November 17, 2017 House tax reform bill and Senate Finance Committee tax reform proposal include new provisions that could impact tax-exempt institutional investors On November 16, 2017, the US House passed its comprehensive tax reform bill titled the "Tax Cuts and Jobs Act" (H.R. 1, and referenced in this Alert as the House bill.) On November 9, 2017, the Senate Finance Committee released the Chairman's Mark of the Tax Cuts and Jobs Acts (referenced in this Alert as the SFC plan). On November 14, 2017, Senate Finance Committee Chairman Orrin Hatch released his modifications to the Chairman's Mark of the Tax Cuts and Jobs Act. The SFC plan adheres to the same basic tax overhaul framework as the tax bill approved by the House but includes significant differences in the design of provisions and their effective dates. Both the House bill and the SFC plan include a number of important changes that would affect tax-exempt institutional investors, whether organized as a trust or a corporation — this Alert reviews these provisions. For more detailed information on other areas, please refer to Tax Alert 2017-1831 for a general discussion of the House bill's provisions, Tax Alert 2017-1907 for a general discussion of the Senate Finance Committee description, Tax Alerts 2017-1841 and 2017-1943 for a detailed discussion of the provisions impacting exempt organizations, Tax Alerts 2017-1840 and 2017-1928 for a detailed discussion of the individual provisions, Tax Alerts 2017-1847 and 2017-1931 for a detailed discussion of the passthrough and partnership-specific considerations, and Tax Alerts 2017-1891 and 2017-1945 for a detailed discussion of the implications for private equity. Discussion Clarification of unrelated business income tax treatment of entities treated as exempt from taxation under Section 501(a) Current law When an organization that is tax-exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to unrelated business income tax (UBIT). It is unclear, however, if the UBIT rules apply to certain state and local government entities (such as public pension plans) that are exempt under Section 115(1) as well as under Section 501(a). Provision The House bill provides that entities tax-exempt under Section 501(a) would be subject to UBIT on unrelated business taxable income, regardless of whether they are also exempt under another Code Section. There is no comparable provision in the SFC plan. Effective date The provision would be effective for tax years beginning after 2017. Implications This provision would remove any ambiguity for "dual status" government-affiliated entities under the respective exemption under Section 501(a) and Section 115(1) and could increase UBIT liabilities for these entities. For example, because of the UBIT partnership look-through rules, dual-status entities invested in partnership vehicles with business activities in lower-tiered partnerships could now face UBIT on such investments, adversely affecting the yield they currently enjoy. Corporate reduction and simplification of income tax rates Current law There are four corporate tax brackets with a top rate of 35%. Provision Both the House bill and SFC proposal would lower the C corporation tax rate to 20%. Effective date The House bill provisions would be effective for tax years beginning after 2017. The SFC plan would delay implementation of the lower corporate tax rate until tax years beginning after 2018. Implications The lower corporate tax rate would be generally favorable for the industry, because the lower effective tax rate would result in increased earnings and capital going forward. Tax rate for individual taxpayers owning businesses organized as passthrough entities Current law Partnerships generally are treated for federal income tax purposes as passthrough entities and are not subject to tax at the entity level. Instead, items of income, gain, loss, deduction, and credit of a partnership are taken into account by partners in computing their taxable income and are taxed at their applicable tax rates. Provision In an effort to assist owners of passthrough entities who are individuals, both the House bill and the SFC plan would change the means of taxing flow through income. The House bill would add a new maximum income tax rate of 25% for individuals on certain net income from passthrough entities, which include partnerships and S corporations. The proposal generally would provide a 25% tax rate for an individual who has passthrough taxable income otherwise subject to a rate higher than 25%. The SFC plan would add a 9% preferential rate, which would be phased in between 2018 and 2022. The SFC plan would also provide a 17.4% deduction of domestic qualified business income from a passthrough entity. Effective date The provisions would be effective for tax years beginning after December 31, 2017. Implications Both the House and SFC proposals appear to be specific to individuals. Therefore, on first view of the current proposals, institutional investors appear to be required to pay tax on partnership investment income at the same rates as regular corporate or trust taxable income. However, unlike the House bill, which provides a separate tax rate that applies only to individuals, the SFC plan would create a phantom deduction to achieve some after-tax target result. We have seen this before with Section 199 (which is proposed to be repealed). Given the generalities of the SFC plan description, it is unclear whether this deduction would apply to taxpayers other than individuals. Reduction and simplification of estate and trust income tax rates Current law Four federal income tax brackets apply for estates and trusts for tax year 2017: 15%, 25%, 35%, and 39.6%. The applicable income tax bracket for an estate or trust depends upon its income level. In the case of an estate or trust, any adjusted net capital gain that otherwise would be taxed at the 10% or 15% rate is not taxed. Any adjusted net capital gain that otherwise would be taxed at rates over 15% and below 39.6% is taxed at a 15% rate. Any adjusted net capital gain that otherwise would be taxed at a 39.6% rate is taxed at a 20% rate. The bracket thresholds are indexed for inflation using a measure of the consumer price index for all-urban consumers. Provision Although the tax bracket amounts would not immediately change under the House bill, the tax rate for estates and trusts applied to the first bracket amount would be reduced from 15% to 12%. The 25%, 35% and 39.6% rates would remain the same as under current law. The House bill would also apply three tax rates (0%, 15% and 20%) to capital gain income of estates and trusts based on the amount of gain. The SFC plan similarly would retain the current four income tax brackets but would change the rates to 10%, 25%, 35% and 38.5%. Under both the House bill and the SFC plan, the brackets would be indexed for inflation using the Chained Consumer Price Index (CPI) instead of the current CPI. Chained CPI takes into consideration substitutions consumers make in response to rising prices of certain goods and services. Effective date The proposals would be effective for tax years beginning after December 31, 2017. Implications The House bill would effectively cut the rate for the first $2,550 of income by 3% whereas the SFC plan would reduce the rate by 5%. The SFC plan would also reduce the highest marginal rate from 39.6% to 38.5%. In addition, the capital gains tax rate would be adjusted. Although a discussion of the consumer price index (CPI) is beyond the scope of this Alert, the chained CPI proposed for use under both proposals takes into consideration substitutions that consumers make in response to rising prices of certain goods and services. The result is that the brackets would generally rise slower than they otherwise would under the CPI. Excise tax based on investment income of private colleges and universities Current law The Section 4940 excise tax on net investment income that applies to private foundations does not apply to public charities, including colleges and universities with substantial investment income. Provision Under both the House bill and the SFC plan, a 1.4% excise tax would be applied for each tax year on the net investment income of an "applicable educational institution." Net investment income would be determined using rules similar to the rules of Section 4940(c), relating to the net investment income of a private foundation. An "applicable educational institution" would be defined as an institution: (1) that has at least 500 tuition-paying students during the preceding tax year; (2) that is an eligible education institution as described in Section 25A; (3) that is not described in the first section of Section 511(a)(2)(B) of the Code (i.e., generally state colleges and universities); and (4) the aggregate fair market value of the assets of which at the end of the preceding tax year (other than those assets that are used directly in carrying out the institution's exempt purpose) is at least $250,000 per student. The number of students of an institution would be based on the daily average number of full-time students attending the institution, with part-time students being taken into account on a full-time student equivalent basis. For purposes of determining whether an institution meets the asset-per-student threshold and determining net investment income, assets and net investment income would include amounts with respect to an organization that is related to the institution. An organization would be treated as related to the institution for this purpose if the organization: (1) controls, or is controlled by, the institution; (2) is controlled by one or more persons that control the institution; or (3) is a supported organization or a supporting organization during the tax year with respect to the institution. The Senate Finance Committee Chairman made a further amendment to the SFC plan on November 16, 2017 clarifying that the related-party rule of this provision applies only to assets held for the educational institution and to investment income that relates to assets held for the educational institution. Effective date Under both the House bill and the SFC plan, the provision would be effective for tax years beginning after December 31, 2017. Implications This provision would effectively treat certain private universities as private foundations subject to the Section 4940 excise tax on their net investment income, even though the university may itself be classified as a public charity. Importantly, it appears that the assets held by certain related organizations would be included in determining whether the asset threshold test is met. Further, investment income earned by such related organizations on assets held for the benefit of the college or university would be subject to the tax, even though there might not be direct control over that related entity such as with a supporting organization. Unrelated business taxable income separately computed for each trade or business Current law When an organization that is tax-exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to unrelated business income tax (UBIT). Under current regulations, in determining unrelated business taxable income (UBTI), an organization that operates multiple unrelated trades or businesses aggregates income from all such activities and subtracts from the aggregate gross income the aggregate of deductions. As a result, an organization may use a deduction from one unrelated trade or business to offset income from another, thereby reducing total UBTI. Section 512(b)(12) permits exempt organizations to take a specific deduction of $1,000 in computing unrelated business taxable income. Provision The SFC plan would require organizations operating one or more unrelated trades or businesses to compute unrelated business taxable income separately for each trade or business (without regard to the specific deduction under Section 512(b)(12)). The organization's unrelated business taxable income for a tax year would be the sum of the amounts (not less than zero) computed for each separate trade or business, less the Section 512(b)(12) specific deduction. An organization would be able to claim a net operating loss deduction only with respect to a trade or business from which the loss arose. This provision is not included in the House bill. Effective date The proposal would be effective for tax years beginning after December 31, 2017. Implications The inability to offset losses from one business against gains from another (or against gains and losses from alternative investments in passthrough entities) would likely increase a tax-exempt organization's overall UBIT burden. It is unclear whether each investment partnership would be considered a separate trade or business, which could have significant consequences to institutional investors. This may prompt significant restructuring and other planning for tax-exempt organizations with multiple activities and taxable subsidiaries to minimize the impact or enable taxable entities to absorb losses that would now otherwise not be available as offsets. Repeal of individual and corporate alternative minimum tax Current law Current law requires taxpayers to compute their income tax obligation in two ways — to determine both the regular income tax amount and the alternative minimum tax (AMT) — and to remit the higher of those two amounts as their income tax liability for the year. Alternative minimum taxable income (AMTI) is the taxpayer's regular taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. For individual taxpayers, estates, and trusts, the two AMT brackets in 2017 are 26% (applied to the first $187,800 of AMT income) and 28% (applied to AMT income over $187,800). An exemption amount applies against AMTI. That amount is $24,100 for tax years beginning in 2017, which is phased out depending on the amount of AMTI. For corporate taxpayers, tentative minimum tax is computed at the rate of 20% on the alternative minimum taxable income in excess of a $40,000 exemption amount that phases out depending on the amount of AMTI. Provision The House bill and SFC plan would call for the repeal of the AMT. In the House bill, taxpayers with AMT credit carryforwards generally would be permitted to claim a refund of 50% of the remaining credits in the 2019, 2020, and 2021 tax years, and could claim any remaining credits beginning in 2022. Under the SFC plan, taxpayers with AMT credit carryforwards generally would be permitted to claim a refund of 50% of the remaining credits for any tax year between 2018 and 2021, and could claim 100% of any remaining credits beginning in 2021. Effective date Both the House bill and SFC plan would be effective for tax years beginning after December 31, 2017. Implications Both the House and the SFC appear to agree that repeal of the AMT is a necessary component of tax reform. Gratefully, both chambers would also allow for a slow release of unused AMT credit carryforwards. The repeal of the AMT is certainly a positive step toward making tax compliance simpler. Of course, for certain taxpayers, it would be replaced with the preferential rate (or phantom deduction) on pass-through business income and a fourth loss limitation provision (three loss limitations already exist). Interestingly, the AMT would not really be repealed. It is more akin to the Rip Van Winkle of tax systems. Because Congress is using budget reconciliation, the separate AMT regime can only be repealed for 10 years. So, to some extent, the AMT would not really be repealed; it would merely be put to sleep for a while. Because the AMT could return in 10 years, taxpayers will likely continue to keep two sets of books to determine, for example, AMT tax basis. If all of the current AMT provisions spring back into effect in 10 years, taxpayers will need to know if there is a gain/loss difference in assets that are sold after its "awakening." Repeal of deduction for personal exemptions Current law Current law allows a taxpayer to claim a personal exemption for an individual taxpayer, his or her spouse, and any dependents. The amount that may be deducted for each personal exemption in the 2017 tax year is $4,050. The personal exemption begins to phase out for taxpayers at certain income levels: single taxpayers beginning at $261,500; head-of-household beginning at $287,650; married couples filing jointly beginning at $313,800; and married taxpayers filing separately beginning at $150,000. While the deductions are defined as personal exemptions, an estate is allowed a deduction of $600, and a trust is allowed a deduction of $100, or $300 if it is required to distribute all its income currently. Provision Both the House bill and SFC plan would repeal the personal exemption deduction and phase-out. Effective date The repeal would be effective for tax years beginning after 2017. Implications The House bill would repeal the deduction for personal exemptions as defined in Section 151. However, Section 642(b) would be amended to allow the continued $600, $100 and $300 deductions available to estates and trusts and would redefine them as a "Basic Deduction" instead of a deduction for personal exemption. The SFC plan would simply repeal the deduction for personal exemption. It remains unclear whether the SFC plan would redefine the estate and trust personal exemption to allow the basic deduction to remain in place. Eliminating this basic deduction would result in a small tax increase for those entities. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg ———————————————
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