This update was prepared by a partner in the tax practice at our CPA affiliate, Wipfli LLP. With more than 1,800 associates, 41 offices in the United States and two offices in India, Wipfli ranks among the top accounting and business consulting firms in the nation.
After months of anticipation and speculation, the House has released its version of a comprehensive tax reform bill. The 429-page document proposes sweeping changes for both businesses and individuals.
The following is a summary of some of those key changes. Unless otherwise noted, the changes would be effective for tax years beginning after 2017. It’s important to acknowledge that the Senate has also just released its own version of a tax reform bill — so the final legislation that gets passed by Congress and signed by the President could be significantly different from this House bill (stay tuned for a follow-up article breaking down the details of the Senate’s proposal).
Individual Income Tax Reform
From the individual tax payer’s perspective, the bill:
– Reduces the number of tax brackets from seven to four: 12%, 25%, 35% and 39.6%. The tax benefit of the 12% bracket will be phased out for taxpayers with over $1 million (single filers) and $1.2 million (joint filers) of adjusted gross income (AGI). For married taxpayers filing jointly, the 25% bracket threshold would be $90,000 of taxable income; the 35% bracket threshold would be $260,000; and the 39.6% bracket threshold would be $1 million.
– Retains lower rates on capital gain income and pre-tax contribution amounts to 401(k) plans.
– Repeals the alternative minimum tax (AMT).
– Eliminates the deductions for personal exemptions and for state and local income or sales taxes.
– Retains the deduction for property taxes, but only up to $10,000.
– Retains the deduction for interest expense on acquisition indebtedness of up to $1 million on existing mortgages. Interest on acquisition indebtedness incurred after November 2, 2017, is limited to $500,000 and can be claimed only on the taxpayer’s principal residence.
– Retains the charitable contribution deduction and increases the AGI limitation for cash donations to 60%.
– Eliminates most other itemized deductions, along with the employee moving expense deduction, educator expense deduction and exclusions for employer-provided dependent care programs, among others.
– Repeals the 3% AGI limitation on itemized deductions, also known as the “Pease limitation.”
– Consolidates the three existing higher education tax credits — American Opportunity Tax Credit (AOTC), Hope Scholarship Credit (HSC) and Lifetime Learning Credit (LLC) — into a new, enhanced AOTC. The new AOTC is the same as the current AOTC, but would also be available for a fifth year of post-secondary education at half the rate as the first four years.
– Repeals the special rule allowing the recharacterization of a traditional IRA contribution as a Roth IRA contribution.
Business Income Tax Reform
If the House’s proposal is passed, business owners will see their fair share of changes as well. Specifically, for this group, the bill:
– Creates a flat corporate income tax rate of 20%. Personal service corporations would be subject to a flat 25% rate.
– Repeals the AMT.
– For business income taxed at the individual level (e.g., sole proprietor or owner of a pass-through entity), a portion of the net income will be characterized as “business income” and taxed at a maximum 25% rate.
The general rule is that 30% of net income will be characterized as “business income,” and the remaining 70% will be taxed at ordinary rates. Taxpayers can elect an alternative formula, which is based on invested capital multiplied by the short-term applicable federal rate plus 7%. Certain industries — such as health, financial and professional services — can only use the invested capital formula to determine “business income.” All income from passive activities (as determined under the current Section 469 rules) will be taxed at a maximum 25% rate.
– Permits full expensing. One-hundred percent expensing is allowed for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. The “new property” requirement is removed and replaced with a taxpayer’s first-use rule. Any property used in a real property trade or business is not eligible for expensing.
– Increases Section 179 expensing for five years. The small business expensing limitation would be increased to $5 million, and the phase-out amount would be increased to $20 million.
– Limits interest expense. The deduction for net interest expense incurred by a business is limited to 30% of the business’s adjusted taxable income. Adjusted taxable income is equivalent to taxable income computed before net interest expense or income, net operating losses, depreciation, amortization and depletion.
Any disallowed interest expense can be carried forward up to five years. Real property trades or businesses are not subject to this limitation, because they are not eligible for the full expensing rules. Note that certain small businesses may be eligible for an interest expense exception — specifically, businesses with average gross receipts of $25 million or less would be exempt from the interest limitation rules.
– Modifies net operating loss (NOL) deduction limitations. An NOL carryover or carryback will be limited to 90% of the taxpayer’s taxable income. In addition, all carrybacks will be repealed, except for a special one-year carryback for small businesses and farms in the event of certain casualty and disaster losses arising in tax years beginning after 2017.
– Eliminates the Section 199 (DPAD) manufacturing deduction and several credits, such as the New Markets Tax Credit (NMTC), Work Opportunity Tax Credit (WOTC) and rehabilitation credit.
– Retains the research and development tax credit.
– Limits the use of like-kind exchanges. The Section 1031 deferral of gain on like-kind exchanges will be available only for real property.
– Disallows the entertainment deduction. No deduction (50% is currently allowed) would be allowed for entertainment, amusement or recreation activities and facilities, or membership dues related to such activities. The 50% deduction for meals is retained.
– Regarding the cash method of accounting, the bill increases the $5 million average gross receipts threshold for corporations and partnerships with corporate partners to $25 million (indexed for inflation), and extends it to farm corporations and farm partnerships with a corporate partner, as well as family farm corporations. The bill repeals the requirement of meeting the test for all prior years.
– Permits businesses with average gross receipts of $25 million or less to use the cash method of accounting even if the business has inventories, as long as it treats inventory as nonincidental materials and supplies; otherwise, the method of accounting conforms to the taxpayer’s applicable financial statements.
International Income Tax Reform
Beyond individual and business income tax concerns, the bill also brings changes to the international income tax code. The House’s proposed reforms:
– Create exemption for foreign-sourced dividends. One-hundred percent of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder who owns 10% or more of the foreign corporation would be exempt from U.S. taxation. This applies to distributions made after 2017. Neither the foreign tax credit nor the deduction are allowed.
– Modify taxation of deferred foreign profits. Accumulated foreign earnings held in cash or cash equivalents and in illiquid assets are deemed repatriated and taxed at 12% and 5%, respectively. Taxpayers may elect to pay the resulting liability over an eight-year period in equal annual installments of 12.5% of the total tax liability due.
Estate Income Tax Reform
Finally, the proposed bill doubles the estate tax exclusion amounts. The basic exclusion amount is doubled from $5 million (as of 2011) to $10 million per person, indexed for inflation. Furthermore, beginning after 2023, the estate and generation-skipping taxes are repealed, while maintaining a beneficiary’s stepped-up basis in estate property.
The gift tax is lowered to a top rate of 35%, and retains a basic exclusion amount of $10 million and an annual exclusion of $14,000 (as of 2017), also indexed for inflation. Note that the exclusion amount was scheduled to be $5.6 million per person in 2018, and the annual exclusion was scheduled to be $15,000 in 2018.
Wipfli’s tax professionals will continue to monitor developments and communicate information as soon as it becomes available, including the Senate’s version of the tax reform bill. Visit Wipfli.com or tune into OneBite to stay up-to-speed.