Tax Reform Bill introduced on November 2. What you may not be aware of is how potential problems with the general tax provisions can directly impact you and your business. This Tax Alert addresses the questions you want answers to, suggests ways to position yourself for financial success and provides a preliminary analysis of the HR1 Tax Cuts and Jobs Act in this ever-evolving legislation.
The “Amendment in the Nature of a Substitute to HR1” is one of several proposed modifications to the House Tax Reform bill, which is essentially a rewrite of the bill by Congressman Kevin Brady, Committee Chairman of the House Ways and Means Committee. The bill is undergoing markup in the House and we anticipate further legislative amendments and wait for the Senate Finance Committee to release of its version of the tax reform. While not as comprehensive as previous tax reform efforts, the bill makes significant and far-reaching changes to the Internal Revenue Code— many of which you have to dig below the surface to find. Most of the changes are effective as of January 1, 2018, but this Alert explores the significant exceptions you need to know about.
As changes brew on Capitol Hill, we’ll keep you informed with future alerts including the difference between the Senate Finance Committee and House Bill’s version of the tax reform, as well as outlines for the international, tax exempt and compensation provisions and affordable housing and local development incentives.
Changes to the Individual Regime
The bill does not change the tax treatment of capital gains and qualified dividends. There would be four official tax brackets: 12%, 15%, 25% and 39.6%, as well as a “hidden bracket” that eliminates the benefit of the 12% bracket for those in the 39.6% bracket. Additionally, the Net Investment Income Tax and Additional Medicare Tax, which were part of the Affordable Care Act, as well as the Individual Mandate to have health insurance are not mentioned in the bill, but there are talks of dealing with them in future versions.
The Alternative Minimum Tax is repealed in the HR1. Taxpayers who have an Alternative Minimum Tax Credit carryforward can receive a partial refund of that credit in 2019 through 2022.
The Standard Deduction is essentially doubled ($24,400 for married filing jointly, $12,200 for single filers, and $18,300 for heads-of-household). This is useful for most taxpayers since all itemized deductions, including personal casualty losses are eliminated, with the exception of the following:
Home Mortgage Interest for existing loans, including certain refinancings, are grandfathered. Interest on loans entered into after November 2, 2017 (the date the legislation was introduced) would be deductible to the extent of the first $500,000 of principal balance and would be limited to one residence.
OBSERVATION: The text of the bill retains the reference to “taxpayer” rather than “residence” meaning that unwed couples jointly owning a personal residence may each deduct interest on up to $500,000 of principal balance.
OPEN POINT: In reading the grandfathering provision, it is unclear if it includes more than one residence or home equity loans in addition to a first mortgage. We are awaiting further clarification.
QUESTIONS: The treatment of state and local income taxes on trade or business income is unclear. The remaining questions:
- Are taxes on the business portion of flow-through income deductible at all? On Schedule A as itemized deductions? On Schedule E where the income is reported?
- What about taxes withheld on composite state returns?
- What about the tax on the business income of Schedule C businesses?
Charitable contributions: Remain deductible and the limit for cash contributions is increased to 60% of the taxpayer’s contribution base.
State and Local Taxes: Deductible property taxes would be capped at $10,000. State and local income taxes are not deductible.
Other provisions aimed at so-called “middle class tax relief” include a consolidation of the various education incentives, an increase to the child care credit, and a temporary (five year) credit would be allowed for the care of non-child dependents.
The exclusion of gain on the sale of a principal residence would require that the home be occupied for 5 out of the 8 years before the sale and that the exclusion can be used only once every five years. Additionally, the exclusion begins to phase out at adjusted gross income of $500,000 and is fully phased out at $1 million.
Most retirement provisions are retained for the moment but the ability to re-characterize Roth IRA contributions as traditional IRA contributions and convert a traditional IRA to a Roth IRA are repealed.
The Estate Tax exemption is doubled for the next five years and the tax is repealed for those dying after December 31, 2023. There is likewise no tax on generation-skipping transfers after that date. For the moment, basis step-up on death remains. The Gift Tax remains but the rate will be reduced in 2023 to 35%.
Key Takeaways from Proposed Business Provisions and Incentives
The corporate income tax rate is reduced to 20%. However, the revenue impact of this rate reduction is one of the major obstacles in moving the bill forward. Look for the effective date to move or the rate to be higher. The latter will also affect the ultimate pass-through rate. Notably, expensing provisions are enhanced and expanded but only for the next five years.
Bonus Depreciation: For all except real property trades or businesses or regulated utilities, qualified property placed in service after September 27, 2017 and before January 1, 2023 is eligible for 100% immediate expensing. Unlike prior incarnations of bonus depreciation, used property now qualifies as long as the taxpayer did not use the property prior to acquisition.
Section 179: For taxable years beginning before January 1, 2023, the expensing limit is increased to $5,000,000 and the phase out begins at $20,000,000.
OBSERVATION: Given that there is 100% bonus depreciation through the same expiration date, this would seem to benefit mostly those businesses not eligible for bonus.
Business interest remains deductible but only up to 30% of adjusted taxable income plus business interest income. This limitation does not apply to public utilities, real property trades or businesses, or so-called “small businesses.” Small business is defined as one with average gross receipts of $25 million or less. The same gross receipts test would also be used to determine what businesses may use the cash method of accounting, even if such a business has inventories. The same gross receipts test is also the threshold for the requirement to use the percentage of completion method for long-term contracts. There are some indications that this threshold may be increased before final passage.
QUESTION: Currently, condominium promotors have generally been limited to the use of the percentage of completion method because of the gross receipts test and the fact that they don’t qualify for any other exceptions. Can such projects be structured to qualify for the completed contract method under the higher gross receipts threshold?
Like-kind exchanges under Code Section 1031 are now limited to real property. The explanation is that with full expensing, such treatment is no longer necessary for personal property used in a trade or business. However, full expensing expires in five years while the change to Section 1031 is permanent. Additionally, full expensing is not available to investment assets (ie. art work) while like-kind exchange treatment is under current law.
Net Operating Losses (NOL) may not be carried back, other than certain eligible disaster losses, but they may be carried forward indefinitely. The amount of NOL which may be used in any year is limited to 90% of taxable income before the NOL deduction.
SUGGESTION: If you have personal property, which was heavily depreciated or has appreciated in value, consider trading it in before the end of the year to take advantage of Section 1031. Of course, only do that if you otherwise want to dispose of the asset or acquire something similar.
Numerous business provisions are repealed, including:
- Rehabilitation Tax Credit
- Domestic Production Activity Deduction
- Orphan Drug Credit
- Work Opportunity Tax Credit
- New Markets Tax Credit
Many of the Energy Credits and related provisions would be modified.
Focusing on state and local incentives to businesses – including relocation incentives, contributions toward building professional stadiums, etc. – contributions to the capital of a corporation or other entity which do not result in the issuance of interests of equal or greater value will be taxable.
OBSERVATION: The way this provision is drafted, capital contributions to insolvent partnerships or S Corporations to pay off creditors or to clean up intercompany liabilities that do not otherwise restore the entity to solvency will result in taxable income at the partnership or S Corp level. The same is of course true at the corporate level. It is not clear whether this is a glitch or a feature of the legislation.
PLANNING POINT: Entities, particularly pass-throughs, will want to pay close attention to this provision. If it passes in its current form, it would be wise to do some balance sheet clean-up before year end.
Executive compensation limitations are also stiffened in the bill. The performance based compensation exception for executive compensation in excess of $1 million is repealed. Moreover, the excess compensation limitation is extended to executives of tax-exempt entities.Deferred compensation provisions reflect significant changes. Essentially, deferred compensation would be taxable as soon as it vests. The provisions affect not only corporate compensation, but also pass-through entities. The provisions appear to favor option programs that are open to a significant majority of employees.
An Analysis of Pass-Through Business Provisions
The bill contains provisions to reduce the rate of tax on the trade or business income of sole proprietorships, partnerships, LLCs, and Subchapter S Corporations in an effort to make business owners tax indifferent to form of entity. Nominally, the rate of tax will be 25% on such income, but there are “guardrails” to prevent gaming the system. There are currently two alternatives to limit the amount of 25% income:
- A flat proration of 70% labor income and 30% trade or business income, or,
- A computation based on a rate of return on the capital invested in the business treated as trade or business income.
The capital computation requires a minimum 10% threshold. Service businesses – accountants, lawyers, architects, doctors, etc. are deemed to have a 100% labor ratio and are not allowed to use the 70/30 proration.
The self-employment tax exemption for limited partners is repealed.
Passive investors are deemed to have a 100% capital ratio. In other words, all of their income would be taxed at the 25% rate. A close reading of the bill implies that 70% of the income of passive investors and rental income from real property will be subject to self-employment tax (SE). It’s unclear if this is intentional.
OBSERVATIONS: The definition of passive investor refers back to the passive loss rules. It is not clear whether it is using only the material participation test or whether per se passive activities such as rental real estate are also included. If not, then rental real estate would be subject to the 70/30 or capital allocation rules and some passive real estate investors would be taxed on a portion of their income at ordinary tax rates plus SE tax.
QUESTION: Several years ago, when the Net Investment Income Tax was enacted, real estate professionals were allowed to make a one-time election to group all rental real estate activities to satisfy the material participation standard and not subject their income from rental real estate to that tax. Now that the lower pass through rate might be available for passive activities (notwithstanding the caveat above), will there be an opportunity to undo this grouping?
This is a pivotal moment for proposed tax reform on Capitol Hill. We continue to closely monitor changes and will keep you updated on the knowns and unknowns, providing expert analysis on areas that can directly impact you and your business. The content of this article reflect analysis as of this morning and doesn't reflect any subsequent changes as a result of the mark up process. In the meantime, reach out to your Friedman LLP professional with any questions you have.
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