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11.03.2017 | Legal Advisory

On November 2, House Ways and Means Committee Chairman Kevin Brady released the Tax Cuts and Jobs Act, a bill that would make sweeping changes to the U.S. tax code. The draft legislation unveiled yesterday is the “chairman’s mark” of the federal tax reform plan proposed by GOP lawmakers, and is expected to be revised in committee before GOP leaders push for passage in the House. While the pressure to move the bill forward is likely to be intense, given the Trump Administration’s focus on tax reform and House Speaker Paul Ryan’s goal to have the House approve a tax bill by Thanksgiving, a number of the bill’s provisions are facing opposition from Republican as well as Democratic representatives.

If enacted, the House plan would entail a major rewrite of the U.S. tax code, with major consequences for both businesses and individuals. Some of the key details of the legislation are outlined below:

Individuals

• Changes to individual tax rates. The House plan replaces the current seven tax brackets with four. The tax brackets are 12% (the bottom rate bracket), 25%, 35%, and 39.6% for top earners (single taxpayers with income above $500,000, and $1 million for joint filers). The 25% bracket applies to single taxpayers with income over $45,000 ($90,000 for joint filers) and the 35% bracket applies to single taxpayers with income over $200,000 ($260,000 for joint filers).
• Increase standard deduction and elimination of personal exemption. The standard deduction is increased to $12,000 for single filers (from $6,350), $18,000 for heads of household (from $9,350), and $24,000 for joint filers (from $12,700). Both the additional standard deduction and the personal exemption are eliminated.
• Limitation and repeal of itemized deductions. Deductions for mortgage interest and charitable donations are retained (although the mortgage interest deduction is capped (noted below) and the mileage rate for charity is indexed for inflation). State and local property taxes can be deducted with a $10,000 cap. State and local tax deductions and other itemized deductions are eliminated. 
  • Flashpoints are already emerging around the limitation on mortgage interest deductions, the cap on property tax deductions, the elimination of the health care expense deduction, and the deduction for state and local income taxes.
  • There are no reductions to the contribution limits for retirement accounts, including 401(k) plans and IRAs, although so-called “backdoor” Roth IRAs would be eliminated.
• Cap on mortgage interest deduction. The mortgage interest deduction is capped at $500,000 of principal for new home purchases (the current cap is $1 million of home loans).
• Other deductions and exclusions. Numerous other deductions are eliminated, including the moving deduction, student loan interest deduction, tax preparation expense deduction, educator expense deduction, deduction for property and casualty losses, and the deduction for alimony payments. Many exclusions are also eliminated, such as the exclusion for employer dependent care programs, reimbursement of qualified moving expenses, employee achievement awards, employer adoption assistance programs, and interest on private activity bonds.
• Capital gains on home sales. The current exclusion for capital gains from primary home sales is narrowed, requiring taxpayers to have owned and resided in the home for at least five of the last eight years (instead of two of the last five years) and limit the exclusion to one sale every five years (instead of one sale every two years).
• Family tax credits. The personal exemption for dependents and the adoption tax credit are eliminated, while the child tax credit is raised to $1,600 (from $1,000) with an increased phase-out threshold. The plan creates a new $300 nonrefundable personal credit and $300 non-child dependent nonrefundable credit (both subject to phase-out).
• Individual alternative minimum tax. The individual alternative minimum tax is eliminated.
• Deferred Compensation. The deferral of taxation for deferred compensation arrangements and stock rights (e.g., stock options and stock appreciation rights) is eliminated. Employees would be taxed on deferred compensation and stock rights once the substantial risk of forfeiture lapses.

Business Taxes (Corporate and Pass-Through)

• Change in corporate tax rate. The plan permanently lowers the corporate income tax rate from a maximum rate of 35% to a flat 20% rate. 
• New pass-through tax rate. Pass-through business income is taxed at a new 25% maximum rate, subject to limitations. For active owners, the bill assumes that 70% of business income is attributable to labor (still subject to ordinary individual income tax rates) and 30% is business income subject to the maximum 25% rate. Pass-through businesses in certain service industries (including health, law, financial services, and professional services) default to the assumption that 100% of income is attributable to labor (subject to ordinary individual income rates instead of the 25% rate).
• Expensing of capital investment. Short-lived capital investment can be fully expensed for five years. Expensing under Code Section 179 is increased to $5,000,000 (from $500,00), with a higher phase-out threshold of $20 million (from $2 million).
• Tax treatment of interest. Net interest expense on new loans can be deducted only up to 30% of EBITDA, with a five-year carryforward, for all businesses with gross receipts of $25 million or more.
• Net operating loss deductions (NOLs). NOLs can be carried forward indefinitely and adjusted by an inflation factor, but deduction of NOLs is limited to 90% of current year taxable income. NOL carrybacks are eliminated (other than one-year carrybacks for certain disaster losses).  
• Business credits and deductions. Numerous business credits and deductions are eliminated, including for orphan drugs, private activity bonds, energy, rehabilitation, and contributions to capital, as well as the Section 199 manufacturing deduction, the New Market Tax Credit, deductions for entertainment, and like-kind exchanges for personal property (like-kind exchanges for real property are retained). Employer-provided child-care credits, work opportunity credits, and credits for expenditures to provide access to disabled individuals are eliminated, and renewable energy production tax credits and investment tax credits are limited. The deductibility of certain compensation paid to certain officers of publicly-traded corporation is further narrowed.
• Corporate alternative minimum tax. The corporate alternative minimum tax is eliminated.
• International income taxation. The plan makes broad changes to the international tax system, moving to a territorial tax system in which foreign-source dividends and profits of U.S. companies are not subject to U.S. tax upon repatriation, although new taxes apply to earnings of U.S. companies’ foreign subsidiaries to discourage shifting income abroad. Other details:
  • 50% of “excess” (higher than routine) returns earned by controlled foreign corporations are included in U.S. shareholders’ gross income.
  • Payments made by U.S. corporations to related foreign corporations are subject to a 20% excise tax, unless the payments are included with the taxable income of the U.S. corporation as effectively connected income (in which case the related foreign corporation’s expenses can be deducted).
• Deemed repatriation. The plan imposes a one-time deemed repatriation of currently deferred foreign profits, at a rate of 12% for cash and cash-equivalent profits, and 5% for reinvested foreign earnings.

Wealth Transfer Taxes

• Gift Taxes. The federal gift tax is retained, but the exemption is increased to $11.2 million per individual on 1/1/18 (with inflation indexing each year) and the rate is reduced from 40% to 35%.
• Estate and Generation-Skipping Transfer Taxes. Both are repealed for tax years beginning after 2023. Effective 1/1/18, the exemption for both taxes is increased to $11.2 million per individual (again indexed for inflation). Property included in an individual’s estate will continue to have its income tax basis “stepped up” to the property’s value on the date of the decedent’s death.

Other Notable Changes

• Political Campaign Activity by Churches. The current rule preventing tax-exempt nonprofits from making explicit election endorsements and statements with respect to political campaigns will not apply to religious organizations.
• Tax on large private university endowments. A new 1.4% excise tax is imposed on the net investment income of private universities with assets of more than $100,000 per student.
• Excise Tax on Exempt Organization Excessive Compensation. A new 20% excise tax is imposed on exempt organizations paying compensation in excess of $1 million paid to the highest five employees. The excise tax would also apply to severance payments that equal or exceed three times such an individual’s average base compensation. 

Next Steps

The Tax Cuts and Jobs Act is the first full bill text for the GOP’s sweeping tax reform proposals and is almost certain to be revised as it is marked up in committee and then pushed toward a House vote. The bill’s limitations on tax incentives for homeowners has already triggered opposition from the National Association of Realtors and the National Association of Homebuilders, and the elimination of the state and local income and sales taxes are controversial among representatives from high-tax states (despite a compromise that permits the deduction for state and local property taxes up to $10,000).   

As the bill moves forward, the Senate is positioned to use budget reconciliation to advance the bill without the risk of a Democratic filibuster. The framework for the budget reconciliation process is included in the recently-passed budget resolution, and permits the bill to add $1.5 trillion to the deficit over 10 years (in current form, Brady has stated that the bill would increase the deficit by $1.51 trillion over 10 years). While the bill itself will certainly generate debate and controversy, it is likely to remain on a highly aggressive timetable, as President Trump has stated repeatedly that he expects to sign the tax bill by the end of the year. We will keep you apprised of significant developments as they materialize.

This advisory was prepared by Susan Repetti, a partner in the firm’s Private Client Department, and members of the firm’s Tax Department. Nutter’s Tax Department will be monitoring these legislative developments as they unfold. Learn more about current proposals by contacting a member of our Tax Department. For information about wealth transfer tax proposals, please contact a member of Nutter’s Private Client Department.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.