On Friday, December 15, the U.S. House of Representative and Senate conferees reached agreement on the Tax Cuts and Jobs Act (H.R. 1) (the "Final Bill"), and released legislative text, an explanation, and the Joint Committee on Taxation estimated budget effects (commonly referred to as the "score"). Next week the House and Senate are each expected to pass the bill, and it is expected to be sent to the President for signature the following week. As the conferees actually signed the conference text, changes (even of a limited and/or technical nature) are extremely unlikely at this point.
The Final Bill largely follows the Senate bill, but with certain important differences. We outline some of the most significant differences between the Final Bill, the earlier House bill, and the Senate bill. We then discuss in detail some of the most significant provisions of the Final Bill. The provisions discussed are generally proposed to apply to tax years beginning after December 31, 2017, subject to certain exceptions (only some of which are noted below). While we discuss some of these provisions in detail, we do not address all restrictions, exclusions, and various other nuances applicable to any given provision.
SUMMARY OF SIGNIFICANT CHANGES IN THE FINAL BILL
- Under the Final Bill, the corporate tax rate is 21%, which is higher than the 20% rate in both bills. The rate will take effect as of January 1, 2018. (The Senate bill would have reduced the rate as of January 1, 2019.)
- Initially, interest deductions will generally be limited to 30% of earnings before interest, taxes, depreciation, and amortization ("EBITDA"); beginning January 1, 2022, the deduction will be limited to 30% of earnings before interest and taxes ("EBIT"). The EBITDA formula is more generous to taxpayers.
- The deduction for qualified pass-through business income generally follows the Senate bill except that the deduction is set at 20% for a maximum effective rate of 29.6% ([100% – 20%] * 37% = 29.6%). The Senate bill proposed a 23% deduction.
- The threshold to avoid the W-2 wage limitation and the "specified trade or business" exclusion is reduced to $315,000 (joint return) or $157,500 (single taxpayer). The W-2 wage limitation is modified to be the greater of the individual's share of (a) 50% of the W-2 wages of the pass-through business or (b) the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition, of depreciable tangible property used in the production of qualified business income.
- The definition of specified service trade or business is modified to exclude engineering and architecture services (so that engineers and architects benefit from the pass-through deduction) and takes into account the reputation or skill of owners (and not only employees, as under the Senate bill). As a result, the owners of a pass-through business with taxable income in excess of $315,000 (for joint filers) that depends on the reputation or skill of its employees generally will not qualify for the pass-through deduction.
- The deduction sunsets for tax years beginning after December 31, 2025.
- The Final Bill repeals the corporate alternative minimum tax ("AMT"). The Senate bill would have preserved the AMT.
- The tax rates for the one-time deemed repatriation of foreign earnings are increased to 8% on non-cash assets (up from 7.5% in the Senate bill) and 15.5% on cash assets (up from 14.5% in the Senate bill).
- The Final Bill does not include the proposal to limit disproportionate net interest expense deductions for U.S. members of worldwide affiliated groups that had been contained in the Senate and House bills.
- The Final Bill retains section 956. Both the Senate bill and the House bill would have repealed section 956 as to U.S. corporate shareholders.
- Under the Final Bill, the "active trade or business" exception to gain recognition under section 367 will be repealed. Accordingly, gain (but not loss) will be required to be recognized when a U.S. taxpayer transfers appreciated property to a foreign corporation in a transaction that would otherwise qualify as tax-free, even if used in an active trade or business, unless another exception applies.
- The Final Bill does not include the provision in the Senate bill that would have permitted a CFC to distribute intangible property to a corporate shareholder without recognizing gain (and therefore without causing its United States shareholders to recognize gain).
- The Final Bill does not accelerate the worldwide interest allocation rules (and they will continue to go in effect after December 21, 2020).
- The Final Bill does not include a provision in the House and Senate bills that would have made permanent the look-through rule for payments of dividends, interest and equivalents, rents, and royalties from one CFC to another CFC.
- The top rate has been reduced to 37% from 39.6% under current law. The Senate bill proposed a top rate of 38.5%.
- The Final Bill follows the Senate bill and repeals the Affordable Care Act's "individual mandate."
- The Final Bill follows the Senate bill with respect to the child tax credit ($2,000 per eligible dependent), except that it increases the refundable portion of the child tax credit to $1,400 (from $1,100 under the Senate bill), and reduces the phase out to $400,000 for married taxpayers and $200,000 for single individuals (from $500,000 for all taxpayers under the Senate bill).
- The Final Bill increases the individual AMT exemption amount to $109,400 for married taxpayers ($70,300 for single taxpayers) from $84,500/$54,300 under current law, and increases the AMT exemption phase-out to $1,000,000 (joint filers) and $500,000 (all other taxpayers) from $160,900 and $120,700, respectively.
- The Final Bill limits the deduction for state and local taxes paid to an aggregate cap of $10,000 for property taxes and either income or sales taxes. The House and Senate bills capped the deduction at $10,000, but would have limited it to property taxes only.
- The Final Bill reduces to $750,000 the amount of acquisition indebtedness on which taxpayers may deduct home mortgage interest (from $1 million under current law).
- The current law 10% adjusted gross income ("AGI") floor for medical expense deductions will be lowered temporarily from 10% to 7.5% for tax years beginning after December 31, 2016, and ending before January 1, 2019, after which the medical expense deduction will be retained as under current law.
- Most changes to taxation of individuals (excluding ACA individual mandate repeal) sunset for tax years beginning after December 31, 2025.
DETAILED DISCUSSION OF THE FINAL BILL
I. BUSINESS PROVISIONS.
21% tax rate on corporate income beginning in 2018; corporate AMT repealed.
The Final Bill permanently reduces the corporate tax rate from 35% to 21% effective for tax years beginning after December 31, 2017. (The House and Senate bills had proposed a reduction to 20%, although the Senate bill would have delayed introduction of the new rate until 2019.) The Final Bill also eliminates the special fixed rate of 35% for personal service corporations.
The Final Bill follows the House bill and repeals the corporate alternative minimum tax ("AMT") entirely.
Correlative reduction of corporate dividends received deduction ("DRD").
Under the Final Bill, the amount of dividends received that a corporation could deduct from its taxable income will be reduced to 50%, in the case of 70% deductible dividends under current law, or 65%, in the case of 80% deductible dividends. Combined with the corporate rate reduction to 21%, the effect is to preserve the rate of tax for a corporate shareholder entitled to a 70% deduction under current law at 10.5%1 and increase the rate slightly for a corporate shareholder entitled to the 80% DRD under current law from 7% to 7.35%.2 A corporation will continue to deduct 100% of the dividends received from another corporation within the same affiliated group.
Net business interest deductions limited to 30% of earnings before interest and taxes.
Under the Final Bill net business interest deductions will generally be limited to 30% of a taxpayer's adjusted taxable income, which before January 1, 2022 is calculated under a formula similar to earnings before interest, taxes, depreciation, and amortization ("EBITDA"), and on after January 1, 2022 under a formula similar to earnings before interest and taxes ("EBIT"). The House bill had used the EBITDA formula permanently and the Senate bill had used the EBIT formula permanently. Excluded interest deductions could be carried forward indefinitely. "Business interest" will include any interest paid or accrued on indebtedness "properly allocable to a trade or business" but will not include "investment interest" (as described in section 163(d)). However, floor plan financing interest, i.e., interest paid or accrued on indebtedness used to finance the purchase of motor vehicle inventories, will not be subject to the limitation.
The limitation will not apply to taxpayers with gross receipts of $25 million or less, or to certain regulated public utilities. Additionally, real property development, construction, rental property management, or similar companies may elect out of this limitation.
For a partnership, the limitation will be applied at the partnership level, applying additional rules to prevent any double counting of the deduction and to allow for an increased deduction limit for excess taxable income applying rules similar to those in current section 163(j). For a group of affiliate corporations filing a consolidated return, the limitation similarly applies at the consolidated return level.
NOL deductions limited to 80% of taxable income beginning in 2018.
The Final Bill limits deductions for net operating losses ("NOLs") to 80% of taxable income for any tax year. (Both the House and Senate bills had proposed a 90% limitation, although the Senate bill would have further reduced the limitation to 80% for tax years beginning after December 31, 2022.) NOLs will no longer expire after 20 years but will be carried forward indefinitely to future tax years; however, the current two-year carryback of NOLs will no longer be available to most taxpayers. The current rules for NOLs (i.e., ability to carry back 2 years, carry forward 20 years, and offset 100% of taxable income) will continue to apply to property and casualty insurance companies.
The Final Bill does not include an inflation adjustment for amounts carried forward (proposed in the House bill).
Denial of nonrecognition for like-kind exchanges of personal property.
The Final Bill, like both the House and Senate bills, limits nonrecognition treatment under section 1031 to like-kind exchanges of real property. Non-simultaneous transfers not completed by December 31, 2017 will be grandfathered, so long as the taxpayer has either received or disposed of the property to be exchanged on or before December 31, 2017.
Temporary full expensing of business assets; other cost recovery changes.
Temporary 100% expensing for certain business assets.
The Final Bill allows 100% expensing of the cost of certain business property placed into service after September 27, 2017 and before January 1, 2023. The Final Bill follows the House bill in allowing immediate expensing for used as well as new eligible property; the analogous Senate bill provision applied only to new property. Beginning in 2023, the immediate first-year expensing will be reduced to 80%, followed by 60% in 2024, 40% in 2025, 20% in 2026, and reduced to 0% thereafter. A transition rule in the Final Bill allows taxpayers to elect to expense 50% of the cost of eligible business property rather than the full 100% for their first tax year beginning after September 27, 2017.
Under the Final Bill, immediate expensing will be available only to taxpayers subject to the net interest deduction limitation in new section 163(j). Therefore, real estate-related trades and businesses electing out of section 163(j) will not be entitled to immediate expensing under this provision.
Reduced cost recovery periods for qualified improvement property; current recovery periods for residential rental and nonresidential real property retained.
Under the Final Bill, the recovery period for all "qualified improvement property" (including qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) will be standardized at 15 years. The Final Bill preserves cost recovery periods for residential rental and nonresidential real property at, respectively, 27.5 years and 39 years. (The Senate bill would have reduced the recovery period to 25 years in both cases.)
Expansion of section 179 expensing.
The Final Bill follows the Senate bill in permitting immediate expensing for up to $1,000,000 of the cost of qualifying tangible personal property placed into service after December 31, 2017, an increase from the $500,000 cap under current law, but less than the House bill's proposal to allow expensing of up to $5 million. The Final Bill, like the Senate bill, expands the definition of qualified real property eligible for section 179 expensing to include certain improvements (e.g., roofs, heating, and alarms systems) made to nonresidential real property after the property is first placed in service.
The benefit under the Final Bill will be reduced (but not below zero) to the extent the value of qualifying property placed into service exceeds $2,500,000 for the tax year (compared to $2 million under current law). Under the Final Bill, the expansion takes effect for tax years beginning after December 31, 2017 and will be permanent.
Required amortization for specified research and experimental expenditures.
Effective for amounts paid or incurred in tax years beginning after December 31, 2021, the Final Bill will require taxpayers to capital and amortize certain research and experimental expenditures (including software development costs) which, under current law, are immediately deductible. The cost recovery period for these expenditures will be 5 years if related to research conducted within the United States, and 15 years if conducted outside of the United States. Like the House and Senate bills, the Final Bill specifically applies to software development expenditures.
Certain contributions to capital included in gross income.
The Final Bill adopts a proposal from the House bill to treat certain contributions to the capital of a corporation—other than money or stock contributed in exchange for stock or equity—as gross income to the corporation. Generally, the contributions giving rise to gross income will include contributions (i) in aid of construction or otherwise by a customer or potential customer, or (ii) by government entities or civic groups (other than a shareholder). The Final Bill corrects the overbreadth of the House bill, which would have applied in unintended circumstances.
Modification of accounting methods for taxpayers with gross receipts of $25 million or less.
The Final Bill, like the House bill, generally permits taxpayers with gross receipts not exceeding $25 million for the three prior tax years (the "25 million gross receipts test") to elect to use the cash method of accounting. (The Senate bill would have set this cap to $15 million; the maximum under current law is $5 million.) The current exceptions from the required use of accrual accounting for certain categories of taxpayers—including taxpayers that do not satisfy the $25 million gross receipts test—will remain.
Taxpayers satisfying the $25 million gross receipts test will not be required to comply with the specific inventory accounting rules imposed under current section 471 but could instead determine cost of goods sold applying their financial accounting method. Additionally, taxpayers meeting this test will be exempt from the 30% limitation on net interest expense deductions, the uniform capitalization rules under section 263A and, if additional requirements are satisfied, from required use of the percentage-of-completion method of calculating taxable income from certain small construction contracts. The $25 million cap will be adjusted for inflation starting in tax years beginning after December 31, 2018.
Repeal of deduction for domestic production activities.
The Final Bill repeals the deduction for domestic production activities under section 199, effective for taxpayers that are C corporations in tax years beginning after December 31, 2018, and for all other taxpayers in tax years beginning after December 31, 2017.
20% deduction (equivalent to a 29.6% maximum effective rate) for qualified business income of certain pass-through business owners.
The Final Bill largely follows the Senate bill and provides for a maximum effective rate of 29.6% on an individual's domestic "qualified business income" from a partnership, S corporation, or sole proprietorship. Amounts received as dividends from real estate investment trusts ("REITs") and the qualified trade or business income from a "qualified publicly traded partnership" will also be eligible for this deduction. The reduced maximum rate arises from a 20% deduction ([100% – 20%] * 37% proposed top marginal rate = 29.6%) and is slightly lower than the 29.645% maximum rate proposed in the Senate bill, which provided for a 23% deduction ([100% – 23%] * 38.5% proposed top marginal rate = 29.645%). Qualified business losses carry forward to the next tax year and reduce the amount of qualified business income included in determining the amount of the deduction for that year.
Qualified business income is net income and gain arising from a qualified trade or business. Qualified trade or business excludes "specified service trades or businesses" except for taxpayers with taxable income below a given threshold ($315,000 for married individuals filing jointly and $157,500 for single taxpayers). The thresholds in the Final Bill are significantly less than the $500,000 and $250,000 thresholds under the Senate bill.
Specified service businesses include any trade or business activity involving the performance of services in the areas of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business the principal asset of which is the reputation or skill of its employees or owners, or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. The Final Bill omits engineering and architecture from the Senate bill's list of specified service businesses, but expands the list to include businesses whose principal asset is the reputation or skill of its employees or owners (instead of merely employees, as proposed in the Senate bill). "Qualified business income" must be income that would be treated as effectively connected with a U.S. trade or business if earned by a non-U.S. person, and does not include certain forms of "investment" income (e.g., capital gain, most dividends, and interest that is not allocable to a qualified trade or business). However, rental income and royalties are not excluded and may qualify for the pass-through deduction.
The deduction for qualified business income sunsets after December 31, 2025.
Deduction capped at (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of qualified property investment.
The amount of the deduction available to a taxpayer from a partnership or S corporation cannot exceed the greater of (a) 50% of the taxpayer's share of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all "qualified property." "Qualified property" is defined as depreciable tangible property that is held by and available for use in a qualified trade or business at the close of the taxable year, is used in the production of qualified business income, and for which the "depreciable period" has not ended before the close of the tax year. The depreciable period with respect to qualified property is the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date or (b) the last day of the last full year of the applicable recovery period that will apply to the property under section 168 (without regard to section 168(g)).
As a result of the new test, the owners of a pass-through entity with no employees that is engaged in a qualified trade or business can benefit from the deduction (and the 29.6% effective rate) with respect to a return of up to 12.5% per year on its investment in depreciable tangible property. To illustrate, a taxpayer with a $100 qualified property investment will be eligible for a deduction of up to $2.50 (2.5% of $100). If the taxpayer earned a 12.5% return on its capital investment, resulting in qualified business income of $12.50 (12.5% * $100), the taxpayer could deduct 20% of the entire return (20% * $12.50 = $2.50) without exceeding the cap.
The W-2 wage/qualified property limitation will not apply to individuals with taxable incomes at or below $315,000 for married individuals filing jointly or $157,000 for single individuals, and will phase-in completely over the next $100,000 or $50,000, as applicable, of taxable income. Qualified business income earned through a publicly traded partnership and otherwise eligible for the deduction will also not be subject to the limitation.
Other changes to pass-through taxation.
Limitation on active pass-through losses.
The Final Bill follows the Senate bill and provides that deductions for "excess business losses" of flow-through taxpayers (i.e., taxpayers other than C corporations) will not be permitted to offset non-business income of the taxpayer. These losses will be treated as NOLs and carried forward into subsequent tax years. An "excess business loss" is defined as the excess of a taxpayer's aggregate deductions attributable to trades or business of the taxpayer over the sum of the taxpayer's aggregate gross income plus a threshold amount ($500,000 for married individuals filing jointly and $250,000 for single individuals, indexed for inflation). The determination whether a net business loss exceeds the threshold amount is made at the individual partner or S corporation shareholder level.
Changes to substantial built-in loss rules; new limits on allocations of partnership losses.
The Final Bill adopts the proposal in the Senate bill to modify the definition of substantial built-in loss for purposes of section 743(d), which under current law requires a partnership to adjust the basis of partnership assets with substantial built-in losses upon transfer of an interest in the partnership. Under the Final Bill, a substantial built-in loss will exist if a fully taxable disposition of all of the partnership's assets at fair market value will result in an allocation of loss to the transferee in excess of $250,000.
The Final Bill also adopts a proposal in the Senate bill to take into account a partner's distributive share of partnership charitable contributions and foreign taxes paid in determining the basis limitation for an allocation of partnership losses.
Extended 3-year holding period required for carried interests.
Under the Final Bill, individual holders of carried interests will be required to satisfy a 3-year holding period (rather than the one-year period under current law) to qualify for long-term capital gains rates on income in respect of profits interests received in exchange for services. The rule will apply to a partnership interest that is held by or transferred to a taxpayer in connection with the performance by that taxpayer (or a related party) of substantial services for an "applicable trade or business." An "applicable trade or business" is one that is conducted on a regular, continuous, and substantial basis (and may include activity by multiple entities) and consists of the development of certain specified assets or the investment in and/or disposition of specified assets (including identification of specified assets for investment and/or disposition). "Specified assets" include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts, and an interest in a partnership to the extent attributable to specified assets.
The 3-year holding period will apply to allocations of distributive share as well as transfers of partnership interests to related parties (to the extent allocable to capital asset held for 3 years or less).
The provision does not apply to carried interests held directly or indirectly through a corporation, apparently including S corporations
 (100% – 50%) * 21% = 10.5%.
 (100% – 65%) * 21% = 7.35%.
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