House and Senate Republicans voted along party lines yesterday and into the early hours today to pass a tax reform bill, after weeks of wrangling by both Chambers to reconcile the respective versions of their bills (the “House Bill” and “Senate Bill”, respectively.) The House vote was not without drama as the Senate parliamentarian objected to three provisions in the Senate Bill, one being the name of the bill itself. This caused the House to cast their votes again today. Formerly known as The Tax Cuts and Jobs Act, the bill had to be renamed. Instead, it will be: “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (the “Tax Bill”). The President is expected to sign the Tax Bill into law soon after final votes are cast.
Our discussion of the initial versions of the House and Senate Bills can be read here and here. For the most part, the provisions of the Tax Bill will be effective for tax years beginning after 2017. In general, the Tax Bill follows the provisions in the Senate Bill. Tax breaks for retirement saving are retained and there are no provisions limiting employees’ ability to make pre-tax contributions.
The signature provision of the Tax Bill is the cut to the corporate tax rate. The rate will be lowered from the current 35% to 21% — higher than 20% rate introduced by both Chambers – effective in 2018. The Tax Bill also repeals the individual mandate under the Affordable Care Act (the “ACA”) beginning after December 31, 2018. However, employer reporting responsibilities under ACA are unaffected.
Below is a high-level summary of the major provisions in the Tax Bill.
The Tax Bill includes the following changes:
- The ability to recharacterize a contribution to one type of IRA as a contribution to the other type of IRA will not apply to Roth conversions, but will still be permitted with respect to other types of IRA contributions. For example, if a taxpayer makes a contribution to a Roth IRA, it can be recharacterized as a contribution to a traditional IRA, so long as it is done prior to the due date of the taxpayer’s return including extension.
- Employees whose plans terminate or who have a severance from employment while they have a plan loan outstanding will have until the due date for filing their tax returns to roll over their outstanding loan balances to an IRA and not have the loans treated as taxable distributions. Under present law, the rollover period is 60 days.
- A section 529 plan under the Internal Revenue Code of 1986, as amended (the “Code”), can permit distributions of $10,000 in expenses for tuition per beneficiary at a public, private or religious elementary or secondary school. Also, rollovers from a section 529 plan accounts to the account of an ABLE program (a tax-favored savings program intended to benefit disabled individuals) will be permitted through December 31, 2025, if the account is owned by the designated beneficiary or a member of his or her family.
- There is an employer credit for paid family and medical leave for certain qualifying employers equal to 12.5% of wages with the potential for increase to 25% of wages. The credit is available during 2018 and 2019 only.
- The employer-provided child care credit is retained.
- Qualified bicycle commuting expense reimbursements are suspended for taxable years beginning after December 31, 2017 and before January 1, 2026.
Nonqualified Deferred Compensation Plans
The provisions of the Tax Bill relating to nonqualified compensation matters are as follows:
- Compensation Paid By Publicly-Traded Companies. With respect to the $1 million deduction limit on compensation paid to “covered employees” available to publicly traded companies, the definition of “covered employee” under Code section 162(m) is modified. A covered employee includes both the principal executive officer and the principal financial officer, and any individual who has served in such capacities during the taxable year, and the three highest compensated employees other than the principal executive officer and principal financial officer for the tax year required to be reported on the company’s proxy statements. Further, if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual will remain a covered employee for all future years. The provision also extends the applicability of Code section 162(m) to include all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (“ADRs”), and also includes additional corporations that are not publicly traded, such as large private C or S corporations. The commission and performance based exclusions, which includes stock options, are eliminated. There is a transition rule for remuneration provided pursuant to a written binding contract in effect on November 2, 2017, and not materially modified after such date.
- Excise Tax on Remuneration for Tax Exempts. A tax-exempt organization will be subject to a 21% excise tax on the sum of (1) any remuneration (other than an excess parachute payment) in excess of $1 million paid to any of its five highest paid employees for the tax year or any employee who was one of the five highest paid employees for any preceding taxable year, and (2) any excess parachute payment. Remuneration means all W-2 wages, other than designated Roth contributions, made by the tax-exempt organization or related organization. Remuneration is treated as paid when there is no substantial risk of forfeiture, as determined under Code section 457(f) and includes amounts required to be included in gross income under Code section 457(f). Excess parachute payment is redefined as one exceeding three times the base amount, which is based on the average annualized compensation for the five years preceding the separation from service. Compensation paid to non-highly compensated employees is excluded from the definition of parachute payments, and compensation attributable to the medical services of certain qualified medical professionals is excluded from the definition of remuneration and parachute payments. This means that the excise tax will apply in certain cases even if the individual’s direct compensation does not exceed $1 million.
- Transfers of Employer Stock to Employees. With regard to the transfer of employer stock to an employee in connection with the performance of services, an employee may elect to defer for income tax purposes (the treatment of FICA and FUTA is unaffected) the inclusion of income attributable to qualified stock. The election must be made no later than 30 days after the stock is substantially vested or becomes transferable, whichever comes first. The income that is deferred is includible in income for the taxable year that is the earliest of the following: (i) the first date that the qualified stock becomes transferable; (ii) the date the employee first becomes an excluded employee (defined below); (iii) the first date on which the employer’s stock becomes readily tradable on an established securities market; (iv) the date five years after the right to the stock becomes substantially vested; and (v) the date of revocation of the election. This provision does not apply to stock includible in income as a result of a Code section 83(b) election. The provision does apply to incentive stock options and employee stock purchase plans.
- An excluded employee is (i) a 1% owner during the current year or any of the 10 preceding calendar years, (ii) who is or has been the CEO or CFO, (iii) a family member of a 1% owner or a CEO or CFO, or (iv) one of the four highest compensated officers in any of the 10 preceding taxable years.
- Qualified stock is stock received in connection with the exercise of an option or in settlement of a restricted stock unit (“RSU”), and the option or RSU was granted in connection with the performance of services for an eligible corporation. Qualified stock does not include stock appreciation rights or restricted stock.
- An eligible corporation is a corporation (determined on a controlled group basis, but only applying Code section 414(b), which includes parents and subsidiaries), no stock of which is traded on an established securities market during any preceding taxable year; and (ii) the corporation has a written plan in place under which at least 80% of all employees providing services to the corporation (excluding excluded employees and part time employees) are granted options and RSUs with the same rights and privileges. (The limits cannot be combined. All such employees must either be entitled to options or restricted stock units.)
- The deferral election is not available if, in the preceding calendar year, the corporation purchased any of its outstanding stock, unless at least 25% of the stock purchased was stock with respect to which an inclusion deferral election was in effect, and the determination of which stock is purchased is done on a reasonable basis.
- The first-in, first-out (“FIFO”) provision for sales of a portion of securities owned was not adopted in the Tax Bill. Because of this, investors are not required to compute taxable gain on a sale of securities with reference to their oldest shares. Thus, investors can minimize taxable gain by choosing to sell those lots with the highest basis.
Individual Income Taxes
The Tax Bill will retain the existing seven tax brackets, with the highest rate being 37% for individuals with income over $500,000 ($600,000 for married filing jointly, and $300,000 for married filing separately). A 12% bracket will replace the existing 15% bracket, while the existing top rate of 39.6% will be reduced to 37%. These tax rates will sunset for taxable years beginning after December 31, 2025. In the chart below, the existing tax brackets for 2017 appear on the left, while those of the Tax Bill appear on the right.
|Rate||Taxable Income Bracket||Rate||Taxable Income Bracket|
The dollar amounts for the bracket thresholds are adjusted for inflation and rounded to the lowest multiple of $100. Beginning in 2018, the Chained Consumer Price Index for all Urban Consumers (the “C-CPI-U”) will be used for inflation adjustments and reflects a slower rate of inflation.
- Through 2022, the standard deduction will increase to $24,000 for joint filers (and surviving spouses), $12,000 for single filers and $18,000 for heads of household.
- The individual alternative minimum tax is retained, but until January 1, 2026, the exemption amount and the exemption amount phase-out thresholds are increased.
- The interest deduction on mortgage indebtedness is reduced from $1,000,000 to $750,000 through December 31, 2025, and the deduction for interest on home equity loans is suspended through December 31, 2025.
- Through December 31, 2025, state and local tax deduction is capped at $10,000 in property, income or sales tax (any combination at the election of the taxpayer).
- The deduction for personal exemptions is suspended through 2025.
- The present-law maximum rates on net capital gains and qualified dividends are retained.
Tax Deductions and Exclusions
- Disallowance for the deduction of expenses associated with providing qualified transportation fringe benefits to employees (although the benefit remains exempt from income) and, except as provided for safety of the employees, any expenses incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of business.
- For tax years beginning after December 31 , 2025, the Tax Bill will disallow an employer’s deduction for expenses associated with meals provided for the convenience of employers on the employer’s business premises, or provided at or near the employer’s business premises through an employer operated facility that meets certain requirements.
- Qualified moving expenses may be deducted through December 31, 2025. The exclusion for qualified moving expense reimbursements is suspended for taxable years beginning after December 31, 2017, and before January 1, 2026.
- The child care credit is temporarily increased to $2,000 per qualifying child (one who has not attained age 17 during the taxable year) and to temporarily provide for a $500 credit for qualifying dependents. The phase-out amounts are $400,000 (in the case of married taxpayers filing jointly) and $200,000 for all other taxpayers. These provisions sunset after December 31, 2025.
- The credit for elderly and permanently disabled is retained.
- The dependent care exclusion, the adoption assistance exclusion, and the educational assistance programs under Code section 127 remain in effect.
- Deductible contributions to Archer Medical Savings Accounts will still be permitted.
- The exclusion for employer provided housing is unchanged.
- There will be a suspension of the overall limit on itemized deductions through December 31, 2025.
- Through December 31, 2025, casualty losses are limited to losses attributable to disasters declared by the President under the Disaster Relief and Emergency Assistance Act.
- The income-based percentage for charitable contributions of cash to public charities and certain other organizations is increased from 50% to 60%.
- All miscellaneous itemized deductions subject to a 2% floor are suspended through December 31, 2025.
- For 2017 and 2018, medical expense deductions will be allowed for amounts in excess of 7.5% of AGI, rather than 10% of AGI.
- Alimony and separate maintenance payments will not be deductible by the payor spouse, and will not be included in income by the recipient. This provision is effective for any divorce or separation instrument executed after December 31, 2018, or any divorce or separation instrument executed before that date but modified after that date.
- Qualified bicycle commuting reimbursements are suspended for taxable years beginning after December 31, 2017 and before January 1, 2026.
- During 2018-2025, the 50% percent deduction for food and beverage expenses associated with a trade or business is extended to expenses of an employer associated with providing food and beverages to employees through an eating facility that meets the requirements for a de minimis fringe and the convenience of the employer standards.
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The Tax Bill doubles the estate and gift tax exemption amount by doubling the basic exclusion amount. The basic exclusion amounts for 2017 and 2018 after indexing for inflation are $5.49 million and $5.6 million, respectively. After doubling under the Tax Bill, the basic exclusion for individuals is $11.2 million in 2018, per individual. The exemption for married individuals is $22.4 million in 2018. This provision is effective for deaths and gifts made after December 31, 2017 and before January 1, 2026. The generation-skipping taxes and the step-up in basis to beneficiaries are retained.
Applicable educational institutions, even though they are public charities, will be subject to a 1.4% tax on their net investment income. An applicable educational institution must have at least 500 students during the preceding taxable year and have assets per student in their endowment funds (other than assets used in carrying out the institution’s exempt purposes) of at least $500,000 per student at the end of the preceding taxable year. Also, more than 50% of students must be located in the United States.
The unrelated business taxable income of a tax-exempt organization will include expenses paid or incurred for a qualified transportation fringe benefit, a parking facility used in connection with qualified parking, or on premises athletic facilities.
Corporate Tax Rate. The Tax Bill lowers the corporate tax rate to a flat 21% beginning in 2018. As we mentioned in our prior Alert, one consequence of this is that expenditures will be more valuable under the current Code than under the changes made by the Tax Bill, which means that corporations will be looking for ways in which to accelerate deductions by year end. The Tax Bill also repeals the corporate alternative minimum tax.
Pass-Through Rate. With respect to taxation of pass-through income to partnerships, sole proprietors, and S corporations, the specific deduction is reduced from the current 23% to 20% of qualified business income. The threshold amount for excluding specified service employees from having qualified business income is $157,500 and $315,000 in the case of a joint return (with the same $50,000 and $100,000 phase-outs). The Conference Committee Report indicates the thresholds were lowered from those proposed in the Senate Bill to reduce the number of high income taxpayers who could take advantage of this provision by converting wage income to pass-through income. Specified services include health, law, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners, or which involves the performance of services that consist of investing, investment management or trading or dealing in securities, partnership interests, and commodities. However, engineering and architectural services are not included.
The deductible amount for each qualified trade or business is the lesser of (i) 20% of the taxpayer’s business income, or (ii) the greater of 50% percent of the W-2 wages with respect to the trade or business or the sum of 25% percent of the W-2 wages with respect to the trade or business plus 2.5% of the adjusted basis, immediately after acquisition, of all qualified property. However, if the taxpayer’s income is below the threshold amount specified above with respect to specified services, the limitation based upon wages is disregarded. This deduction is allowed as a deduction in computing taxable income, rather than adjusted gross income, and is available to both itemizers and non-itemizers of deductions.
Qualified business income for a taxable year generally means the net amount of domestic qualified items of income, gain, deduction, and loss with respect to the taxpayer’s qualified businesses. Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount allocated or distributed by a partnership to a partner who is acting other than in his or her capacity as a
partner for services. Qualified business income or loss does not include certain investment-related income, gain, deductions, or loss.
Note that under the Tax Bill’s pass-through rules, individuals in the fields of health, law, consulting, athletics, financial services, brokerage services who choose to operate as independent contractors will be in a better tax position than if they are employees. This type of arbitrage may be an unintended consequence of the Tax Bill. Congress is aware of this issue, but because of the haste by which Republicans believe that they need to act to enact tax reform, the Code provision does not specifically address it. However, the Tax Bill does contain anti-abuse provisions to prevent taxpayers from converting wage income into qualified business income, and it is likely that the IRS will issue regulations as high income taxpayers performing specified services look for creative ways to take advantage of the favorable pass-through rates. Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Further, if a number of individuals were to form a partnership or LLC together, the amount of their qualified business income cannot include any guaranteed payment for services rendered with respect to the trade or business. In order to have the more advantageous tax treatment apply, the individuals will need to somehow structure their compensation so that it will not constitute guaranteed payments, as determined under the Code’s partnership rules. Also, the IRS is likely to view with skepticism claims by an individual who was formerly an employee and who separated from service and prospectively claims to be an independent contractor if he or she is conducting his or her daily activities in substantially the same manner before and after his or her purported change in status.
Partnership Profits Interests. With respect to the three-year holding period for long-term capital gains treatment for applicable partnership interests, the three- year holding period applies even if the taxpayer has included an amount in income under Coode Section 83, or made an election under Code section 83(b).
Affordable Care Act
The individual mandate under the ACA – the requirement to obtain a basic level of health insurance coverage or pay a penalty – is repealed for months beginning after December 31, 2018. There is a concern that if there is no penalty, healthy individuals will no longer participate in the individual market. As a result, premiums will rise, and it is anticipated that the number of uninsured individuals will increase. Although the Congressional Budget Office does not believe that the repeal of the individual mandate will cause carriers to exit the market, some states have voiced concerns.
Conclusion – Planning for Year-End
The Tax Bill may prompt taxpayers to engage in year-end tax planning and strategizing. With the highest individual tax bracket lowered to 37%, pass-throughs that have joint income less than $315,000 deducting 20% of their qualified business income, accelerating deductions into 2017 may make sense.
Pre-paying state and local income taxes owed in 2018 is not an option since the tax Bill specifically provides such amounts will not be deductible in 2017.
Pass-through entities may also want to consider deferring business income until 2018.
With the House and Senate voting now completed, the Tax Bill will be sent to the President for signature.