Tax Alert: Tax Reform Bill Clears Congress

On Wednesday, December 20, the House and Senate both approved the Tax Cuts and Jobs Act bill that came out of the Conference Committee last Friday. The bill will then go to the President, and upon his signature, becomes law.

The bill combines parts of both the Senate and House bills, adds a few new items and somewhat surprisingly removes several pieces on which the House and Senate had both originally agreed. The final bill is generally effective January 1, 2018 though there are numerous exceptions. This includes a number of items in the bill which have sunset provisions, many of which are set to expire after 2025. The following is a high-level summary of some of the more noteworthy items in the bill. Note that these are the general rules and there are special rules and exceptions which must be considered.

Individuals

Tax Rates: There will be seven brackets of taxable income:

Bracket Married Filing Joint /Surviving Spouse Married Filing Separately Head of Household Single
10% 0-$19,050 0-$9,525 0-$13,600 0-$9,525
12% $19,050-$77,400 $9,525-$38,700 $13,600-$51,800 $9,525-$38,700
22% $77,400-$165,000 $38,700-$82,500 $51,800-$82,500 $38,700-$82,500
24% $165,000-$315,000 $82,500-157,500 $82,500-157,500 $82,500-157,500
32% $315,000-$400,000 $157,500-$200,000 $157,500-$200,000 $157,500-$200,000
35% $400,000-$600,000 $200,000-300,000 $200,000-$500,000 $200,000-$500,000
37% $600,000+ $300,000+ $500,000+ $500,000+

The rate changes will expire after 2025. No change is made to the reduced tax rate on capital gains or qualified dividends, and there is no phase-out of the lower tax rates for higher income taxpayers.

Standard Deduction: The standard deduction increased to $24,000 for married filing jointly filers, $18,000 for heads of households and $12,000 for other individuals (and will be indexed for inflation); the additional standard deduction for the blind and elderly has been retained. Personal exemptions eliminated.

Child and Dependent Credits: The child tax credit increased from $1,000 to $2,000 of which $1,400 would be refundable. In addition, a $500 nonrefundable credit is provided for qualifying dependents other than children.

Medical Expenses: Although the medical expense deduction was considered for repeal, the Conference bill keeps the deduction and lowers the income threshold to 7.5% of adjusted gross income. The medical expense deduction expires in 2019.

State and Local Taxes: In a late move, the Committee decided to retain a deduction for state and local income or sales tax as well as property tax, but with an overall limit of $10,000.

Caution: The bill contains a rule that prevents taxpayers from pre-paying income taxes attributable to 2018 in 2017 in order to accelerate a deduction and avoid the $10,000 limitation on state and local taxes in 2018.

Mortgage Interest: Qualifying debt for home mortgage interest will be limited to $750,000 for debt incurred after December 15, 2017. A first or second residence may qualify for the mortgage interest deduction. The deduction for interest on home equity loans is suspended for tax years beginning after December 31, 2017 and before January 1, 2026.

Charitable Contributions: The income limit is increased to 60% of AGI. Contributions made in exchange for university athletic seating rights will be non-deductible beginning for tax years starting after December 31, 2017.

Other Itemized Deductions: Most other itemized deductions including tax preparation fees and unreimbursed employee business expenses are repealed.

Gain on Sale of Principal Residence: No change from current law. Home must occupied by a resident for 2 out of the last 5 years.

Education: Most of the education-related tax benefits are retained in the Conference bill, including those for employer-provided education assistance and the exclusion for graduate student tuition waivers.

Alimony:  The deduction for alimony paid and the inclusion in income for alimony received are both repealed.  However, in order to allow more time for the transition, this would only apply to divorce or separation agreements executed after December 31, 2018.

Estate Tax: Both the estate tax and generation skipping transfer tax are retained. However, for decedents dying and gifts made after 2017 and before 2026, the exclusion is increased to $10 million and indexed for inflation.

Alternative Minimum Tax:  Although the AMT for individuals was not repealed in the bill, the exemption amounts and the phase-out levels for the exemptions have been increased.

Businesses

Corporate Tax Rate: Beginning in 2018, the corporate tax rate drops from a top rate of 35% to a flat rate of 21%. The corporate AMT is repealed and unused minimum tax credits can be carried forward to offset the regular tax liability for any taxable year. In addition, the AMT credit is refundable for any taxable year beginning after 2017 and before 2022 in an amount equal to 50% (100 percent in the case of taxable years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the minimum tax credit will be allowed in taxable years beginning before 2022.

Dividend Received Deduction (“DRD”): The DRD under current law of either 80% (for 20% owned corporations) or 70% is reduced to 65% or 50%, respectively.

Expensing of Equipment: The bonus depreciation deduction has been increased to 100% and the Section 179 expense deduction has been increased to $1 million. The bill expands the definition of qualifying real property for Section 179 depreciation.

Research & Development: The R&D credit was retained. Specified research or experimental expenditures that were previously expensed are required to be capitalized and amortized over 5 years (15 years if foreign).  The capitalization requirement is effective for amounts paid or incurred in tax years beginning after December 31, 2021.

Small Business Accounting Methods: Corporations and partnerships with corporate partners are permitted to use the cash basis of accounting if prior three-year average gross receipts are less than $15 million. Family farms will continue to have a $25 million threshold. Also, certain taxpayers with less than $25 million in gross receipts will not be required to account for inventories, but could instead use a method that allows expensing or otherwise conforms to the financial accounting treatment.

Carried Interests: The holding period for certain carried interests in partnerships transferred in connection with services is extended to 3 years in order to obtain long term capital gains rates.

Pass-Through Businesses: For certain owners of partnerships, S corporations and sole proprietorships, a deduction is allowed for 20% of qualified business income, subject to income limitations. Certain service providers such as accountants, lawyers and doctors, will not be eligible for the pass-through deduction.

Net Operating Losses (NOLs):  The Conference bill limits the NOL deduction to 80% of taxable income and repeals NOL carrybacks of losses generated in tax years after 2017. NOLs can be carried forward indefinitely.

Interest Deductions: A new rule applies to limit businesses from deducting interest in excess of 30% of adjusted taxable income, with an exemption for smaller businesses that have average gross receipts of $15 million or less.

Domestic Production Activities Deduction: The Section 199 deduction for domestic production activities is repealed.

International Taxes

Transition to Participation Exemption System: A 100% dividends received deduction (DRD) is allowed to 10% owners of specified foreign corporations. A one-year holding period is required.

Deemed Repatriation Tax: A tax on undistributed earnings of  8% ( illiquid assets) or 15.5% (liquid assets) will be imposed on 10% owners of controlled foreign corporations. This tax will also apply to individuals who own shares in the CFC.  A foreign tax credit would be allowed but only to the extent of the equivalent percentage of income subject to tax. Tax is generally applied to post ’86 E&P measured at the higher of November 2 or December 31, 2017; tax is payable over 8 years.

Look-Through Rule on Subpart F Income: The special rule under Section 954(c)(6) to remove certain types of income from being treated as Subpart F income is retained, though not made permanent as had been presented in previous draft bills.

Base Erosion Taxes: The Conference bill includes two provisions that impact U.S. companies doing business with foreign related parties:

The first is the Global Intangible Low Taxed Income (GILTI) tax. This is essentially a new Subpart F inclusion for 50% of a U.S. shareholder’s share of GILTI (essentially foreign base company intangible income). GILTI would be excess of shareholder’s net CFC tested income over “net deemed intangible income” which is 10% of the aggregate of the U.S. shareholder’s prorata share of the “qualified business investment”. Offsetting the income inclusion is a 37.5% deduction on income received for foreign intangibles.

The second is the Base Erosion minimum tax of 10% which is imposed on “modified taxable income” (taxable income after adding back deductions for certain related party payments). The minimum tax increases to 12.5% for tax years after 2025.

Foreign Tax Credit (FTC) Changes: The indirect foreign tax credit allowed under current law (Section 902) is repealed.  For FTC purposes, the fair market value method of apportioning expenses is no longer allowed. For sourcing of sales of tangible personal property, Section 863(b) no longer applies; income would be sourced solely on the basis of the production activities.

Other Items

Individual Mandate: The bill provides that the penalty rate for not complying with the individual mandate in the Affordable Care Act will be reduced to zero percent for years after 2018.

Oil Exploration: Several items that would have been unfavorable to the oil & gas industry were removed in the Conference Committee process. In addition, a new provision was added that would permit oil exploration and development in Alaska’s Arctic National Wildlife Refuge.

We Can Help

If you have questions about any of the provisions in the Tax Cuts and Jobs Act, or need help in understanding how it may affect your business, please contact your Elliott Davis tax advisor.